FIN415 Class Web
Page, Spring '25
Jacksonville
University
Instructor:
Maggie Foley
The
Syllabus Overall Grade Calculator (FYI)
Term Project Part I
(due with final)
Term
project part II (excel questions) (due
with final)
Weekly SCHEDULE,
LINKS, FILES and Questions
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Week |
Coverage, HW, Supplements -
Required |
Supplemental Reaching Materials |
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Marketwatch Stock Trading Game (Pass
code: havefun) 1. URL for your game: 2. Password for this private game: havefun. ·
Click on the 'Join Now' button to get started. ·
If you are an existing MarketWatch member, login. If
you are a new user, follow the link for a Free account - it's easy! ·
Follow the instructions and start trading! 3. Game will be over
on 4/25/2025 5. Game
·
Mutual Fund
Selection Game (FYI) ·
Order Type Explained
Game (FYI) 6. Youtube Instructions · How to Use
Finviz Stock Screener (youtube, FYI)
· How To Win
The MarketWatch Stock Market Game (youtube, FYI)
· How Short
Selling Works (Short Selling for Beginners) (youtube,
FYI)
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The Implications of Trump's Return on U.S.
Trade Policy: Will Tariffs and Trade Wars Resurface? Background Trump's
presidency (2017-2021) featured aggressive trade policies, including
significant tariffs on China and other trading partners, renegotiations of
trade agreements, and discussions about protecting American manufacturing
through quotas and tariffs. Discussion Topics ·
U.S.-China
Trade Relations:
What would a potential second Trump presidency mean for the ongoing
U.S.-China trade war and the tariffs imposed during his first term? ·
Impact
on Global Supply Chains:
How would renewed tariffs or quotas affect global supply chains, especially
in key sectors like technology, agriculture, and automotive manufacturing? ·
Trade
Protectionism vs. Free Trade: Analyzing the economic and political implications of shifting
back toward protectionist policies. ·
Geopolitical Strategies: How might Trump's trade
policies impact relations with allies and adversaries in a changing global
landscape?
Key
Insights
1.
Jobs:
2.
Cost of Living: ·
Prices rise for everyday goods (e.g.,
food, clothes, electronics) when tariffs increase import costs. ·
Higher energy costs can have widespread
effects across industries. 3.
Availability of Goods: ·
Imported goods (e.g., seasonal produce,
luxury cars, and tech gadgets) may become limited or delayed. ·
Domestic alternatives might not match
global competition in terms of quality, price, or innovation. Now,
let’s work on this survey about tariffs. Tariff Survey Game: Tariff Trade Simulation
A simple game No Homework on the topic of Tariff |
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Chapter 1 – Part
1 - World Economy Review of 2024
https://www.imf.org/en/Publications/WEO/weo-database/2024/October/select-country-group Currency Performance Analysis: Changes
from January 1, 2024, to December 31, 2024
https://www.exchange-rates.org/exchange-rate-history/eur-usd-2024 In Class
Discussion Questions Curency_jigsaw_game Self-Produced
Video
Quiz
Homework - Chapter 1-1 (due with the
first midterm exam):
1)
How
tariffs affect trade balances (exports vs. imports) 2)
The
impact of reduced imports on foreign demand for the dollar 3)
How
tariffs might influence global investor confidence in the U.S. economy. 2 Do you prefer a strong dollar or a
weak dollar? Why? ·
Advantages
of a strong dollar:
I.
Cheaper imports for consumers.
II.
Increased purchasing power for U.S. travelers abroad. ·
Advantages of a weak dollar:
I.
Boosts U.S. exports by making them more competitive globally.
II.
Supports domestic manufacturing and job creation. ·
Discuss which groups (e.g., consumers, exporters, travelers) benefit
from each scenario and why you hold your preference. Submission Requirements: Write a 250-300 word response addressing both
parts of the assignment.
Hint:
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Part 2 - In class exercise – practice of
converting currencies 1. If the dollar
is pegged to gold at US $1800 = 1 ounce of gold and the British pound is
pegged to gold at £1200 = 1 ounce of gold. What should be the exchange rate
between US$ and British £? How much can you make without any risk if the
exchange rate is 1£ = 2$? Assume that your initial investment is $1800. What
about the exchange
rate set at 1£ = 1.2$? Solution: 1£ = 2$ (note
that the exchange rate is set at 1£ = 1.5$ since $1800 = £1500=1 ounce of
gold è $1.5=1£). è With $1800, you can buy 1 ounce of gold at US $1800
= 1 ounce of gold. èWith
one ounce of gold, you can sell it in UK at £1200 = 1 ounce of gold, so you can
get back £1200 è convert £ to $ at $2=1£ as given èget back £1200 * 2$/£ = $2400 > $1800, initial
investment è you could make a profit of $600 ($2400 -
$1800=$600) è Yes. 1£ = 1.2$ (note
that the exchange rate is set at 1£ = 1.5$ since $1800 = £1500=1 ounce of
gold è $1.5=1£). è With $1800, you can buy either 1 ounce of gold at US
$1800 = 1 ounce of gold. è With
one ounce of gold, you can sell it in UK at £1200 = 1 ounce of gold, so you
can get back £1200 è convert
£ to $ at $1.2=1£ as givenèget
back £1200 * 1.2$/£ = $1440 < $1800 è you will lose $360 ($1440 - $1800=$-360) è No. è So should convert to £ first and then buy gold in
UK è With $1800, you can convert to £1500 ($1800 /
(1.2$/£ = £1500 ). è buy
gold in UK at £1200 = 1 ounce of gold, so you can get back £1500/£1200 = 1.25
ounce of gold è Sell gold in US at US $1800 = 1 ounce of
gold è So get back 1.25 ounce of gold * $1800 = $2250 > $1800 è you will make a profit of $450 ($2250 -
$1800=$450) è Yes. 1. If the Euro (EUR) to US Dollar
(USD) exchange rate is 1.18, and the US Dollar to Japanese Yen (JPY) exchange
rate is 110, what is the implied exchange rate between Euro and Japanese Yen?
Answer: The implied exchange rate
between Euro and Japanese Yen is approximately 129.80 (110 * 1.18). Explanation: ·
1
EUR = 1.18 USD; 1 USD = 110 JPY. So
1.18 USD/EUR * 110 JPY/USD = 1.18 * 110 = 129.80 JPY/EUR (one EUR =
129.80 JPY) ·
Or,
1 EUR = 1.18 USD è 1 USD = (1/1.18) EUR; 1USD
= 110 JPY, so è (1/1.18)EUR = 110 JPY è 1 EUR = 110/(1/1.18) =
129.80 JPY 2. If the Euro to the British
Pound (GBP) exchange rate is 0.85, and the Swiss Franc (CHF) to Euro exchange
rate is 1.10, what is the implied exchange rate between British Pound and
Swiss Franc? Answer: The implied exchange rate
between British Pound and Swiss Franc is approximately (1/0.85)/1.1 = 1.07 CHF/GBP è one GBP is worth 1.07 CHF Explanation: ·
1
EUR = 0.85 GBPè 1 GBP = (1/0.85) EUR, 1
CHF = 1.10 EUR, so (1/0.85) EUR/ GBP / 1.1 EUR/CHF = (1/0.85)/1.1 CHF/EUR =
1.07 CHF/GBP ·
Or
1 EUR = 0.85 GBP, 1 CHF=1.1 EUR è 1 EUR = (1/1.1) CHF, so 1
EUR = 0.85 GBP = (1/1.1) CHF è 1 GBP = (1/1.1)/0.85 =
1.07 CHF 3. If the Australian Dollar
(AUD) to US Dollar exchange rate is 0.75, and the Canadian Dollar (CAD) to US
Dollar exchange rate is 1.25, what is the implied exchange rate between
Australian Dollar and Canadian Dollar? Answer: The implied exchange rate
between Australian Dollar and Canadian Dollar is 0.60 (0.75 / 1.25). Explanation: ·
1
AUD = 0.75 USD, 1 CAD = 1.25 USD, So 1 AUD can get 0.75 USD, and since 1 USD
can get (1/1.25=0.8) 0.8 CAD, so 1 AUD = 0.75 *(1/1.25) = 0.6 CAD. So one AUD
is worth 0.6 CAD. ·
Or,
0.75USD/AUD * (1/1.25) CAD/USD = 0.75 * 0.8 CAD/AUD = 0.6 CAD/AUD 4.
Are there any arbitrage opportunities based
on the information provided below? Why or why not?
Homework chapter1-2 (due with the first
midterm exam) 1.
If the dollar is pegged to gold at US $1800 = 1 ounce of
gold and the British pound is pegged to gold at €1500 = 1 ounce of gold. What
should be the exchange rate between US$ and Euro €? How much can you make
without any risk if the exchange rate is 1€ = 1.5$? (hint: $1800 è get gold
è sell
gold for euro è convert
euro back to $) How much can you make without any risk if
the exchange rate is 1€ = 0.8$? (hint: $1800 è
get euro è buy gold using euro è
sell gold for $) Assume that your initial
investment is $1800. (answer: $1.2/euro, $450, $900) 2.
If USD to the Chinese Yuan (CNY)
exchange rate is 7.35, and USD to the Indian Rupee (INR) exchange rate is
94.20, what is the implied exchange rate between Chinese Yuan and Indian
Rupee, eg 1 CNY = ? INR? (answer: 1
CNY = 12.816 INR) 3.
If the New Zealand Dollar (NZD) to
Australian Dollar (AUD) exchange rate is 1.05, and the Singapore Dollar (SGD)
to New Zealand Dollar exchange rate is 0.94, what is the implied exchange
rate between Singapore Dollar and Australian Dollar? (answer: 1 AUD = 1.013 SGD, or 1 SGD = 0.987 AUD) |
Swiss franc carry trade
comes fraught with safe-haven rally risk (FYI) By Harry Robertson September 2, 20241:03 AM EDTUpdated 5 months ago LONDON, Sept 2 (Reuters) - As investors turn to the Swiss
franc as an alternative to Japan's yen to fund carry trades, the risk of the
currency staging one of its rapid rallies remains ever present. The Swiss franc has long been used in the popular strategy
where traders borrow currencies with low interest rates then swap them into
others to buy higher-yielding assets. Its appeal has brightened further as the yen's has dimmed. Yen
carry trades imploded in August after the currency rallied hard on weak U.S.
economic data and a surprise Bank of Japan rate hike, helping spark global
market turmoil. The Swiss National Bank (SNB) was the first major central bank
to kick off an easing cycle earlier this year and its key interest rate
stands at 1.25%, allowing investors to borrow francs cheaply to invest
elsewhere. By comparison, interest rates are in a 5.25%-5.50% range in
the United States, 5% in Britain, and 3.75% in the euro zone. "The Swiss franc is back as a funding currency,"
said Benjamin Dubois, global head of overlay management at Edmond de
Rothschild STABILITY The franc is near its highest in eight months against the
dollar and in nine years against the euro , reflecting its status as a
safe-haven currency and expectations for European and U.S. rate cuts. But investors hope for a gradual decline in the currency's
value that could boost the returns on carry trades. Speculators have held on to a $3.8 billion short position
against the Swiss franc even as they have abruptly moved to a $2 billion long
position on the yen , U.S. Commodity Futures Trading Commission data shows. "There is more two-way risk now in the yen than there has
been for quite some time," said Bank of America senior G10 FX strategist
Kamal Sharma. "The Swiss franc looks the more logical funding currency
of choice." BofA recommends investors buy sterling against the franc ,
arguing the pound can rally due to the large interest rate gap between
Switzerland and Britain, in a call echoed by Goldman Sachs. The SNB appears set to cut rates further in the coming months
as inflation dwindles. That would lower franc borrowing costs and could weigh
on the currency, making it cheaper to pay back for those already borrowing
it. Central bankers also appear reluctant to see the currency
strengthen further, partly because of the pain it can cause exporters. BofA
and Goldman Sachs say they believe the SNB stepped in to weaken the currency
in August. "The SNB will likely guard against currency appreciation
through intervention or rate cuts as required," said Goldman's G10
currency strategist Michael Cahill. 'INHERENTLY RISKY' Yet the Swissie, as it is known in currency markets, can be an
unreliable friend. Investors are prone to pile into the currency when they get
nervous, thanks to its long-standing safe-haven reputation. Cahill said the franc is best used as a funding currency at
moments when investors are feeling optimistic. A quick rally in the currency used to fund carry trades can
wipe out gains and cause investors to rapidly unwind their positions, as the
yen drama showed. High levels of volatility or a drop in the higher-yielding
currency can have the same effect. The SNB and Swiss regulator Finma declined to comment when
asked by Reuters about the impact of carry trades on the Swiss currency. As stock markets tumbled in early August, the Swiss franc
jumped as much as 3.5% over two days. The franc-dollar pair has proven sensitive
to the U.S. economy, often rallying hard on weak data that causes U.S.
Treasury yields to fall. "Any carry trade
is inherently risky and this is particularly true for those funded with
safe-haven currencies," said Michael Puempel, FX strategist at
Deutsche Bank. "The main risk is that when yields move lower in a
risk-off environment, yield differentials compress and the Swiss franc can
rally," Puempel added. A gauge of how much investors expect the Swiss currency to
move , derived from options prices, is currently at around its highest since
March 2023. "Considering the central banks, you can see how there may
be more sentiment for some carry players to prefer the franc over the
yen," said Nathan Vurgest, head of trading at Record Currency Management. "The ultimate success of this carry trade might still be
dependent on how quickly it can be closed in a risk-off scenario,"
Vurgest said, referring to a moment where investors cut their riskier trades
to focus on protecting their cash. Get the latest news and expert analysis about the state of the
global economy with the Reuters Econ World newsletter. Sign up here. Reporting by Harry Robertson; Editing by Dhara Ranasinghe and
Alexander Smith Key Insights from the
Article:
1.
Swiss Franc as a Funding
Currency:
2.
Carry Trade Dynamics:
3.
Safe-Haven Risks:
4.
Central Bank Influence:
5.
Strategist Views:
6.
Risks of Swiss Franc
Carry Trades:
7.
Investor Sentiment:
This
analysis highlights the opportunities |
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Part III: Multilateral
Trade vs. Bilateral Trade Multilateralism Explained
| Model Diplomacy (youtube)
Game quiz
Key Takeaways:
1.
Multilateral Trade
Agreements:
2.
Bilateral Trade
Agreements:
Homework chapter1-3 (due with first
midterm exam) 1)
What is bilateralism? What is Multilateralism? 2) Do you advocate
for bilateralism or multilateralism as being more suitable for the U.S.
economy? Why Chapter 2 : International Trade Let’s watch this video together. Imports, Exports, and Exchange Rates: Crash Course Economics
#15 (youtube) Topic 1- What is BOP? The balance of payment of a country contains two
accounts: current and capital. The current account records exports and imports of goods and services
as well as unilateral transfers, whereas the capital account records purchase and sale transactions of foreign
assets and liabilities during a particular year. Summary: Current Account: ·
Definition: The current
account represents the country's transactions in goods, services, income, and
current transfers with the rest of the world. ·
Components: A. Trade Balance: The difference between exports and imports
of goods. B. Services: Transactions related to services (e.g.,
tourism, transportation). C. Income: Receipts and payments of interest, dividends, and
wages. D. Current Transfers: Gifts, aids, and remittances. Capital Account: ·
Definition: The
capital account tracks capital transfers and the acquisition or disposal of non-financial
assets. Now includes financial account. ·
Components: A. Capital Transfers: Non-financial transfers (e.g., debt
forgiveness) and financial transfers. B. Acquisition/Disposal of Non-Financial Assets: Sale or purchase
of non-financial assets, such as patents, goodwill, copy rights, etc, and
financial assets, such as FDI, changes in reserves, portfolio investment, and
financial derivative. Balance of Payments (BoP): ·
Definition: The BoP
is a comprehensive record of a country's economic transactions with the rest
of the world over a specific period. ·
Equation: BoP = Current Account + Capital Account ·
Significance: It
indicates whether a country has a surplus or deficit in its transactions with
the rest of the world. Summary: ·
Current Account:
Records day-to-day transactions, including trade, services, income, and
transfers. ·
Capital Account:
Deals with transfers of non-financial and financial assets and capital
transfers. ·
Balance of Payments:
The overall record combining the Current and Capital Accounts, reflecting a
country's economic relationship with the world. |
Multilateral Trade Agreements With Their Pros, Cons and
Examples 5 Pros and 4 Cons to the World's
Largest Trade Agreements https://www.thebalance.com/multilateral-trade-agreements-pros-cons-and-examples-3305949 BY KIMBERLY AMADEO REVIEWED
BY ERIC ESTEVEZ Updated October
28, 2020 Multilateral trade
agreements are commerce treaties among three or more nations. The
agreements reduce tariffs and make
it easier for businesses to import and export. Since they are
among many countries, they are difficult to negotiate. That same broad scope makes them more
robust than other types of trade agreements once all
parties sign. Bilateral agreements are
easier to negotiate but these are only between two countries. They don't
have as big an impact on economic growth as does a multilateral
agreement. 5 Advantages of multilateral
agreements · Multilateral
agreements make all signatories treat each other equally. No country can
give better trade deals to one country than it does to another. That
levels the playing field. It's especially critical for emerging
market countries. Many of them are smaller in
size, making them less competitive. The Most
Favored Nation Status confers the
best trading terms a nation can get from a trading partner. Developing
countries benefit the most from this trading status. · The
second benefit is that it increases trade for every participant. Their
companies enjoy low tariffs. That makes their exports
cheaper. · The
third benefit is it standardizes commerce regulations for all
the trade partners. Companies save legal costs since they follow the same
rules for each country. · The
fourth benefit is that countries can negotiate trade deals with
more than one country at a time. Trade agreements undergo
a detailed approval process. Most countries would prefer to get one
agreement ratified covering many countries at once. · The
fifth benefit applies to emerging markets. Bilateral trade agreements
tend to favor the country with the best economy. That puts the weaker nation
at a disadvantage. But making emerging markets stronger helps the
developed economy over time. As those emerging markets become
developed, their middle class population increases. That creates
new affluent customers for everyone. 4 Disadvantages of multilateral
trading · The
biggest disadvantage of multilateral agreements is that they are
complex. That makes them difficult and time consuming to
negotiate. Sometimes the length of negotiation means it won't take place
at all. · Second,
the details of the negotiations are particular to trade and business
practices. The public often misunderstands them. As a result, they receive
lots of press, controversy, and protests. · The
third disadvantage is common to any trade agreement. Some companies and
regions of the country suffer when trade borders disappear. · The
fourth disadvantage falls on a country's small businesses. A
multilateral agreement gives a competitive advantage to giant
multi-nationals. They are already familiar with operating in a
global environment. As a result, the small firms can't compete. They lay off
workers to cut costs. Others move their factories to countries with a
lower standard of living. If a region depended on that industry, it
would experience high unemployment rates. That makes multilateral
agreements unpopular. Pros
Cons
Examples Some regional trade agreements are
multilateral. The largest had been the North American
Free Trade Agreement (NAFTA), which was ratified on
January 1, 1994. NAFTA quadrupled trade between the United
States, Canada, and Mexico from its 1993 level to
2018. On July 1, 2020, the U.S.-Mexico-Canada Agreement (USMCA) went
into effect. The USMCA was a new trade agreement between the three countries
that was negotiated under President Donald Trump. The Central American-Dominican
Republic Free Trade Agreement was signed on August 5, 2004. CAFTA-DR
eliminated tariffs on more than 80% of U.S. exports to six countries: Costa
Rica, the Dominican Republic, Guatemala, Honduras, Nicaragua, and El
Salvador. As of November 2019, it had increased trade by 104%, from
$2.44 billion in January 2005 to $4.97 billion. The Trans-Pacific
Partnership would have been bigger than NAFTA.
Negotiations concluded on October 4, 2015. After becoming
president, Donald Trump withdrew from the agreement. He promised to
replace it with bilateral agreements. The TPP was between
the United States and 11 other countries bordering the Pacific
Ocean. It would have removed tariffs and standardized business
practices. All global trade agreements
are multilateral. The most successful one is the General
Agreement on Trade and Tariffs. Twenty-three countries signed GATT in
1947. Its goal was to reduce tariffs and other trade barriers. In September 1986, the Uruguay
Round began in Punta del Este, Uruguay. It centered on extending
trade agreements to several new areas. These included services and
intellectual property. It also improved trade in agriculture and
textiles. The Uruguay Round led to the creation of the World Trade
Organization. On April 15, 1994, the 123 participating governments
signed the agreement creating the WTO in Marrakesh, Morocco. The
WTO assumed management of future global multilateral negotiations. The WTO's first project was the Doha round of
trade agreements in 2001. That was a
multilateral trade agreement among all WTO members. Developing countries
would allow imports of financial services, particularly banking. In so
doing, they would have to modernize their markets. In return, the developed
countries would reduce farm subsidies. That would boost the growth
of developing countries that were good at producing food. Farm lobbies in the United States and
the European Union doomed
Doha negotiations. They refused to agree to lower subsidies or accept
increased foreign competition. The WTO abandoned the Doha round in July 2008. On December 7, 2013, WTO
representatives agreed to the so-called Bali package. All countries
agreed to streamline customs standards and reduce red tape to expedite
trade flows. Food security is an issue. India wants to subsidize food so
it could stockpile it to distribute in case of famine. Other countries worry
that India may dump the cheap food in the global market to gain market
share. |
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Part I - What is the current
account? Current vs. Capital Accounts: What's the
Difference? Interactive Game on Current
Account and Capital Account
Balance of payments:
Current account (video, Khan academy) Quiz
1 Quiz
2 https://www.bea.gov/data/intl-trade-investment/international-transactions
The U.S. current-account deficit widened by $35.9 billion, or 13.1 percent, to $310.9 billion in the third quarter of 2024, according to statistics released today by the U.S. Bureau of Economic Analysis. The revised second-quarter deficit was $275.0 billion. The third-quarter deficit was 4.2 percent of current-dollar gross domestic product, up from 3.7 percent in the second quarter.
Capital-Account
Transactions ·
Capital-transfer receipts were $1.6 billion in the third
quarter. The transactions reflected receipts from foreign insurance companies
for losses resulting from Hurricane Helene. For information on transactions
associated with hurricanes and other disasters, see “How do losses recovered from foreign insurance companies
following natural or man-made disasters affect foreign transactions, the
current account balance, and net lending or net borrowing?”.
Capital-transfer payments increased $1.8 billion to $3.3 billion, reflecting
an increase in infrastructure grants. Financial-Account
Transactions ·
Net
financial-account transactions were −$493.6
billion in the third quarter, reflecting net U.S. borrowing from foreign
residents. https://www.bea.gov/news/2024/us-international-transactions-3rd-quarter-2024 Part II - What
is the Capital Account
Balance of payments: Capital account (video,
Khan Academy) Quiz 3 https://fred.stlouisfed.org/tags/series?t=capital+account Chapter
2 part 1 (Due with the first mid term exam) 1.
Can a trade war
help reduce current account deficit? Why or why not? 2.
How do tariffs impact the current account deficit in the context of
ongoing trade disputes? 3.
Below are examples of various
economic activities. Based on each example, determine whether the factor increases
or decreases the current account balance. Write your answers in the
blank space provided. 1)
A local
factory sells more goods overseas, creating jobs and income locally. Effect
on Current Account: ___________ 2)
Workers
abroad send more money back to their families at home. Effect on Current
Account: ___________ 3)
Paying
less interest on loans taken from international lenders. Effect on Current
Account: ___________ 4)
Buying
fewer foreign-made products, such as cars or electronics. Effect on
Current Account: ___________ 5)
More
tourists visit the country and spend money on hotels, food, and services. Effect
on Current Account: ___________ 6)
Buying
more imported products, such as foreign luxury goods. Effect on Current
Account: ___________ 7)
Exporting
fewer goods due to higher costs or less demand abroad. Effect on Current
Account: ___________ 8)
Traveling
abroad and spending more on international vacations. Effect on Current
Account: ___________ 9)
Receiving
less income from foreign investments due to low returns. Effect on Current
Account: ___________ 10)
Paying
more interest on loans owed to foreign banks or investors. Effect on
Current Account: ___________ 11)
Sending
more money to family members living in other countries. Effect on Current
Account: ___________ Optional Homework: 3. Internet
exercises (not required,
information for intereted students only) a. IMF,
world bank and UN are only a few of the major organizations that
track, report and aid international economic and financial
development. Based on information provided in those websites, you could learn
about a country’s economic outlook. · IMF: www.imf.org/external/index.htm · UN: www.un.org/databases/index.htm · World bank: www.worldbank.org’ · Bank of international settlement: www.bis.org/index.htm b. St. Louis
Federal Reserve provides a large amount of recent open economy macroeconomic
data online. You can track down BOP and GDP data for the major industrial
countries. · Recent international economic data: https://research.stlouisfed.org/publications/ Balance of Payments statistics: https://fred.stlouisfed.org/categories/125 |
Current vs. Capital Accounts: What's the
Difference? By
THE INVESTOPEDIA TEAM, Updated June
29, 2021, Reviewed by ROBERT C. KELLY Current
vs. Capital Accounts: An Overview The
current and capital accounts represent two halves of a nation's balance of
payments. The current account
represents a country's net income over a period of time, while the capital
account records the net change of assets and liabilities during a particular
year. In
economic terms, the current account deals with the receipt and payment in
cash as well as non-capital items, while the capital account reflects sources
and utilization of capital. The sum of
the current account and capital account reflected in the balance of payments
will always be zero. Any surplus or deficit in the current account is matched
and canceled out by an equal surplus or deficit in the capital account. KEY
TAKEAWAYS ·
The current and
capital accounts are two components of a nation's balance of payments. ·
The current account
is the difference between a country's savings and investments. ·
A country's capital
account records the net change of assets and liabilities during a certain
period of time. Current Account The
current account deals with a country's short-term transactions or the
difference between its savings and investments. These are also referred to as
actual transactions (as they have a real impact on income), output and
employment levels through the movement of goods and services in the economy. The current account consists of visible trade
(export and import of goods), invisible trade (export and import of services),
unilateral transfers, and investment income (income from factors such as land
or foreign shares). The credit and debit of foreign exchange from these
transactions are also recorded in the balance of the current account. The
resulting balance of the current account is approximated as the sum total of
the balance of trade. Current Account vs. Capital Account Transactions
are recorded in the current account in the following ways: Exports are noted as credits in the balance
of payments Imports are recorded as debits in the
balance of payments The
current account gives economists and other analysts an idea of how the
country is faring economically. The
difference between exports and imports, or the trade balance, will determine
whether a country's current balance is positive or negative. When it is
positive, the current account has a surplus, making the country a "net
lender" to the rest of the world. A deficit means the current account
balance is negative. In this case, that country is considered a net borrower. If
imports decline and exports increase to stronger economies during a
recession, the country's current account deficit drops. But if exports
stagnate as imports grow when the economy grows, the current account deficit
grows. Capital Account The capital account is a record of the
inflows and outflows of capital that directly affect a nation’s foreign
assets and liabilities. It is concerned
with all international trade transactions between citizens of one country and
those in other countries. The
components of the capital account include foreign investment and loans,
banking, and other forms of capital, as well as monetary movements or changes
in the foreign exchange reserve. The capital account flow reflects factors
such as commercial borrowings, banking, investments, loans, and capital. A surplus in the capital account means
there is an inflow of money into the country, while a deficit indicates money
moving out of the country. In this case,
the country may be increasing its foreign holdings. In
other words, the capital account is concerned with payments of debts and
claims, regardless of the time period. The balance of the capital account
also includes all items reflecting changes in stocks. The
International Monetary Fund divides capital account into two categories: The
financial account and the capital account. The term capital account is also used in accounting. It
is a general ledger account used to record the contributed capital of
corporate owners as well as their retained earnings. These balances are
reported in a balance sheet's shareholder's equity section. |
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Topic 2 of Chapter 2 --- Evolution
of international monetary system 1. Finance:
The History of Money (combined) (video, fan to watch) Quiz
2. Timeline of the history of Money:
· Quiz
on Gold Standard
· Quiz
on Bretton Woods System · Quiz
on Exchange Rate Regime
HISTORY OF EXCHANGE RATE SYSTEMS
Videos ·
The Gold Standard Explained in One
Minute (video)
·
The Bretton Woods Monetary System (1944 - 1971) Explained
in One Minute (video) ·
FLOATING AND FIXED EXCHANGE RATE (video)
3.
Bretton Woods Agreement
and System
U.S. Perspective: A Comparison of the Bretton Woods
System and the Post-Bretton Woods System
For class discussion: Why was the Bretton Woods System created
after World War II, and what factors led to its collapse in 1973? (Why the World Abandoned
the Gold Standard, FYI) (Bretton Woods system,
FYI)
|
Bretton Woods Agreement and System By
JAMES CHEN Updated April 28, 2021, Reviewed by SOMER ANDERSON What
Was the Bretton Woods Agreement and System? The Bretton Woods Agreement was
negotiated in July 1944 by delegates from 44 countries
at the United Nations Monetary and Financial Conference held in Bretton
Woods, New Hampshire. Thus, the name “Bretton Woods Agreement.” Under
the Bretton Woods System, gold was the
basis for the U.S. dollar and other currencies were pegged to the U.S.
dollar’s value. The Bretton Woods
System effectively came to an end in the early 1970s when President Richard
M. Nixon announced that the U.S. would no longer exchange gold for U.S.
currency. The
Bretton Woods Agreement and System Explained Approximately
730 delegates representing 44 countries met in Bretton Woods in July 1944 with the principal goals of creating an
efficient foreign exchange system, preventing competitive devaluations of
currencies, and promoting international economic growth. The Bretton Woods
Agreement and System were central to these goals. The Bretton Woods Agreement
also created two important organizations—the International Monetary Fund
(IMF) and the World Bank. While the Bretton Woods System was dissolved in
the 1970s, both the IMF and World Bank have remained strong pillars for the
exchange of international currencies. Though
the Bretton Woods conference itself took place over just three weeks, the
preparations for it had been going on for several years. The primary
designers of the Bretton Woods System were the famous British economist John
Maynard Keynes and American Chief International Economist of the U.S.
Treasury Department Harry Dexter White. Keynes’ hope was to establish a
powerful global central bank to be called the Clearing Union and issue a new
international reserve currency called the bancor. White’s plan envisioned a
more modest lending fund and a greater role for the U.S. dollar, rather than
the creation of a new currency. In the end, the adopted plan took ideas from
both, leaning more toward White’s plan. It wasn't until 1958 that the Bretton
Woods System became fully functional. Once implemented, its
provisions called for the U.S. dollar to be pegged to the value of gold.
Moreover, all other currencies in the system were then pegged to the U.S.
dollar’s value. The exchange rate applied
at the time set the price of gold at $35 an ounce. KEY
TAKEAWAYS ·
The Bretton Woods
Agreement and System created a collective international currency exchange
regime that lasted from the mid-1940s to the early 1970s. ·
The Bretton Woods
System required a currency peg to the U.S. dollar which was in turn pegged to
the price of gold. ·
The Bretton Woods
System collapsed in the 1970s but created a lasting influence on
international currency exchange and trade through its development of the IMF
and World Bank. Benefits
of Bretton Woods Currency Pegging The
Bretton Woods System included 44 countries. These countries were brought
together to help regulate and promote international trade across borders. As
with the benefits of all currency pegging regimes, currency pegs are expected
to provide currency stabilization for
trade of goods and services as well as financing. All
of the countries in the Bretton Woods System agreed to a fixed peg against
the U.S. dollar with diversions of only 1% allowed. Countries were required
to monitor and maintain their currency pegs which they achieved primarily by
using their currency to buy or sell U.S. dollars as needed. The Bretton Woods System, therefore,
minimized international currency exchange rate volatility which helped
international trade relations. More stability in foreign currency
exchange was also a factor for the successful support of loans and grants
internationally from the World Bank. The
IMF and World Bank The
Bretton Woods Agreement created two Bretton Woods Institutions, the IMF and
the World Bank. Formally introduced in December 1945 both institutions have
withstood the test of time, globally serving as important pillars for
international capital financing and trade activities. The
purpose of the IMF was to monitor exchange rates and identify nations that
needed global monetary support. The World Bank, initially called the
International Bank for Reconstruction and Development, was established to
manage funds available for providing assistance to countries that had been
physically and financially devastated by World War II.1
In the twenty-first century, the IMF has 189 member countries and still
continues to support global monetary cooperation. Tandemly, the World Bank
helps to promote these efforts through its loans and grants to governments.2 The Bretton Woods System’s Collapse In 1971, concerned that the U.S. gold
supply was no longer adequate to cover the number of dollars in circulation,
President Richard M. Nixon devalued the U.S. dollar relative to gold. After a
run on gold reserve, he declared a temporary suspension of the dollar’s
convertibility into gold. By 1973 the Bretton Woods System had collapsed. Countries
were then free to choose any exchange arrangement for their currency, except
pegging its value to the price of gold. They could, for example, link its
value to another country's currency, or a basket of currencies, or simply let
it float freely and allow market forces to determine its value relative to
other countries' currencies. The
Bretton Woods Agreement remains a significant event in world financial
history. The two Bretton Woods Institutions it created in the International
Monetary Fund and the World Bank played an important part in helping to
rebuild Europe in the aftermath of World War II.
Subsequently, both institutions have continued to maintain their founding
goals while also transitioning to serve global government interests in the
modern-day. |
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Topic 3: Shall we go back to Gold
Standard for its currency? Play the “Gold Standard Adventure Game” to learn Video: The US should not return
to the gold standard for its currency: Jerome Powell (youtube)
(refer to: https://www.forbes.com/sites/nathanlewis/2020/03/27/what-if-we-had-a-gold-standard-right-now/?sh=1bfba3313e58)
Homework of chapter 2 part ii (due with the first midterm
exam) ·
Do you support returning to gold standard? Why or why not? Hint:
·
What is the Bretton Woods agreement? Why is the Bretton Woods Agreement a
significant event in world financial history? ·
What are
some alternative currencies that have emerged as potential contenders to
challenge the dollar's supremacy? Chinese Yuan? Euro? Yen? Bitcoin?... And
why? (Hint:
according to Why The U.S. Dollar May Be In
Danger (youtube), the three necessary conditions for
a currency to be perceived as a global reserve currency are: An independent
central bank; Strong military backing; A large and liquid debt market).
|
Mar 27, 2020,04:54pm
EDT|30,167 views What
If We Had A Gold Standard System, Right Now? Nathan
LewisContributor https://www.forbes.com/sites/nathanlewis/2020/03/27/what-if-we-had-a-gold-standard-right-now/?sh=1bfba3313e58 For most of the 182 years between 1789 and 1971, the United
States embraced the principle of a dollar linked to gold — at first, at
$20.67/oz., and then, after 1933, $35/oz. Nearly every economist today will
tell you that was a terrible policy. We can tell it was a disaster because,
during that time, the United States became the wealthiest
and most prosperous country in the history of the world. This is economist logic. But, even if some economists might agree with the general
principle, they might be particularly hesitant to apply such monetary
discipline right now, in the midst of economic and financial turmoil. This
kind of event is the whole reason why we put up with all the chronic
difficulties of floating currencies, and economic manipulation by central
banks. Isn't it? So, let's ask: What if we were on a gold standard system, right
now? Or, to be a little more specific, what if we had been on a gold standard
system for the last ten years, and continued on one right now, in the midst
of the COVID-19 panic and economic turmoil? In the end, a gold standard system is just a fixed-value
system. The International Monetary Fund tells us that more than half the
countries in the world, today, have some kind of fixed-value system —
they link the value of their currency to some external standard, typically
the dollar, euro, or some other international currency. They have fixed
exchange rates, compared to this external benchmark. The best of these
systems are currency boards, such as is used by Hong Kong vs. the U.S.
dollar, or Bulgaria vs. the euro. If you think of a gold standard as just a "currency
board linked to gold," you would have the general idea. These currency boards
are functioning right now to keep monetary stability in the midst of a lot of
other turmoil. If you had all the problems of today, plus additional monetary
instability as Russia or Turkey or Korea has been experiencing (or the euro ...),
it just piles more problems on top of each other. Actually, it would probably be easier to link to gold
than the dollar or euro, because gold's value tends to be stable, while the
floating fiat dollar and euro obviously have floating values, by design. If
you are going to link your currency to something, it is easier to link it to
something that moves little, rather than something that moves a lot. Big
dollar moves, such as in 1982, 1985, 1997-98 and 2008, tend to be accompanied
by currency turmoil around the world. But, even within the discipline of a gold standard system, you
could still have a fair amount of leeway regarding central bank activity, and
also various financial supports that arise via the Treasury and Congress. Basically, you could do just about anything that is compatible
with keeping the value of the dollar stable vs. gold. In the pre-1914 era, there was a suite of policies to this
effect, generally known as the "lender of last resort," and
described in Walter Bagehot's book Lombard Street (1873).
Another set of solutions resolved the Panic of 1907, without ever leaving the
gold standard. The Federal Reserve was explicitly designed to operate on a
gold standard system; and mostly did so for the first 58 years of its
existence, until 1971. Others have argued that a functional "free
banking" system, as Canada had in the pre-1914 era, would allow private
banks to take on a lot of these functions, without the need for a central
bank to do so. What could the Federal Reserve do today, while still adhering to
the gold standard? First: It could expand the monetary base, by any amount
necessary, that meets an increase in demand to hold cash (base money). Quite commonly, when
things get dicey, people want to hold more cash. Individuals might withdraw banknotes
from banks. Banks themselves tend to hold more "bank reserves"
(deposits) at the Federal Reserve — the banker's equivalent of a safe full of
banknotes. This has happened, for example, during every major war. During the
Great Depression, the Federal Reserve expanded its balance sheet by a huge
amount, as banks increased their bank reserve holdings in the face of
uncertainty. Nevertheless, the dollar's value remained at its $35/oz. parity. Federal Reserve Liabilities 1917-1941. NATHAN LEWIS Second: The Federal Reserve could extend loans to certain
entities - banks, or corporations - as long as this lending is consistent
with the maintenance of the currency's value at its gold parity. In the pre-1914 era, this was done via
the "discount window." One way this could come about is by swapping
government debt for direct lending. For example, the Federal Reserve could
extend $1.0 trillion of loans to banks and corporations, and also reduce its
Treasury bond holdings by $1.0 trillion. This would not expand the monetary
base. But, it might do a lot to help corporations with funding issues. What the Federal Reserve would not be able to do is: expand the
"money supply" (monetary base) to an excessive amount — an amount
that tended to cause the currency's value to fall due to oversupply, compared
to its gold parity. Now we come to a wide variety of actions that are not really
related to the Federal Reserve, but rather, to the Treasury and Congress. In 1933, a big change was Deposit Insurance. The Federal
Government insured bank accounts. It helped stop a banking panic at the time.
This is a controversial policy even today, and some think it exacerbated the
Savings and Loan Crisis of the 1980s, not to mention more issues in 2008.
But, nevertheless, it didn't have anything to do with the Federal Reserve. In 2009, the stock market bottomed when there was a rule change
that allowed banks to "mark to model" rather than "mark to
market." Banks could just say: "We are solvent, we promise."
It worked. Today, Congress has been making funds available to guarantee
business lending, and for a wide variety of purposes that should help
maintain financial calm. Whether this is a good idea or not will be debated
for a long time I am sure. But, it has nothing to do with the Federal Reserve.
All of these actions are entirely compatible with the gold standard. What about interest rates? Don't we want the Federal Reserve to
cut rates when things get iffy? In the 1930s, interest rates were set by
market forces. Given the economic turmoil of the time, government bond rates,
and especially bill rates, were very low. The yield on government bills
spent nearly
the whole decade of the 1930s near 0%. Markets lower "risk-free" rates
automatically, during times of economic distress, when you just allow them to
function without molestation. Every bond trader already knows this. |
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Why Cryptocurrency Will Never Become
the World’s Primary Currency ·
Economist explains the two
futures of crypto | Tyler Cowen
·
Self produced video: Crypto Cannot Be Cash
·
Self
produced video: The Crypto
Hustle: Easy Money or Easy Mistake?
· Quiz
For class discussion: The
Role of Cryptocurrency in the Future Financial System 1) Will cryptocurrency remain just an investment asset, or
can it become mainstream for daily purchases? 2) What are the biggest technological and social barriers
preventing crypto from replacing cash? 3) What role will blockchain innovation play in shaping the
future of finance? For your information on Blockchain Technology: ·
Private key vs. Public Key: https://www.jufinance.com/game/crypto_wallet.html https://www.youtube.com/watch?v=izwkoczLj3w
(self-produced video) ·
Create your private key at https://www.bitaddress.org/bitaddress.org-v3.3.0-SHA256-dec17c07685e1870960903d8f58090475b25af946fe95a734f88408cef4aa194.html ·
What is Bitcoin Mining?: https://www.jufinance.com/game/bitcoin_mining.html https://www.youtube.com/watch?v=649Jh6-_WdA
(self-produced video) ·
Blockscout: An open-source
block explorer that allows users to search transactions, verify smart
contracts, and analyze addresse https://eth.blockscout.com/?utm_source=chatgpt.com
Homework of chapter 2 part iii (due with the first midterm
exam) Will cryptocurrency ever replace traditional national
currencies? Why or why not?
|
By
Nathan Reiff Updated April 19, 2024
Reviewed by Somer Anderson https://www.investopedia.com/tech/bitcoin-or-altcoin-can-one-them-replace-fiat/ Can Cryptocurrency Replace Fiat? Cryptocurrencies
are treated as a store of value and as money by many people, but to replace
fiat currency, they must overtake fiat's use and acceptance in most
geographies. Between 2020 and 2022, cryptocurrency adoption rates increased
globally. However, rates have since decreased, except in certain geographies. Lower and middle-income (LMI) countries are
where cryptocurrency use is more likely to replace fiat use—coincidentally, according to research, LMIs are where crypto
adoption rates are still increasing. This is most likely because many people
in these areas do not have access to financial services, or the existing
systems suffer from inefficiencies or corruption. Key
Takeaways ·
Developed countries are less likely to adopt cryptocurrencies over
existing fiat currencies. ·
Some people expect cryptocurrency to replace fiat worldwide, but
others are skeptical. ·
Cryptocurrency addresses many issues faced by those in lower and
middle-income countries. ·
The most likely scenario is similar to now, where cryptocurrency
remains convertible with fiat currencies while some countries ban it
altogether. Fiat Currency Issues That Crypto Addresses Many
agencies and regulators define money as anything that is a widely accepted
means of exchange, a store of value, and a unit of account. Fiat currency,
sometimes called real or physical money, has met all three requirements for
over a millennium. However, advancements have already begun to reduce the
need for physical currency in most developed countries. Cryptocurrency
removes many of the requirements in today's financial systems. Here are a
few. The Need to Trust Our
current systems need third parties to issue debit and credit cards or conduct
electronic transfers. Governments, banks, businesses, and people transfer
funds by having a third party, usually a bank, change numbers on the
equivalent of an electronic ledger. These third parties are necessary to
ensure transactions are valid, and the costs of maintaining these financial
systems are high. These
third parties also bring the necessity of trusting someone else with your
money. This trust has been violated on many occasions, and unethical
practices by third parties have even contributed to global financial crises. Cryptocurrency
reduces the need to involve another person to verify transactions and ensure
accuracy. Each party is credited or debited correctly because blockchain
technology and automated consensus mechanisms verify transactions and store
the information in an unalterable way. Decentralization of Control One of
the more significant issues many believe cryptocurrencies address is control
of financial services. Undoubtedly, many people have problems accessing
necessary financial services, with many being denied access for
discriminatory reasons, lack of collateral, or not meeting other requirements
set by lenders. Some
may not have services available in their jurisdictions. However, since even
those considered "unbanked" generally have access to the internet,
decentralized finance applications that use cryptocurrencies can solve many
of these problems. Another
issue many people debate is centralized control of the supply of money. The
argument is that central banks use the amount of circulating money to
influence demand, which messes with exchange rates and purchasing power.
Central banks also control interest rates to attempt to increase or decrease
spending, depending on the inflationary environment. The
belief is that if control is taken away from these central banks, people will
be the ones to influence demand and supply, which will help the currency
maintain a more stable value. Additionally, if money and financial services
become peer-to-peer, it is believed that inflation will be tempered
automatically by the people who are lending to each other. What Would Happen If Cryptocurrency Replaces
Fiat? Cryptocurrencies,
in their current form, transcend borders and regulations, which has both
positive and negative effects. They are not controlled or influenced by
central banks like fiat currencies. Central banks use monetary policy tools
to influence inflation and employment through interest rates and open market
operations. Decentralization, one of the fundamental principles behind
cryptocurrency, removes these tools. Consumers
may not have financial recourse or protections if cryptocurrency, in its
current state, replaces fiat currency. The
effects of completely replacing the tools used by central banks are still
being explored and evaluated. The change could have significant adverse
impacts on economic and financial stability or usher in an era of complete
global stability. The
International Monetary Fund (IMF) recommends against adopting cryptocurrency
as a main national currency in its current state due to price volatility.
Additionally, the organization feels that the risks of macro-financial
stability and lack of consumer protections should be addressed. However,
the IMF does acknowledge that adoption is most likely to occur more rapidly
in countries where cryptocurrency risks are an improvement on the financial system
in place. For
example, many Ukrainians turned to cryptocurrency after fleeing the Russian
invasion in 2022. Without cryptocurrency, many might not have had the money
to survive. It is
also being used by many in countries with severe fiat devaluation to preserve
their savings, send and accept remittances, and conduct business. What Does the Future of Currency Look Like? You can
already exchange cryptocurrency for fiat through exchanges or trades with
other cryptocurrency users. Cryptocurrency continues to gain popularity in
areas that are obviously in need of change, and blockchain use cases,
popularity, understanding, and acceptance continue to grow. The more each is
understood and used, the more value cryptocurrency could have as a means of
exchange. As seen
from cryptocurrency's use, research, and development, it is very likely that
cryptocurrency use worldwide will continue to grow. If
these trends continue, several currency scenarios could emerge. First, a
society and economy could embrace cryptocurrency to the point that the
country's fiat currency would be replaced. Its government would be forced to
recognize it as legal tender and fiat currency would cease to be used. This
is unlikely to occur in most areas. A
second scenario might be a hybrid of digital assets and fiat currency.
Governments could recognize both and be able to collect tax revenues and fund
their programs and militaries. Consumers and businesses could choose
whichever they wanted. This seems the most likely scenario to occur, and in
many areas, it is already the case. Third,
a society could reject cryptocurrency entirely and keep using its established
fiat currency. This scenario might occur, at least regarding cryptocurrency.
However, pressures to address corruption and awareness of blockchain
advancements are guiding societies toward financial systems where information
cannot be altered or faked. It is very likely that blockchain technology,
rather than cryptocurrencies, will become part of existing monetary systems. Lastly,
there might be a mix of governments worldwide that ban cryptocurrency use
entirely, while others allow it to exist and be convertible to fiat currency,
similar to how it is used today. |
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Chapter 3 International Financial Market/ References: Go to www.forex.com and set up a practice account
and you can trade with $50,000 virtue money. Visit http://www.dailyfx.com/to get daily foreign
exchange market news. Part I: international
financial centers *Ranking The ranking is an aggregate of indices
from five key areas: "business environment", "financial sector
development", "infrastructure factors", "human
capital", "reputation and general factors". As of September
2022, the top centres worldwide are:
Part II – Interest Rate Benchmarks: LIBOR
vs. SOFR
·
Secured Overnight Financing Rate (SOFR): https://www.newyorkfed.org/markets/reference-rates/sofr
o The Secured
Overnight Financing Rate (SOFR) is a broad measure of the cost of borrowing cash overnight collateralized by Treasury
securities.
o
The SOFR includes all trades in the Broad
General Collateral Rate plus bilateral Treasury repurchase agreement (repo) transactions cleared through the
Delivery-versus-Payment (DVP) service offered by the Fixed Income Clearing
Corporation (FICC), which is filtered to remove a portion of transactions
considered “specials”. o
The SOFR is calculated as a
volume-weighted median of transaction-level tri-party repo data collected
from the Bank of New York Mellon as well as GCF Repo transaction data and
data on bilateral Treasury repo transactions cleared through FICC's DVP
service, which are obtained from the U.S. Department of the Treasury’s Office
of Financial Research (OFR). · Here's What Went Wrong
With LIBOR (youtube)
·
Libor: Bank of England
implicated in secret recording - BBC News
·
LIBOR vs. SOFR :
Introduction, Scandals & Replacement : The Interest-Rate Benchmark
·
LIBOR VS SOFR (youtube)
Comparisons
2. Key Differences Table
https://www.forbes.com/advisor/investing/what-is-libor Timeline of LIBOR’s Phase-Out Here is
a timeline of LIBOR’s phase-out, showing key
milestones from the 2012 LIBOR scandal to its official cessation on June 30,
2023.
SOFR Calculation from Repo Transactions
Homework - Chapter 3 Part I 1. What does LIBOR stand for, and how
was it used in financial markets? Explain how LIBOR was calculated and why it
was considered unreliable. 2. Describe the role LIBOR played in the
2008 financial crisis. What was the LIBOR manipulation scandal, and which
banks were involved? 3. What is SOFR, and how does it differ
from LIBOR? How is SOFR calculated, and why is it considered more reliable
than LIBOR? 4. A financial institution previously
used LIBOR + 2% for a loan. If LIBOR was 0.5%, what was the total interest
rate on the loan? 5.
If
SOFR is currently 0.3% and a bank charges SOFR + 2% for a similar loan, what is the new
total interest rate? |
What Makes a City a Financial Hub? https://www.investopedia.com/articles/investing/091114/worlds-top-financial-cities.asp A financial center, or a financial hub,
refers to a city with a strategic location, leading financial institutions,
reputed stock exchanges, a dense concentration of public and private banks
and trading and insurance companies. In addition, these hubs are equipped with
first-class infrastructure, communications and commercial systems, and there
is a transparent and sound legal and regulatory regime backed by a stable
political system. Such cities are favorable destinations for
professionals because of the high living standards they offer along with
immense growth opportunities. Here
is a look at the top financial hubs across the globe, in no particular order. KEY
TAKEAWAYS ·
Cities that are
concentrations of commerce, trading, real estate, and banking tend to become
global financial hubs. ·
These important
cities employ a large number of financial professionals and are home to stock
exchanges and corporate headquarters for investment banks. ·
Found around the
world, examples include New York City, Frankfurt, and Tokyo. London Since
the middle ages, London has been one of the most prominent trade and business
centers. The city is one of the most visited places on earth and is among the
most preferred places to do business. London is a well-known center for
foreign exchange and bond trading in addition to banking activities and
insurance services. The city is a
trading hub for bonds, futures, foreign exchange and insurance. The United
Kingdom’s central bank, the Bank of England, is the second oldest central
bank in the world and is located in London. The bank controls the
monetary system and regulates the issue of currency notes in the United
Kingdom. London is also the seat of
the London Stock Exchange, which is the second largest stock exchange in
Europe. Another financial paragon is The London bullion market, managed
by London Bullion Market Association (LBMA), which is the world's largest
market for gold and silver bullion trading. Due to Brexit uncertainty,
London may ultimately lose its stature as a global financial hub. Singapore From
a business perspective, Singapore's attractiveness lies in its transparent
and sound legal framework complementing its economic and political stability.
The small island located in the Southeast Asia region has emerged as one of the
Four Asian Tigers and established itself as a major financial center.
Singapore has transformed its economy despite the disadvantages of limited
land and resources. Singapore is both
diversified and specialized across industries such as chemicals, biomedical
sciences, petroleum refining, mechanical engineering and electronics.
Singapore has deep capital markets and is a leading insurance and wealth
management marketplace. It has a disciplined and efficient workforce with
a population made up of people of Chinese, Malay and Indian origin. Zurich Zurich,
the largest city in Switzerland, is recognized as a financial center
globally. The city has a disproportionately large presence of financial
institutions and banks and has developed into a hub for insurance and asset
management companies. The low tax regime makes Zurich a good investment
destination, and the city attracts a large number of international companies.
Switzerland’s primary stock exchange, the SIX Swiss Exchange, is in Zurich
and is one of the largest in the world, with a market capitalization of $1.4
trillion as of July 2021. The city has a robust business environment and
offers many finance sector jobs. Zurich is one of the cleanest, most
beautiful and crime free places to live and work. New York
City New
York, commonly regarded as the finance capital of the world, has been ranked
first in the World’s Financial Centers by the Global Financial Centres
Index.9 New York is famous for Wall Street, the most happening stock market
and the New York Stock Exchange (NYSE), the largest stock exchange by market
capitalization. The city is a mix of various cultures from across the globe
providing a diverse population and workforce. It plays host to some of the
largest and finest companies (Fortune 500 and Fortune 1000), biggest banks
(Goldman Sachs, Morgan Stanley, and Merrill Lynch, JP Morgan) and industries.
It is difficult to find a big name in the world of business that does not
have a presence in the city. Hong
Kong Hong
Kong is a key financial hub with a high number of banking institutions. The
former British colony also has a sound legal system for both residents and
companies and is the home of many fund management companies. Hong Kong has
benefited from its strategic location. For
more than a century, the city has been a conduit of trade between China and
the world. Hence, Hong Kong is China's second largest trading partner
after the United States. Its proximity to other countries in the region has
also worked in its favor. Hong Kong has an efficient and transparent judicial
and legal system with excellent infrastructure and telecommunication
services. It has a favorable tax
system in place with very few and low tax rates, which adds to its
attractiveness. The Hong Kong Stock Exchange is the fourth largest in the
world. Chicago Chicago owes its fame to the derivative
market (CME group), which started at the Chicago Board of Trade (CBOT) in
1848 with commodity futures trading. It is the oldest futures exchange in
the world and the second largest by volume, behind the National Stock
Exchange of India. The Chicago-based
Options Clearing Corporation (OCC) clears all U.S. option contracts.
Chicago is the headquarters of over 400 major corporations, and the state of
Illinois has more than 30 Fortune 500 companies, most of which are located in
Chicago. These companies include State Farm Insurance, Boeing, Archer Daniels
Midland and Caterpillar. Chicago also one of the most diverse economies
excelling from innovation in risk management to information technology to
manufacturing to health. Another
financial notable is the Federal Reserve Bank of Chicago. Tokyo Tokyo
is the capital of the third-largest economy in the world and a major
financial center.16 The city is the headquarters of many of the world’s largest
investment banks and insurance companies. It is also the hub for the
country’s telecommunications, electronic, broadcasting and publishing
industries. The Japan Exchange Group
(JPX) was established January 1, 2013, by combining the Tokyo Stock Exchange
(TSE) Group and the Osaka Securities Exchange. The exchange had a market
capitalization of $5.9 trillion as of July 2021. The Nikkei 225 and the TOPIX are the main indices tracking the buzz
at the TSE. Tokyo has time and
again been rated among the most expensive cities in the world. Frankfurt
Frankfurt is home to the European Central
Bank (ECB) and the Deutsche Bundesbank, the central bank of Germany. It has one of the busiest airports in the world and is
the address of many top companies, national and international banks. In 2014,
Frankfurt became Europe's first renminbi payment hub. Frankfurter
Wertpapierbörse, the Frankfurt Stock Exchange, is among the world’s largest
stock exchanges. It had a $2.65 trillion market capitalization as of July
2021. Deutsche Börse Group operates the Frankfurt Stock Exchange. Shanghai Shanghai
is the world's third most populous city, behind Tokyo and Delhi. The Chinese
government in early 2009 announced its ambition of turning Shanghai into an
international financial center by 2020. The
Shanghai Stock Exchange (SSE) is mainland China’s most preeminent market for
stocks in terms of turnover, tradable market value and total market value.
The SSE had a market capitalization of $7.63 trillion as of July 2021.
The China Securities Regulatory Commission (CSRC) directly governs the SSE.
The exchange is considered restrictive in terms of trading and listing
criteria. What Is Libor And Why Is It Being
Abandoned? Miranda Marquit, Benjamin Curry Updated: Nov 7, 2022, 7:38pm https://www.forbes.com/advisor/investing/what-is-libor/ For more than 40 years, the London Interbank Offered Rate—commonly
known as Libor—was a key benchmark for setting the interest rates charged on
adjustable-rate loans, mortgages and corporate debt. Over the last decade, Libor has been burdened by scandals and crises.
Effective January 2022, Libor will no longer be used to issue new loans in
the U.S. It is being replaced by the Secured Overnight Financing Rate (SOFR),
which many experts consider a more accurate and more secure pricing
benchmark. Understanding Libor Libor
provided loan issuers with a benchmark for setting interest rates on
different financial products. It was set each day by collecting estimates
from up to 18 global banks on the interest rates they would charge for
different loan maturities, given their outlook on local economic conditions. Libor was calculated in five currencies: UK
Pound Sterling, the Swiss Franc, the Euro, Japanese Yen and the U.S. Dollar. The London Interbank Offered Rate was used to price adjustable-rate
mortgages, asset-backed securities, municipal bonds, credit default swaps,
private student loans and other types of debt. As of 2019, $1.2 trillion
worth of residential mortgage loans and $1.3 trillion of consumer loans had
been priced using Libor. When
you applied for a loan based on Libor, a financial firm would take a Libor
rate and then tack on an additional percentage. Here’s how it worked for a private student
loan, based on the Libor three-month rate plus 2%. If the Libor three-month
rate was 0.22%, the base rate for the loan would be 2.22%. Other factors,
such as your credit score, income and the loan term, are also factored in. While
Libor is no longer being used to price new loans, it will formally stick
around until at least 2023. One-week and two-month Libor have ceased being published, while
overnight, 1-month, 3-month, 6-month, and 12-month maturities will continue
to be published through June 2023. With an adjustable-rate loan, your lender sets regular periods where
it makes changes to the rate you’re being charged. The lender referenced
Libor when adjusting the interest rate on your loan, changing how much you
pay each month. How Is Libor Calculated? Each day, 18 international banks submit their ideas of the rates they
think they would pay if they had to borrow money from another bank on the
interbank lending market in London. To help guard against extreme highs or lows that might skew the
calculation, the Intercontinental Exchange (ICE) Benchmark Administration
strips out the four highest submissions and the four lowest submissions
before calculating an average. It’s
important to note that Libor isn’t set on what banks actually pay to borrow
funds from each other. Instead, it’s based on their submissions related to
what they think they would pay. As a result, it’s possible for banks to
submit lower rates and manipulate Libor fairly easily. In the past, a panel of bankers oversaw Libor in each currency, but
scandals exposing manipulation of Libor has led many national regulators to
identify alternatives to Libor. Libor Scandals and the 2008 Financial Crisis Libor is being phased out in large part because of the role it played
in worsening the 2008 financial crisis, as well as scandals involving Libor
manipulation among the rate-setting banks. Libor and the 2008 Financial Crisis The use and abuse of credit default swaps (CDS) was one of the major
drivers of the 2008 financial crisis. A very wide range of interrelated
financial companies insured risky mortgages and other questionable financial
products using CDS. Rates for CDS were set using Libor, and these derivative
investments were used to insure against defaults on subprime mortgages. American International Group (AIG) was the biggest player in the CDS
disaster. The firm issued vast quantities of CDS on subprime mortgages and
countless other financial products, like mortgaged-backed securities. The
crash of the real estate market in 2007, followed by the even larger market
meltdown in 2008, forced AIG into bankruptcy, resulting in one of the largest
government bailouts in history. Once AIG started falling apart, it became clear that failing subprime
mortgages and the securities built on top of them weren’t properly insured,
many banks became reluctant to lend to each other. Libor transmitted the
crisis far and wide since every day Libor rate-setting banks estimated higher
and higher interest rates. Libor rose, making loans more expensive, even as
global central banks rushed to slash interest rates. With rates on trillions of dollars of financial products soaring day
after day, and fears about stunted bank lending reducing the flow of money through
the economy, markets crashed. Libor was only one of the many factors that
created the financial industry disasters of 2008, but its key role in
transmitting the crisis to all parts of the global economy has driven many
nations to seek safer alternatives. Libor Manipulation In 2012, extensive investigations into the way Libor was set
uncovered a widespread, long-lasting scheme among multiple banks—including
Barclays, Deutsche Bank, Rabobank, UBS and the Royal Bank of Scotland—to
manipulate Libor rates for profit. Barclays was a key player in this complicated scam. Barclays would
submit its Libor estimates, claiming that it was lower than what other banks
actually charged it. Because a lower rate supposedly indicates a smaller risk
of default, it is considered a sign that a bank is in better shape than
another bank with a higher rate. It wasn’t just Barclays, though. At UBS, one trader involved in Libor
setting, Thomas Hayes, managed to rake in hundreds of millions of dollars for
the bank over the course of three years. Hayes also colluded with traders at
the Royal Bank of Scotland on rigging Libor. UBS executives denied all
knowledge of what had been going on, although the ring managed to manipulate
rate submissions across multiple institutions. SOFR Is Replacing Libor in the U.S. It’s not just these scandals that undercut Libor. According to ICE,
banks have been changing the way they transact business, and, as a result, Libor
rate became a less reliable benchmark. SOFR
is the main replacement for Libor in the United States. This benchmark is
based on the rates U.S. financial institutions pay each other for overnight
loans. These
transactions take the form of Treasury bond repurchase agreements, otherwise
known as repos agreements. They allow banks to to meet liquidity and reserve
requirements, using Treasurys as collateral. SOFR comprises the weighted
averages of the rates charged in these repo transactions. How Does the End of Libor Impact Your Loans? Even if Libor doesn’t completely disappear as soon as expected,
there’s a good chance banks and other lenders will start looking for other
ways to determine market rates. If you have an adjustable-rate loan, check to see if it’s based on
Libor. For loans based on Libor, find out what index your lender will be
switching to. While there might not be a set answer now, keep an eye on the
situation. A switch to a different index might mean a higher base rate in the
future. |
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Part II: Forex quote
6 Correlated
Currency Pairs by Investopedia (youtube) Quiz
Key
Summary: Quote Currency in Forex from
Quiz
https://www.investopedia.com/terms/q/quotecurrency.asp 1.
What is a Quote
Currency?
2.
How
Currency Pairs Work:
3.
How
to Read Exchange Rates:
4.
How
Buying & Selling Works:
5.
Example:
6.
Factors
Affecting Currency Values:
Final Takeaway:
In Class Exercise 1.
What is the current exchange rate for the
GBP/USD pair? _________________ 2.
What is the current exchange rate for the
USD/GBP pair? _________________ 3.
What is the current exchange rate for the
EUR/USD pair? ________________ 4.
What is the current exchange rate for the
USD/JPY ? ____________________ 5.
What is the current exchange rate for the
EUR/ JPY? ___________________ 6.
What is the current exchange rate for the
GBP/NOK? ____________________ 7.
What is the current exchange rate for the
NOK/USD? ____________________ Currency Conversion Exercise
1.
If 1 USD = 150 JPY and 1 GBP = 1.25 USD, how many
JPY is 1 GBP worth? 2. If 1 EUR = 1.10 USD and 1 USD = 10 NOK, how many NOK is 1 EUR? 3.
If 1 CHF = 0.90 EUR and 1 EUR =
1.05 USD, how many USD is 1 CHF? 4.
If 1 GBP = 1.20 EUR and 1 USD =
0.93 EUR, how many USD is 1 GBP? 5.
If 1 USD = 140 JPY and 1 NOK =
0.10 USD, how many JPY is 1 NOK? 6.
If 1 EUR = 1.05 CHF and 1 USD =
1.1 CHF, how many USD is 1 EUR? 7.
Suppose you observe the following exchange
rates: €1 = $.7; £1 = $1.40; and €2.20 = £1.00. Starting with $1,000,000, how
can you make money?(Answer: get £ first. Your profit is $100,000) 8.
Suppose you start with $100 and buy stock
for £50 when the exchange rate is £1 = $2. One year later, the stock rises to
£60. You are happy with your 20 percent return on the stock, but when you
sell the stock and exchange your £60 for dollars, you find that the pound has
fallen to £1 = $1.75. What is your return to your initial investment of $100?
(Answer: 5%) Solution: $100 è £50
at £1 = $2 è one year later, get back £60 è convert to £60 * 1.75 $/£ = $105. So a
gain of $5 and a return of 5%. 9. You observe the following
exchange rates:1€=1.1$; 1£=1.21$; 1£=1.05€.
Starting with $1,000,000, how can you make money through
arbitrage? What is your profit? Solution: $1,000,000 è $1,000,000 / 1.1 $/€ = €909,090.91 è€909,090.91 / 1.05€/£= £865,800.87 è £865,800.87 *
1.21 $/£ =
$1,047,619.05, a profit of
$47,619.05 10. You observe the following
exchange rates:1€=1.1$; 1£=1.21$; 1£=1.15€.
Starting with $1,000,000, how can you make money through arbitrage?
What is your profit? Solution: $1,000,000 è $1,000,000 / 1.21 $/£ = £826,446.2810 è£826,446.2810 * 1.15€/£ = €950,413.2231 è €950,413.2231€ *
1.1 $/€ = $1,045,454.55, a profit of $45,454.55 11. You observe the following exchange
rates:1€=1.1$; 1£=1.21$; 1£=1.1€.
Starting with $1,000,000, how can you make money through arbitrage?
What is your profit? Solution: No arbitrage
opportunity. Profits = 0 : In Class Discussion and Homework (due with the first midterm exam): 1.
Do you
think the Chinese Yuan (CNY) will become one of the major global currencies?
Why or why not? 2. Do you think the Norwegian
Krone (NOK) will become one of the major global currencies? Why or why not? Hint:
|
Quote Currency in Forex: Meaning and Examples https://www.investopedia.com/terms/q/quotecurrency.asp By ADAM HAYES Updated May
25, 2022 Reviewed by GORDON SCOTT Reviewed by Gordon Scott What
Is a Quote Currency? In
foreign exchange (forex), the quote currency, commonly known as the counter
currency, is the second currency in both a direct and indirect currency pair
and is used to determine the value of the base currency. In
a direct quote, the quote currency is the foreign currency, while in an indirect
quote, the quote currency is the domestic currency.
The quote currency is listed after the base currency in the pair when
currency exchange rates are quoted. One can determine how much of the quote
currency they need to sell in order to purchase one unit of the first or base
currency. KEY
TAKEAWAYS ·
The quote currency (counter currency) is
the second currency in both a direct and indirect currency pair and is used
to value the base currency. ·
Currency quotes show many units of the
quote currency they will need to exchange for one unit of the first (base)
currency. ·
In a direct quote, the quote currency is
the foreign currency, while in an indirect quote, the quote currency is the
domestic currency. ·
When somebody buys (goes long) a currency
pair, they sell the counter currency; if they short a currency pair, they
would buy the counter currency. Understanding
Quote Currency Understanding the quotation
and pricing structure of currencies is essential for anyone wanting to trade currencies
in the forex market. Market makers tend to trade specific currency pairs in
set ways, either direct or indirect, which means understanding the quote
currency is paramount. A currency pair's exchange
rate reflects how much of the quote currency is needed to be sold/bought to
buy/sell one unit of the base currency. As the rate in a currency pair
increases, the value of the quote currency falls, whether the pair is direct
or indirect. Most U.S. dollar (USD) pairs
hold the USD as the base currency. If the USD is not the base, it is a
reciprocal currency. For example, the cross rate
between the U.S. dollar and the Canadian dollar is denoted as USD/CAD and is
a direct quote. This means that the CAD is the quote currency, while the USD
is the base currency. The CAD is used as a reference to determine the value
of one USD. From a U.S.-centric point of view, the CAD is a foreign currency. On the other hand, the
EUR/USD denotes the cross rate between the euro and the U.S. dollar and is an
indirect quote. This means that the EUR is the base currency, and the USD is
the quote currency. Here, the USD is the domestic currency and determines the
value of one EUR. Special
Considerations Currency pairs—both base and
quote currencies—are affected by a number of different factors. Some of these
include economic activity, the monetary and fiscal policy enacted by central
banks, and interest rates. Major currencies, such as
the euro and U.S. dollar, are more likely to be the base currency rather than
the quote currency in a currency pair, especially when it comes to trades in
exotic currencies. The most commonly traded
currency pairs on the market in 2021 were: EUR/GBP EUR/USD GBP/USD USD/CHF USD/JPY As noted above, the first
currency in these pairings is the base currency while the second one (after
the slash) is the quote currency. In the GBP/USD pairing, the pound is the
base currency or the one that is being purchased while the dollar is the
quote currency. This is the one that is being sold. Example
of a Quote Currency Let's assume a trader wants
to purchase £400 using U.S. dollars. This would involve a trade using the
GBP/USD currency pair. In order to execute the trade, they need to figure out
how many USD (the quote currency) they need to sell in order to get £400. The exchange rate for the
pair at the end of the trading day on June 3, 2021, was 1.4103. This means it
cost the trader $1.4103 to purchase £1. To complete the transaction on that
day, the trader had to sell 564.12 units of the quote currency in order to
get 400 units of the base currency or $564.12 for £400 = (400 x 1.4103). |
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|
Chapter
4 Exchange Rate Determination Part I: What determines the strength of a
currency? Hint: The value of currency is determined
by demand and supply, unless it is manipulated by the government. What Determines The Strength Of A Currency?
|
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|
Currency |
Country/Region |
Reasons for Strength |
|
Swiss Franc (CHF) |
Switzerland |
Safe-haven status, strong banking system, low inflation, political
stability |
|
US Dollar (USD) |
United States |
Global reserve currency, strong economy, high demand in
international trade, stable government |
|
Euro (EUR) |
Eurozone |
Backed by multiple strong economies (Germany, France, etc.),
widely used in trade, European Central Bank (ECB) monetary policies |
|
British Pound (GBP) |
United Kingdom |
Historically strong financial sector, independent central bank
policies, investor confidence |
|
Japanese Yen (JPY) |
Japan |
Safe-haven currency, trade surplus, government stability, Bank
of Japan’s monetary policies |
|
Singapore Dollar (SGD) |
Singapore |
Strong financial hub, stable economy, sound fiscal policies,
low debt |
|
Norwegian Krone (NOK) |
Norway |
Backed by strong oil and gas reserves, sovereign wealth fund,
stable economic policies |
|
Canadian Dollar (CAD) |
Canada |
Resource-rich economy (oil, minerals), stable government,
close trade ties with the US |
Examples of weak currencies and the
reasons behind their weakness
|
Currency |
Country/Region |
Reasons for Weakness |
|
Venezuelan Bolívar (VES) |
Venezuela |
Hyperinflation, economic mismanagement, political instability,
reliance on oil exports |
|
Iranian Rial (IRR) |
Iran |
Economic sanctions, high inflation, restricted access to
global financial systems |
|
Lebanese Pound (LBP) |
Lebanon |
Banking crisis, political instability, debt defaults |
|
Argentine Peso (ARS) |
Argentina |
High inflation, frequent debt crises, weak investor confidence |
|
Turkish Lira (TRY) |
Turkey |
High inflation, political interference in central bank
decisions, currency devaluation |
|
Pakistani Rupee (PKR) |
Pakistan |
Trade deficits, external debt, political instability |
|
Zimbabwean Dollar (ZWL) |
Zimbabwe |
History of hyperinflation, weak economic fundamentals,
unstable government policies |
|
Nigerian Naira (NGN) |
Nigeria |
Oil dependency, inflation, foreign exchange shortages |
|
Egyptian Pound (EGP) |
Egypt |
High inflation, reliance on imports, foreign exchange
shortages |
|
Russian Ruble (RUB) |
Russia |
Economic sanctions, reliance on oil exports, geopolitical
risks |
Key
Insights on Foreign Exchange Markets and Exchange Rates Quiz
|
Key Insight |
Description |
|
Foreign Exchange Market Participants |
Firms, households, and investors trade currencies through banks
and key foreign exchange dealers. |
|
Exchange Rate Determination |
Exchange rates are set at equilibrium where currency demand
and supply meet; exchange rates between two currencies are inversely
related. |
|
Factors Influencing Exchange Rates |
Increased demand or decreased supply strengthens a currency
(appreciation), while decreased demand or increased supply weakens it
(depreciation). |
|
Role of Expectations |
Future appreciation expectations increase demand and reduce
supply, raising the exchange rate, while depreciation expectations lower
demand and increase supply, reducing the exchange rate. |
|
Simultaneous Demand and Supply Shifts |
In currency markets, demand and supply typically shift
together, influenced by global events and investor sentiment. |
|
Self-Reinforcing Exchange Rate Movements |
Exchange rate trends are amplified by investor behavior,
leading to rapid fluctuations and speculative trading. |
|
Impact on Global Trade and Policy |
Exchange rate volatility affects international trade and
economic stability, prompting potential government or central bank
intervention. |
The foreign exchange market involves firms,
households, and investors who demand and supply currencies coming together
through their banks and the key foreign exchange dealers. Figure 1 (a)
offers an example for the exchange rate between the U.S. dollar and the
Mexican peso. The vertical axis shows the exchange rate for U.S.
dollars, which in this case is measured in pesos. The horizontal
axis shows the quantity of U.S. dollars being traded in the foreign exchange market
each day. The demand curve (D) for U.S. dollars intersects with the supply
curve (S) of U.S. dollars at the equilibrium point (E), which is an exchange
rate of 10 pesos per dollar and a total volume of $8.5 billion.
Figure 1. Demand
and Supply for the U.S. Dollar and Mexican Peso Exchange Rate. (a) The
quantity measured on the horizontal axis is in U.S. dollars, and the exchange
rate on the vertical axis is the price of U.S. dollars measured in Mexican
pesos. (b) The quantity measured on the horizontal axis is in Mexican pesos,
while the price on the vertical axis is the price of pesos measured in U.S.
dollars. In both graphs, the equilibrium exchange rate occurs at point E, at
the intersection of the demand curve (D) and the supply curve (S).
Figure 1 (b)
presents the same demand and supply information from the perspective of the
Mexican peso. The vertical axis shows the exchange rate for Mexican pesos,
which is measured in U.S. dollars. The horizontal axis shows the quantity of
Mexican pesos traded in the foreign exchange market. The demand curve (D) for Mexican
pesos intersects with the supply
curve (S) of Mexican pesos at the equilibrium point (E), which
is an exchange rate of 10 cents in U.S. currency for each Mexican peso and a
total volume of 85 billion pesos. Note that the two exchange rates
are inverses: 10 pesos per dollar is the same as 10 cents per peso (or $0.10
per peso). In the actual foreign exchange market, almost all of the
trading for Mexican pesos is done for U.S. dollars. What factors would cause
the demand or supply to shift, thus leading to a change in the equilibrium exchange rate? The answer
to this question is discussed in the following section.
Expectations
about Future Exchange Rates
One reason to demand a currency
on the foreign exchange market is the belief that the value of the currency
is about to increase. One reason to supply a currency—that
is, sell it on the foreign exchange market—is the
expectation that the value of the currency is about to decline. For
example, imagine that a leading business newspaper, like the Wall Street Journal or the Financial Times, runs an article
predicting that the Mexican peso will appreciate in value. The likely effects
of such an article are illustrated in Figure 2.
Demand for the Mexican peso shifts to the right, from D0 to D1, as investors become eager to purchase pesos. Conversely,
the supply of pesos shifts to the left, from S0 to S1, because investors will be less willing to give them
up. The result is that the equilibrium exchange rate rises from 10 cents/peso
to 12 cents/peso and the equilibrium exchange rate rises from 85 billion to
90 billion pesos as the equilibrium moves from E0 to E1.
Figure 2. Exchange
Rate Market for Mexican Peso Reacts to Expectations about Future Exchange
Rates. An announcement that the peso exchange rate is likely to
strengthen in the future will lead to greater demand for the peso in the
present from investors who wish to benefit from the appreciation. Similarly,
it will make investors less likely to supply pesos to the foreign exchange
market. Both the shift of demand to the right and the shift of supply to the
left cause an immediate appreciation in the exchange rate.
Figure 2 also
illustrates some peculiar traits of supply and demand diagrams in the foreign
exchange market. In contrast to all the other cases of supply and demand you
have considered, in the foreign
exchange market, supply and demand typically both move at
the same time. Groups of participants in the foreign exchange market like
firms and investors include some who are buyers and some who are sellers. An
expectation of a future shift in the exchange rate affects both buyers and
sellers—that is, it affects both demand and supply
for a currency.
The shifts in demand and
supply curves both cause the exchange rate to shift in the same direction; in
this example, they both make the peso exchange rate stronger. However, the
shifts in demand and supply work in opposing directions on the quantity
traded. In this example, the rising demand for pesos is causing the quantity
to rise while the falling supply of pesos is causing quantity to fall. In
this specific example, the result is a higher quantity. But in other cases,
the result could be that quantity remains unchanged or declines.
This example also helps to
explain why exchange rates often move quite substantially in a short
period of a few weeks or months. When investors expect a country’s currency to strengthen in the future, they buy the
currency and cause it to appreciate immediately. The appreciation of the
currency can lead other investors to believe that future appreciation is
likely—and thus lead to even further appreciation.
Similarly, a fear that a currency might weaken
quickly leads to an actual weakening
of the currency, which often reinforces the belief that the currency is going
to weaken further. Thus, beliefs about the future path of exchange
rates can be self-reinforcing, at least for a time, and a large share of the
trading in foreign exchange markets involves dealers trying to outguess each
other on what direction exchange rates will move next.
In class exercise
Think about the changes in
demand and supply when the following changes occur. And draw demand and
supply curve to explain.
1)
Inflation goes up è currency
demand high or low? è currency
value up or down?
2) Real
interest rate goes up è currency demand high or low? è currency value up or down?
3) Public debt goes up è currency demand high or low? è currency value up or down?
4) Recession or crisis è currency demand high or low? è currency value up or down?
Supply
and demand curves in foreign exchange (khan academy)
Summary
Key Terms (Lesson
summary: the foreign exchange market (article) | Khan Academy)
|
Key term |
Definition |
|
foreign exchange market |
a market in which one currency is exchanged for another
currency; for example, in the market for Euros, the Euro is being bought
and sold, and is being paid for using another currency, such as the yen. |
|
demand for currency |
a description of the willingness to buy a currency based on
its exchange rate; for example, as the exchange rate for Euros increases,
the quantity demanded of Euros decreases. |
|
appreciate |
when the value of a currency increases relative to another
currency; a currency appreciates when you need more of another currency to
buy a single unit of a currency. |
|
depreciate |
when the value of a currency decreases relative to another
currency; a currency depreciates when you need less of another currency to
buy a single unit of a currency. |
|
floating exchange rates |
when the exchange rate of currencies are determined in free
markets by the interaction of supply and demand |
·
Why the demand
for a currency is downward sloping
When the
exchange rate of a currency increases, other countries will want less of that
currency. When a currency appreciates (in other words, the exchange rate
increases), then the price of goods in the country whose currency has
appreciated are now relatively more expensive than those in other countries.
Since those goods are more expensive, less is imported from those countries,
and therefore less of that currency is needed.
·
The
equilibrium exchange rate is the interaction of the supply of a currency and
the demand for a currency
As in any
market, the foreign exchange market will be in equilibrium when the quantity
supplied of a currency is equal to the quantity demanded of a currency. If
the market has a surplus or a shortage, the exchange rate will adjust until
an equilibrium is achieved.
|
Economic Factor |
Increase |
Impact on Demand for Peso |
Impact on Supply of Peso |
Impact on Peso |
|
Economic Growth |
↑ |
↑ |
↓ |
Appreciation |
|
Interest Rate |
↑ |
↑ |
↓ |
Appreciation |
|
Inflation |
↑ |
↓ |
↑ |
Depreciation |
|
Political Uncertainty |
↑ |
↓ |
May ↑ |
Depreciation |
|
Public Debt |
↑ |
↓ |
May ↑ |
Depreciation |
|
Current Account |
↑ |
↓ |
May ↑ |
Depreciation |
|
Recession |
↑ |
↓ |
↑ |
Depreciation |
|
Economic Factor |
Decrease |
Impact on Demand for Peso |
Impact on Supply of Peso |
Impact on Peso |
|
Economic Growth |
↓ |
↓ |
↑ |
Depreciation |
|
Interest Rate |
↓ |
↓ |
↑ |
Depreciation |
|
Inflation |
↓ |
↑ |
↓ |
Appreciation |
|
Political Uncertainty |
↓ |
↑ |
↓ |
Appreciation |
|
Public Debt |
↓ |
↑ |
↓ |
Appreciation |
|
Current Account |
↓ |
↑ |
↓ |
Appreciation |
Part II: Fixed
exchange rate vs. floating exchange rate
Floating and
Fixed Exchange Rates- Macroeconomics (youtube)
How Are International
Exchange Rates Set?
https://www.investopedia.com/ask/answers/forex/how-forex-exchange-rates-set.asp
Key Insights on How International Exchange
Rates Are Set
1. Fixed vs. Floating Exchange Rates
- Floating Exchange
Rates: Determined by supply and demand in
global currency markets. Most major currencies follow this system.
- Fixed (Pegged)
Exchange Rates: Set and maintained by
a country's central bank against another major currency (e.g., U.S. dollar,
euro). The government intervenes to keep the rate stable.
2. Factors That Influence Exchange Rates
- Market Forces: Floating rates fluctuate based on
supply and demand. If demand for a currency increases, its value rises.
- Economic Indicators: Interest rates, inflation, GDP,
unemployment rates, and manufacturing data impact currency values.
- Central Bank
Intervention: Even in a floating
system, central banks may intervene to prevent extreme fluctuations.
- Geopolitical
Stability: Political risk and instability
reduce confidence in a currency, leading to depreciation.
3. Short-Term vs. Long-Term Movements
- Short-Term Changes: Driven by speculation, news,
disasters, and daily supply and demand fluctuations.
- Long-Term Trends: Influenced by macroeconomic
policies, trade balances, and long-term economic performance.
4. Commodity-Linked Currencies
- Canadian Dollar
(CAD): Correlated with oil prices since
Canada is a major oil exporter.
- Australian Dollar
(AUD): Linked to gold prices due to
Australia's large gold exports.
5. Purchasing Power Parity (PPP) and Interest
Rates
- The 'Law of One
Price': Suggests that goods should cost the
same across countries after adjusting for exchange rates, but deviations
occur due to economic factors.
- Interest Rate
Parity: Countries with higher interest
rates often attract foreign capital, strengthening their currency.
6. Maintaining Fixed Exchange Rates
- Countries using a pegged exchange rate
must hold large reserves of foreign currency to control supply and
demand and stabilize their exchange rate.
Comparison
of Fixed vs. Floating Exchange Rates
|
Exchange Rate System |
Pros (Advantages) |
Cons (Disadvantages) |
|
Fixed Exchange Rate |
Provides stability in trade and investment, reducing uncertainty
for businesses and investors. |
Requires large foreign reserves to maintain the peg, which can
strain the economy. |
|
|
Helps control inflation by preventing rapid currency
depreciation. |
Limits the ability of a country to use monetary policy to
respond to economic changes. |
|
|
Reduces currency speculation, making financial markets more
stable. |
Can lead to an overvalued or undervalued currency, causing
trade imbalances. |
|
|
Attracts foreign investment by providing a predictable
exchange rate environment. |
If the fixed rate becomes unsustainable, the country may face
a currency crisis and forced devaluation. |
|
Floating Exchange Rate |
Automatically adjusts to market conditions, correcting trade
imbalances and inflation naturally. |
Can be highly volatile, making international trade and
investment riskier. |
|
|
Allows central banks to use monetary policy freely to manage
the economy. |
Speculative trading can cause rapid and unpredictable currency
fluctuations. |
|
|
Reduces the need for large foreign currency reserves. |
Exchange rate instability can negatively impact trade
relationships and economic planning. |
|
|
Reflects real economic conditions, ensuring that the currency
value aligns with market fundamentals. |
A weak currency can lead to inflation, while a strong currency
may hurt exports. |
Homework
(due with the first midterm exam):
Refer to the above table. In your
view, should China adopt a floating exchange rate while Norway implements a
fixed exchange rate?
Explain your reasoning based on
economic stability, trade dependencies, and government intervention.
How Are International
Exchange Rates Set?
https://www.investopedia.com/ask/answers/forex/how-forex-exchange-rates-set.asp
By
CAROLINE BANTON Updated March 04, 2021, Reviewed by GORDON SCOTT, Fact checked
by YARILET PEREZ
International
currency exchange rates display how much one unit of a currency can be
exchanged for another currency. Currency
exchange rates can be floating, in which case they change continually based
on a multitude of factors, or they can be pegged (or fixed) to another
currency, in which case they still float, but they move in tandem with the
currency to which they are pegged.
Knowing
the value of a home currency in relation to different foreign currencies
helps investors to analyze assets priced in foreign dollars. For example, for
a U.S. investor, knowing the dollar to euro exchange rate is valuable when
selecting European investments. A declining U.S. dollar could increase the
value of foreign investments just as an increasing U.S. dollar value could
hurt the value of your foreign investments.
KEY
TAKEAWAYS
·
Fixed exchange rate regimes are set to a
pre-established peg with another currency or basket of currencies.
·
A floating exchange rate is one that is
determined by supply and demand on the open market as well as macro factors.
·
A floating exchange rate doesn't mean
countries don't try to intervene and manipulate their currency's price, since
governments and central banks regularly attempt to keep their currency price
favorable for international trade.
·
Floating exchange rates are the most
common and became popular after the failure of the gold standard and the
Bretton Woods agreement.
Floating vs. Fixed Exchange
Rates
Currency
prices can be determined in two main ways: a floating rate or a fixed rate. A floating rate is determined by the open
market through supply and demand on global currency markets. Therefore, if
the demand for the currency is high, the value will increase. If demand is
low, this will drive that currency price lower. Of course, several
technical and fundamental factors will determine what people perceive is a
fair exchange rate and alter their supply and demand accordingly.
The currencies of most of
the world's major economies were allowed to float freely following the
collapse of the Bretton Woods system between 1968 and 1973. Therefore, most
exchange rates are not set but are determined by on-going trading activity in
the world's currency markets.
Factors That Influence
Exchange Rates
Floating rates are determined
by the market forces of supply and demand. How
much demand there is in relation to supply of a currency will determine that
currency's value in relation to another currency. For example, if the demand
for U.S. dollars by Europeans increases, the supply-demand relationship will
cause an increase in the price of the U.S. dollar in relation to the euro.
There are countless geopolitical and economic announcements that affect the
exchange rates between two countries, but a few of the most common include interest rate changes, unemployment
rates, inflation reports, gross domestic product numbers, manufacturing data,
and commodities.
A fixed or pegged rate is
determined by the government through its central bank. The rate is set against
another major world currency (such as the U.S. dollar, euro, or yen). To
maintain its exchange rate, the government will buy and sell its own currency
against the currency to which it is pegged.Some
countries that choose to peg their currencies to the U.S. dollar include
China and Saudi Arabia.
Short-term
moves in a floating exchange rate currency reflect speculation, rumors,
disasters, and everyday supply and demand for the currency. If supply
outstrips demand that currency will fall, and if demand outstrips supply that
currency will rise. Extreme short-term
moves can result in intervention by central banks, even in a floating rate
environment. Because of this, while most major global currencies are
considered floating, central banks and governments may step in if a nation's
currency becomes too high or too low.
A currency that is too high
or too low could affect the nation's economy negatively, affecting trade and
the ability to pay debts. The government or central bank will attempt to
implement measures to move their currency to a more favorable price.
Macro Factors
More
macro factors also affect exchange rates. The 'Law of One Price' dictates that in a world of international
trade, the price of a good in one country should equal the price in another.
This is called purchasing price parity (PPP). If prices get out of whack, the
interest rates in a country will shift—or else the
exchange rate will between currencies. Of course, reality doesn't always
follow economic theory, and due to several mitigating factors, the law of one
price does not often hold in practice. Still, interest rates and relative prices will influence exchange rates.
Another macro factor is the
geopolitical risk and the stability of a country's government. If the
government is not stable, the currency in that country is likely to fall in
value relative to more developed, stable nations.
Generally,
the more dependent a country is on a primary domestic industry, the stronger
the correlation between the national currency and the industry's commodity
prices.
There
is no uniform rule for determining what commodities a given currency will be
correlated with and how strong that correlation will be. However, some
currencies provide good examples of commodity-forex relationships.
Consider
that the Canadian dollar is positively correlated to the price of oil.
Therefore, as the price of oil goes up, the Canadian dollar tends to
appreciate against other major currencies. This is because Canada is a net
oil exporter; when oil prices are high, Canada tends to reap greater revenues
from its oil exports giving the Canadian dollar a boost on the foreign
exchange market.
Another
good example is the Australian dollar, which is positively correlated with
gold. Because Australia is one of the world's biggest gold producers, its
dollar tends to move in unison with price changes in gold bullion. Thus, when
gold prices rise significantly, the Australian dollar will also be expected
to appreciate against other major currencies.
Maintaining Rates
Some
countries may decide to use a pegged exchange rate that is set and maintained
artificially by the government. This rate will not fluctuate intraday and may
be reset on particular dates known as revaluation dates. Governments of
emerging market countries often do this to create stability in the value of
their currencies. To keep the pegged
foreign exchange rate stable, the government of the country must hold large
reserves of the currency to which its currency is pegged to control changes
in supply and demand.
The Impossible Trinity
or "The Trilemma"
– can a country controls its interest rates, exchange
rates, and capital flow simultaneously?
Impossible
Trinity (youtube)
The Impossible Trinity -
60 Second Adventures in Economics (5/6) (youtube)
The
Impossible Trinity in Simple Terms
Imagine you are running a country, and you
have to make a tough choice between three powerful economic goals. But here’s the catch—you can only pick two at any given
time. The three goals are:
- Fixed Exchange Rate – You want
your currency to stay stable compared to another country’s currency.
- Free Capital Flows – You want
money to move freely in and out of your country (investments, trade,
etc.).
- Independent Monetary Policy – You want
to control your own interest rates to manage inflation, unemployment,
and economic growth.
The
Problem? You Can’t Have All Three at the Same Time!
Your Three Choices (Pick Two, Sacrifice One)
|
Choice |
What You Get |
What You Sacrifice |
Real-World Example |
|
A. Fixed Exchange Rate + Free Capital Flows |
Stable currency + Money moves freely |
No control over interest rates (must match global rates) |
Denmark (DKK pegged to EUR), Hong Kong (HKD pegged to USD) * · Both have a
fixed exchange rate and free capital movement but must follow the interest
rates of the ECB (Denmark) or the Fed (Hong Kong). |
|
B. Free Capital Flows + Independent Monetary Policy |
Control over interest rates + Free money movement |
Currency value fluctuates (no fixed exchange rate) |
U.S., UK, Japan, Norway · Money moves
freely, and they set their own interest rates, but exchange rates float and
fluctuate. |
|
C. Fixed Exchange Rate + Independent Monetary Policy |
Stable currency + Control over interest rates |
No free capital flows (capital controls restrict money
movement) |
China (before 2005), Bretton Woods system (1944–1971) ·
China restricted capital movement while keeping its currency
pegged. · Under Bretton
Woods, countries maintained exchange rate pegs but used capital controls to
prevent excessive flows. |
Note: 1. Denmark (DKK) –
Pegged to Euro under ERM II
- Fixed Exchange Rate: The Danish Krone (DKK) is pegged to the Euro at
approximately 7.46 DKK per EUR under the European Exchange Rate Mechanism II
(ERM II).
- Free Capital Flows: Denmark allows unrestricted capital
movement.
- Sacrifice: No independent monetary
policy:
1) Denmark
must align its interest rates
with those of the European
Central Bank (ECB).
2) If
the ECB raises rates, Denmark must follow; otherwise, speculative capital
flows could destabilize the peg.
Note 2. Hong Kong (HKD) –
Pegged to USD
- Fixed Exchange Rate: The Hong Kong Dollar (HKD) is pegged to
the U.S. Dollar at around 7.8 HKD per USD.
- Free Capital Flows: No capital controls—money
moves freely in and out.
- Sacrifice: No independent monetary
policy:
1) Hong
Kong must match U.S. interest
rates set by the Federal
Reserve to maintain the peg.
2) If the Fed hikes rates, Hong Kong must follow, even if it’s bad for the local economy.
Why
Can’t You Have All Three?
Let’s say you try:
- You
fix your exchange
rate and allow free capital flows → If global interest rates are 5% but you set
yours at 2%, investors will dump your currency, and you’ll run out of
reserves trying to keep it stable.
- You
fix your exchange
rate and set your own interest rates → You must block money from flowing freely
(capital controls), or speculators will attack your currency.
- You
allow free capital
flows and set your own interest rates → Your exchange rate will move up and down based
on market forces.
Key Takeaway
·
Every country makes a trade-off. The U.S. picks free capital flow and independent monetary policy
(floating exchange rate), while Eurozone countries pick free
capital flow and a fixed exchange rate (but give up control
over interest rates).
·
·
This is why some economists, like Dani Rodrik, argue that
limiting capital flows (Option C) can sometimes be a better choice to avoid
frequent financial crises.
Homework (due with the first midterm exam):
Based on the Impossible Trinity,
should China transition to a floating exchange rate, and should Norway adopt
a fixed exchange rate? Explain your reasoning by considering each country's
economic structure, capital flow policies, and monetary policy objectives.
A - set a fixed exchange rate between its currency and
another while allowing capital to flow freely across its borders,
B - allow capital to flow freely and set
its own monetary policy, or
C - set its own monetary policy and
maintain a fixed exchange rate.
The Impossible Trinity or "The
Trilemma", in which two policy positions are possible. If a nation were
to adopt position a, for example,
then it would maintain a fixed exchange rate and allow free capital flows,
the consequence of which would be loss of monetary sovereignty.
The Impossible Trinity - 60 Second
Adventures in Economics (5/6) (video)
The impossible trinity (also
known as the trilemma) is a concept in international
economics which states that it is
impossible to have all three of the following at the same time:
· free capital movement
(absence of capital controls)
· an
independent monetary policy
It
is both a hypothesis based on the uncovered interest rate
parity condition, and a finding from empirical studies where governments
that have tried to simultaneously pursue all three goals have failed. The
concept was developed independently by both John Marcus Fleming in
1962 and Robert Alexander Mundell in
different articles between 1960 and 1963.
Policy
choices
According to the impossible trinity, a central bank can only
pursue two of the above-mentioned three policies simultaneously. To see why,
consider this example:
Assume that world interest rate is at 5%. If the home central bank tries
to set domestic interest rate at a rate lower than 5%, for example at 2%,
there will be a depreciation pressure on the home currency, because
investors would want to sell their low yielding domestic currency and buy
higher yielding foreign currency. If the central bank also wants to have free
capital flows, the only way the central bank could prevent depreciation of
the home currency is to sell its foreign currency reserves. Since foreign
currency reserves of a central bank are limited, once the reserves are
depleted, the domestic currency will depreciate.
Hence, all three of the policy objectives
mentioned above cannot be pursued simultaneously. A central bank has to forgo one of the three objectives.
Therefore, a central bank has three policy combination options.
Options
In terms of the diagram above (Oxelheim, 1990), the options are:
·
Option (a): A stable exchange rate and free capital
flows (but not an independent monetary policy because setting a domestic
interest rate that is different from the world interest rate would undermine
a stable exchange rate due to appreciation or depreciation pressure on the
domestic currency).
·
Option (b): An independent monetary policy and free
capital flows (but not a stable exchange rate).
·
Option (c): A stable exchange rate and independent
monetary policy (but no free capital flows, which would require the use
of capital controls.
Currently, Eurozone members have chosen
the first option (a) while most other countries have opted for the second one
(b). By contrast, Harvard
economist Dani Rodrik advocates
the use of the third option (c) in his book The Globalization Paradox,
emphasizing that world GDP grew fastest during the Bretton Woods era when
capital controls were accepted in mainstream economics. Rodrik also argues
that the expansion of financial globalization and the free movement
of capital flows are the reason why economic crises have become more frequent
in both developing and advanced economies alike. Rodrik has also developed
the "political trilemma of the world economy", where
"democracy, national sovereignty and global economic
integration are mutually incompatible: we can combine any two of the
three, but never have all three simultaneously and in full."
(from
Wikipedia)
First Midterm Exam
·
Date:
February 20, 2025
·
In-Class,
Closed-Book, Closed-Notes
·
50
T/F questions similar to quizzes
Study Guide – Key Terms Solution
·
Tariff
·
Quota
·
Trade War
·
Sanction
·
Bilateral Trade
·
Multilateral
Trade
·
Balance of
Payments (BOP)
·
Current Account
·
Capital Account
·
Bretton Woods
System
·
Floating Exchange
Rate System
·
Fixed Exchange
Rate System
·
Pros and Cons of
Floating vs. Fixed Exchange Rate
·
Gold Standard
·
Cryptocurrency
·
LIBOR (London
Interbank Offered Rate)
·
SOFR (Secured
Overnight Financing Rate)
·
Direct Quote
·
Indirect Quote
·
Base Currency
·
Quote Currency
·
7 Major Currency
Pairs
·
Factors That
Determine Currency Values
·
Demand and Supply
Curves for Currency Values
·
Impossible Trinity
Chapter
5 - Part I
What is
SWIFT? How could banning Russia from the banking system impact the country?
https://www.usatoday.com/story/money/2022/02/24/swift-russia-banki
Video (CNBC): What is
SWIFT? How Russian banks got cut out of the financial system Quiz
· What is SWIFT?
- SWIFT (Society for
Worldwide Interbank Financial Telecommunication) is a global
financial messaging system.
- It does not transfer money
directly but facilitates communication between banks regarding
transactions.
· SWIFT's Role in Global Finance
- SWIFT connects over 11,000
financial institutions in more than 200 countries.
- It processes millions of
secure financial messages daily for international transactions.
· SWIFT and International Sanctions
- SWIFT has been used as a tool
for financial sanctions.
- Russia was removed from SWIFT
in 2022 as a response to its
invasion of Ukraine.
- Iran was also disconnected
from SWIFT in 2012 due
to nuclear program sanctions but was reconnected in 2016.
· Alternatives to SWIFT
- SPFS (Russia's System for
Transfer of Financial Messages):
Russia’s domestic alternative to SWIFT.
- CIPS (China’s Cross-Border
Interbank Payment System):
China’s alternative for processing international transactions.
· Impact of Being Cut Off from SWIFT
- Severe disruption to international trade and
financial transactions.
- Countries cut off from SWIFT
struggle to send and receive payments globally.
- Forces affected nations to
develop alternative financial systems.
· The U.S. Influence on SWIFT
- The U.S. and its European
allies play a major role in SWIFT’s operations.
- Sanctions imposed through
SWIFT can isolate economies
and limit access to global banking.
· Misconceptions About SWIFT
- SWIFT does not control
money flows; it is a messaging system.
- Not all banks in a sanctioned
country get disconnected—only
those specifically targeted.
· Cryptocurrency as an Alternative
- Some countries explore cryptocurrencies
as a way to bypass SWIFT sanctions.
- Russia and Iran have explored
digital assets to continue financial
transactions.
· Current Status of Russia and SWIFT
- As of Dec 31, 2024, Russia is
still disconnected from SWIFT
due to ongoing sanctions.
- Efforts to reconnect Russia
remain a topic of geopolitical debate.
|
Country |
Year Removed from SWIFT |
Reason for Removal |
Immediate Impact |
Long-Term Impact |
Year Allowed Back |
Reason for Reconnection |
|
Russia |
2022 |
Invasion of Ukraine |
Severe disruption to financial transactions, loss of foreign
trade revenue |
Development of alternative payment systems like SPFS, deeper
financial ties with China |
? |
Economic necessity, shifting geopolitical alliances |
|
Iran |
2012 |
Nuclear program sanctions |
50% loss in oil export revenue, 30% drop in foreign trade |
Reconnected in 2016, but economy remained strained due to
other sanctions |
2016 |
Nuclear deal agreement and partial sanction relief |
|
Argument |
Why Allow Russia Back into SWIFT |
Why Russia Should Not Be Allowed Back into SWIFT |
|
Economic Stability |
Reconnecting Russia could stabilize global financial markets
and reduce transaction inefficiencies. |
Keeping Russia excluded maintains pressure on its economy,
restricting its ability to finance military actions. |
|
Energy Trade |
Facilitating Russian energy exports through SWIFT would help
maintain steady global oil and gas supplies. |
Preventing Russia from using SWIFT limits its ability to
profit from energy exports, weakening its war financing. |
|
Diplomatic Leverage |
Allowing Russia back could be used as a negotiation tool to
de-escalate tensions and foster diplomatic solutions. |
Exclusion signals a strong stance against aggression,
reinforcing international norms and deterring similar actions in the
future. |
|
Sanctions Enforcement |
Some argue that cutting Russia off has not stopped its
actions, making SWIFT sanctions less effective than expected. |
Russia's disconnection has been one of the most significant
financial penalties imposed, and reintroducing it could weaken the
credibility of future sanctions. |
|
Geopolitical Consequences |
Blocking Russia could push it closer to adversarial alliances,
strengthening economic and military ties with China, Iran, and others. |
Reconnecting Russia too soon might be seen as appeasement,
emboldening further geopolitical instability. |
|
Alternative Systems |
Russia has developed its own alternative system (SPFS), and
prolonged exclusion may weaken SWIFT’s dominance in global finance. |
Keeping Russia out forces other nations to rely on SWIFT
rather than alternative financial systems, preserving its dominance. |
For Discussion and
Homework (due with the second midterm exam):
Read the following
article and discuss: How long should the sanctions last? Should they be
lifted when the war is over?
Also refer to the
video Inside Russia: Putin's
war, three years on - The Global Story podcast, BBC World Service
Trump hands Russian economy a
lifeline after three years of war
Quiz Game
By Alexander Marrow
and Darya Korsunskaya February 24, 20251:24 PM
Summary
•
US push for Ukraine deal could benefit Russia's economy
•
Russia's inflation remains stubbornly high
•
Russia's overheated economy set to cool
•
Some winners, losers in Russia's war economy
LONDON, Feb 24 (Reuters) - Russia's overheating economy is
on the cusp of serious cooling, as huge fiscal stimulus, soaring interest
rates, stubbornly high inflation and Western sanctions take their toll, but
after three years of war, Washington may just have thrown Moscow a lifeline.
U.S. President Donald Trump is pushing for a quick deal to
end the war in Ukraine, alarming Washington's European allies by leaving them
and Ukraine out of initial talks with Russia and blaming Ukraine for Russia's
2022 invasion, political gifts for Moscow that could also bring strong
economic benefits.
Washington's push comes as Moscow faces two undesirable
options, according to Oleg Vyugin, former deputy chairman of Russia's central
bank.
Russia can either stop inflating military spending as it
presses to gain territory in Ukraine, he said, or maintain it and pay the
price with years of slow growth, high inflation and falling living standards,
all of which carry political risks.
Key Insights from the Reuters Article: "After Three
Years of War, Trump Hands Russian Economy a Lifeline"
|
Key Topics |
Insights |
|
Russia's Economy is
Overheating |
Military spending keeps Russia’s economy afloat but causes
high inflation and economic strain. Interest rates at 21% are slowing corporate
investment and increasing financial pressure. |
|
Trump’s Push for a
Peace Deal |
Trump is pushing for a quick resolution to the Ukraine war,
excluding European allies and Ukraine from early talks while favoring
direct discussions with Russia. |
|
Potential Economic
Relief for Russia |
A peace deal could ease sanctions and potentially allow
Western companies to return to Russia. The Russian ruble has already
strengthened due to speculation of future economic relief. |
|
Russia's Dilemma: Guns
vs. Butter |
Russia must choose between reducing military spending to
stabilize the economy or continuing high defense spending, leading to
long-term stagnation and inflation. |
|
Labor Shortages and
Inflation Risks |
War-driven recruitment and emigration have pushed unemployment
to a record low of 2.3%. High demand and labor shortages are keeping
inflation high, adding economic pressure. |
|
The U.S. Strategy:
Carrot & Stick |
The U.S. offers possible sanctions relief if Russia cooperates
but threatens tougher sanctions if no progress is made. |
|
No Mention of SWIFT
Reconnection |
While the article discusses potential sanctions relief, it
does not explicitly mention Russia being reconnected to SWIFT. |
What
is SWIFT? How could banning Russia from the banking system impact the
country?
Marina Pitofsky, USA TODAY
https://www.usatoday.com/story/money/2022/02/24/swift-russia-banking-system-sanctions/6930931001/
What is SWIFT and why were
some Russian banks excluded from it? (video)
The White House announced Saturday that the United States and allies agreed
to block select Russian banks from SWIFT, the global financial messaging
system.
In a joint statement with leaders of the European
Commission, France, Germany, Italy, the United Kingdom, Canada, the officials
said Russia being excluded from SWIFT ensures “that these banks are disconnected from the international financial system
and harm their ability to operate globally.”
The announcement comes after President Joe Biden on
Thursday told reporters that the penalties from the latest round of sanctions
against Russia are “maybe more consequence than SWIFT.”
What does it mean for Russia to be kicked out of the
SWIFT banking system? Here’s what you need to know:
What is the SWIFT financial system?
SWIFT
stands for the Society for Worldwide Interbank Financial Telecommunication.
It is a global messaging system connecting thousands of financial
institutions around the world.
SWIFT was formed in 1973, and it is headquartered in
Belgium. It is overseen by the National Bank of Belgium, in addition to the
U.S. Federal Reserve System, the European Central Bank and others. It connects more than 11,000 financial
institutions in more than 200 countries and territories worldwide so banks
can be informed about transactions.
Alexandra Vacroux, executive director of the Davis
Center for Russian and Eurasian Studies at Harvard University, told NPR,
"It doesn't move the money, but
it moves the information about the money."
SWIFT said it recorded 42 million messages a day on
average in 2021 and 82 million messages overall this month. That includes
currency exchanges, trades and more.
How would a removal from SWIFT affect Russia?
Barring
Russia from SWIFT would damage the country’s economy right away and, in the
long term, cut Russia off from a swath of international financial
transactions. That includes international profits from oil and gas
production, which make up more than 40% of Russia’s revenue.
Iran lost access to SWIFT in 2012 as part of
sanctions over its nuclear program, though many of the country's banks were
reconnected to the system in 2016. Vacroux told NPR that when Iran was kicked
off, "they lost half of their oil export revenues and 30% of their
foreign trade."
What have other leaders said about removing Russia
from SWIFT?
Ukrainian President Volodymyr Zelenskyy urged the
U.S. and other countries to cut Russia from the system. Some nations resisted
the move out of concerns for the broader economy, but as the invasion wore on
more European Union nations got on board.
Early Saturday morning, Italian Prime Minister Mario
Draghi told Zelenskyy that Italy supported "Russia's disconnection from
SWIFT, the provision of defense assistance."
Several hours later, Germany, which had been the
last European Union nation holding out on the sanctions, offered measured
support for Russia's disconnection from SWIFT, according to a joint statement
from German Foreign Minister Annalena Baerbock and German Economics Minister
Robert Habeck.
“We are working flat out on how to limit the collateral
damage of a disconnection from #SWIFT, so that it hits the right people,” the
officials wrote in a statement. "What we need is a targeted and
functional restriction of SWIFT.”
Trump hands
Russian economy a lifeline after three years of war
By Alexander
Marrow and Darya Korsunskaya February 24, 20251:24 PM
Summary
• US push for Ukraine deal could
benefit Russia's economy
• Russia's inflation remains
stubbornly high
• Russia's overheated economy set to
cool
• Some winners, losers in Russia's
war economy
LONDON,
Feb 24 (Reuters) - Russia's overheating economy is on the cusp of serious
cooling, as huge fiscal stimulus, soaring interest rates, stubbornly high
inflation and Western sanctions take their toll, but after three years of
war, Washington may just have thrown Moscow a lifeline.
U.S.
President Donald Trump is pushing for a quick deal to end the war in Ukraine,
alarming Washington's European allies by leaving them and Ukraine out of
initial talks with Russia and blaming Ukraine for Russia's 2022 invasion,
political gifts for Moscow that could also bring strong economic benefits.
Washington's
push comes as Moscow faces two undesirable options, according to Oleg Vyugin,
former deputy chairman of Russia's central bank.
Russia
can either stop inflating military spending as it presses to gain territory
in Ukraine, he said, or maintain it and pay the price with years of slow
growth, high inflation and falling living standards, all of which carry
political risks.
Though
government spending usually stimulates growth, non-regenerative spending on
missiles at the expense of civilian sectors has caused overheating to the
extent that interest rates at 21% are slowing corporate investment and
inflation cannot be tamed.
"For
economic reasons, Russia is interested in negotiating a diplomatic end to the
conflict," Vyugin said. "(This) will avoid further increasing the
redistribution of limited resources for unproductive purposes. It's the only
way to avoid stagflation."
While
Russia is unlikely to swiftly reduce defence spending, which accounts for
about a third of all budget expenditure, the prospect of a deal should ease
other economic pressures, could bring sanctions relief and eventually the
return of Western firms.
"The
Russians will be reluctant to stop spending on arms production overnight,
afraid of causing a recession, and because they need to restore the
army," said Alexander Kolyandr, researcher at the Center for European
Policy Analysis (CEPA).
"But
by letting some soldiers go, that would take a bit of pressure off the labour
market."
War-related
recruitment and emigration have caused widespread labour shortages, pushing
Russian unemployment to a record low 2.3%.
Inflation
pressure could also ease, Kolyandr added, as peace prospects may make
Washington less likely to enforce secondary sanctions on companies from
countries like China, making imports more straightforward and, therefore,
cheaper.
NATURAL
SLOWDOWN
Russian
markets have already seen a boost. The rouble surged to a near six-month high
against the dollar on Friday, buoyed by prospects for sanctions relief.
Russia's
economy has grown strongly since a small contraction in 2022, but authorities
expect 2024's 4.1% growth to slow to around 1-2% this year and the central
bank is not yet seeing sustainable grounds to cut rates.
When
holding rates at 21% on February 14, Central Bank Governor Elvira Nabiullina
said demand growth has long been faster than production capacity, hence the
natural slowdown in growth.
The
bank's challenge in finding a balance between growing the economy and
lowering inflation is complicated by rampant fiscal stimulus. Russia's fiscal
deficit ballooned to 1.7 trillion roubles ($19.21 billion) in January alone,
a 14-fold increase year on year as Moscow frontloads 2025 spending.
"...it
is very important for us that the budget deficit...remains as the government
is currently planning," Nabiullina said.
The
finance ministry, which expects a 1.2-trillion-rouble deficit for 2025 as a
whole, rejigged its budget plans three times last year.
CARROT
& STICK
The war
has brought economic advantages for some Russians but pain for others.
For
workers in sectors linked to the military, fiscal stimulus has sharply raised
wages, while others in civilian sectors struggle with soaring prices for
basic goods.
Some
businesses have seized opportunities presented by huge shifts in trade flows
and reduced competition. For example, Melon Fashion Group's revenues have
steadily risen as it has ridden the consumer demand wave.
Melon's
brands have significantly expanded over the last two years, the company told
Reuters, and since 2023, the average size of stores it opens has doubled.
But for
many others, high rates pose a serious challenge.
"At
current lending rates, it is difficult for developments to launch new
projects," said Elena Bondarchuk, founder of warehouse developer
Orientir. "The once-wide circle of investors has narrowed and those who
remain are also dependent on banks' terms."
Lower
oil prices, budget constraints and a rise in bad corporate debt are among the
top economic risks facing Russia, internal documents seen by Reuters show.
And Trump, though dangling the carrot of concessions over Ukraine, has
threatened additional sanctions if no deal is forthcoming.
"The
United States has significant leverage in terms of the economy and it's why
the Russians are happy to meet," Chris Weafer, chief executive of
Macro-Advisory Ltd, told Reuters.
"The
United States is saying: 'We can ease sanctions if you cooperate, but if you
don't we can make it a hell of a lot worse'."
Part II: In Class
Exercise
Class Exercise1:
Chicago bank expects the exchange rate of the
NZ$ to appreciate from $0.50 to $0.52 in 30 days.
— Chicago bank can borrow $20m on a
short term basis.
— Currency Lending
Rate Borrowing
rate
$ 6.72% 7.20%
NZ$ 6.48% 6.96%
Question: If Chicago bank anticipate NZ$ to appreciate,
how shall it trade? (refer to ppt)
Answer:
◦ NZ$ will
appreciate, so you should buy NZ$ now and sell later. Borrow $à convert
to NZ$ today à lend it for 30 days à convert to $ 30 days
later àpayback the $ loan.
◦ Convert
the borrowed $ to NZ$ today. So your NZ$ worth: $20m / 0.50 $/NZ$=40m NZ$.
◦ Lend NZ$
for 6.48% * 30/360=0.54% and get
40m NZ$ *(1+0.54%)=40,216,000 NZ$ 30 days
lateè at new rate $0.52/1NZ$, 40,216,000 NZ$ equals t 40,216,000
NZ$*$0.52/1NZ$ = $20,912,320
◦ Your
borrowed $20m should be paid back for
20m *(1+7.2%* 30/360)=$20.12m.
◦ So the
profit is:
$20,912,320 - $20.12m =$792,320, a pure
profit from thin air!
Class Exercise 2:
Blue Demon Bank expects that the Mexican peso will
depreciate against the dollar from its spot rate of $.15 to $.14 in 10 days. The
following interbank lending and borrowing rates exist:
Lending
Rate Borrowing Rate
U.S.
dollar 8.0% 8.3%
Mexican
peso 8.5% 8.7%
Assume that Blue Demon Bank has a
borrowing capacity of either $10 million or 70 million pesos in the interbank
market, depending on which currency it wants to borrow.
a. How
could Blue Demon Bank attempt to capitalize on its expectations without using
deposited funds? Estimate the profits that could be generated from this
strategy.
b. Assume all the
preceding information with this exception: Blue Demon Bank expects the peso
to appreciate from its present spot rate of $.15 to $.17 in 30 days. How
could it attempt to capitalize on its expectations without using deposited
funds? Estimate the profits that could be generated from this strategy.
Answer:
Part a: Blue Demon Bank can capitalize on its expectations
about pesos (MXP) as follows:
1. Borrow
MXP70 million
2. Convert
the MXP70 million to dollars:
a. MXP70,000,000 × $.15
= $10,500,000
3. Lend
the dollars through the interbank market at 8.0% annualized over a 10 day
period. The amount accumulated in 10 days is:
a. $10,500,000 × [1
+ (8% × 10/360)] = $10,500,000 × [1.002222] = $10,523,333
4. Convert
the Peso back to $ at $.14 / peso:
a. $10,523,333
/ $.14 / MXP = MXP 75,166,664
5. Repay
the peso loan. The repayment amount on the peso loan is:
a. MXP70,000,000 × [1
+ (8.7% × 10/360)] =
70,000,000 × [1.002417]=MXP70,169,167
6. The
arbitrage profit is:
a. MXP
75,166,664 - MXP70,169,167 = MXP 4,997,497
7. Convert
back to at $0.14 / MXP
a. We
get back MXP 4,997,497 * $0.14 / MXP = $699,649.6 (solution)
Part b: Blue Demon Bank can capitalize on its expectations
as follows:
1. Borrow
$10 million
2. Convert
the $10 million to pesos (MXP):
a. $10,000,000/$.15
= MXP66,666,667
3. Lend
the pesos through the interbank market at 8.5% annualized over a 30 day
period. The amount accumulated in 30 days
is:
a. MXP66,666,667 × [1
+ (8.5% × 30/360)] = 66,666,667 × [1.007083] =
MXP67,138,889
4. Repay
the dollar loan. The repayment amount on the dollar loan is:
a. $10,000,000 × [1
+ (8.3% × 30/360)] = $10,000,000 × [1.006917] =
$10,069,170
5. Convert
the pesos to dollars to repay the loan. The amount of dollars to be received
in 30 days (based on the expected spot rate of $.17) is:
a. MXP67,138,889 × $.17
= $11,413,611
Homework (due with the
second midterm exam):
Question 1: Baylor Bank
believes the New Zealand dollar will depreciate over the next five days from
$.52 to $.5. The following annual interest rates apply:
Currency Lending
Rate Borrowing Rate
Dollars 5.50% 5.80%
New
Zealand dollar
(NZ$) 4.80% 5.25%
Baylor
Bank has the capacity to borrow either NZ$11 million or $5 million. If Baylor
Bank’s forecast if correct, what will its dollar profit be from speculation
over the five day period (assuming it does not use any of its existing
consumer deposits to capitalize on its expectations)? (Answer: 0.44 million NZ$ profits; or $0.88 million)
Question 2: Baylor Bank
believes the New Zealand dollar will depreciate over the next five days from
$.52 to $.55. The following annual interest rates apply:
Currency Lending
Rate
Borrowing Rate
Dollars 5.50% 5.80%
New
Zealand dollar
(NZ$) 4.80% 5.25%
Baylor
Bank has the capacity to borrow either NZ$11 million or $5 million. If Baylor
Bank’s forecast if correct, what will its dollar profit be from speculation
over the five day period (assuming it does not use any of its existing
consumer deposits to capitalize on its expectations)? (Answer: $0.288 million, or 0.524 million NZ$
profits )
0.52 *(1+5.5%/360*5) /0.5 –
11*(1+5.25%/360*5)
=
5/0.52*(1+4.8%/360*5)*0.55-5*(1+5.8%/360*5)
Part
III - Currency Derivatives
For class discussion:
Assume that you are an importer for seafood from
Norway. This special seafood is only available in the summer. How can you
hedge against the exchange rate risk?
|
Hedging Strategy |
Description
|
|
Forward Contracts |
Enter into agreements with a bank or financial institution to lock
in a specific exchange rate for future transactions, protecting against
adverse exchange rate movements. |
|
Options Contracts |
Purchase contracts granting the right (but not obligation) to
exchange currency at a predetermined rate on or before a specified date,
offering flexibility with limited downside risk. |
|
Currency Swaps |
Exchange cash flows in different currencies through
agreements, such as swapping domestic currency for Japanese yen at a fixed
rate, mitigating exchange rate fluctuations. |
|
Natural Hedging |
Offset currency exposure by aligning revenue or expenses in
Japanese yen, naturally hedging against exchange rate risk through matching
currency inflows and outflows.
|
Part a - Forward
market vs. Future market
Futures vs.
Forward Contract Game Futures Trading Simulator Forward Trading Simulator
Let’s watch the following videos to understand how the forward and
future markets work.
Forward contract introduction
(video, khan academy)
Futures introduction (video,
khan academy)
|
Feature |
Forward
Contract |
Futures
Contract |
|
Definition |
A
customized agreement between two parties to exchange currencies at a future
date at a predetermined rate. |
A
standardized contract traded on an exchange to buy or sell a currency at a set
price on a future date. |
|
Trading Venue |
Over-the-counter
(OTC), typically through banks or financial institutions. |
Traded
on organized exchanges (e.g., CME Group). |
|
Customization |
Fully
customizable (amount, maturity date, settlement terms). |
Standardized
(contract size, expiration date, and settlement terms are fixed). |
|
Regulation |
Not
regulated; risk depends on counterparty creditworthiness. |
Highly
regulated by exchanges and clearinghouses. |
|
Margin Requirement |
No
margin required, but a credit line is needed. |
Requires
an initial margin and daily mark-to-market settlements. |
|
Settlement |
Delivered
at contract expiration (physical settlement). |
Mostly
cash-settled daily; delivery is rare. |
|
Flexibility |
More
flexible but less liquid. |
Less
flexible but highly liquid. |
|
Counterparty Risk |
High
(depends on the creditworthiness of the counterparty). |
Low
(exchange acts as an intermediary and guarantees the contract). |
Example of
Each
- Forward Contract Example:
A U.S. company expects to receive €1,000,000 in three months and enters into a forward contract to lock in the exchange rate of 1 EUR = 1.10 USD with a bank. No daily price fluctuations affect the agreement. - Futures Contract Example:
A speculator believes the EUR/USD exchange rate will rise. They buy EUR futures contracts on the Chicago Mercantile Exchange (CME), benefiting if the euro strengthens against the U.S. dollar.
When to
Use Each
|
Situation |
Best
Choice |
|
Hedging
an exact amount for a specific future transaction |
Forward Contract |
|
Speculating
on currency price movements |
Futures Contract |
|
Avoiding
counterparty credit risk |
Futures Contract |
|
Needing
a flexible, customized agreement |
Forward Contract |
|
Trading
with high liquidity and transparency |
Futures Contract |
|
Business
importing/exporting goods with long-term contracts |
Forward Contract |
Major
Websites for More Info
·
Forward
Contracts:
·
Futures
Contracts:
Forward Rate Math Equations:
1) Forward Contract
F = S * ((1
+ iq) / (1 + ib)
A simpler version: F - S = S*(iq - ib)
Where:
- ib is
the interest rate in the base currency (for partial interest rate,
use ((days
to maturity / 360) * annual interest rate) to get id )
- iq is
the interest rate in the quoted currency (for partial interest rate,
use ((days to maturity / 360) *
annual interest rate) to get if )
- S is the
current spot foreign exchange rate.
- F is the
forward foreign exchange rate.
Examples: USD/GBP, the US Dollar is the base currency;
EUR/USD, the EURO is the base currency
GBP/USD = 2 è GBP is the based currency and USD is the quoted currency.
If interest rate in UK is 10%, interest rate is US is 5% è F = 2*(1+5%) / (1+10%) = 1.9091
https://www.jufinance.com/irp/
For
example:
A Jacksonville-based seafood company plans to import NOK
1,000,000 worth of salmon in the summer. Concerned about the potential appreciation
of the NOK in the coming months due to trade tensions, the company seeks to
hedge against exchange rate fluctuations. To mitigate this risk, they
approach Deutsche Bank to establish a forward contract, securing the exchange
rate at present. As the market maker for this forward contract, you observe
that the current interest rates are 6% in the U.S. and 2% in Norway. How
should you determine the forward rate, and what is the reasoning behind your
calculation?
Answer:
The
current exchange rate is NOK/USD = 0.1,
meaning 1 NOK = 0.1 USD, where NOK
is the base currency and USD is the quoted currency.
To determine the forward rate, we use the
interest rate parity (IRP) formula:
Since
there are three months left
until summer, the three-month interest rates are calculated as:
Applying
the formula:
Thus,
the forward rate should be approximately
0.101 NOK/USD.
Using a
Simplified Approximation:
A simpler way to estimate the forward rate is:
F - S = S*(iq - ib)
Where:
- (quoted currency,
USD) = 1.5%
- (base currency, NOK) = 0.5%
- = 0.1 NOK/USD
Thus,
the forward rate remains
0.101 NOK/USD, confirming the calculation.
Margin in
Futures Contracts
Benefits of Futures:
Margin (video)
What Is Margin
Call? | FXTM Learn Forex in 60 Seconds
(Video) 20X Leverage
Futures Game 125X Futures
Game
|
Term |
What It Means |
|
Margin |
Money
you must deposit to trade futures (like a security deposit). |
|
Initial Margin |
The
minimum
money you need to open a futures trade (like a down payment). |
|
Maintenance Margin |
The
minimum
balance required to keep the trade open (like a minimum bank balance). |
|
Margin Call |
A
warning when your balance drops too low; you must add money or close the
trade (like a teacher telling you to do homework or fail). |
|
Mark-to-Market |
Daily
profit/loss adjustment in your account (like updating your grade every
day). |
|
Leverage |
You
control a large contract with a small margin (like borrowing a big car with
a small deposit). |
|
Clearing House |
Ensures
everyone follows margin rules (like a referee in a game). |
Example: Speculating on Oil Futures
·
You think oil prices
will rise from $80
per barrel to $90
per barrel next month.
·
Instead of buying actual oil, you buy 1 oil futures contract
(each contract = 1,000 barrels).
·
The Initial
Margin required is $5,000
(not the full price).
Scenario 1: You Win (Price Goes Up)
- Oil
price rises
from $80 to $90
per barrel.
- Your
profit = ($90 - $80) × 1,000 barrels = $10,000 profit
- You
only invested $5,000 margin, but you doubled your money!
Advantage: Leverage è
You controlled $80,000 worth of oil
with just $5,000.
Scenario 2: You Lose (Price Drops)
- Oil
price falls
from $80 to $75
per barrel.
- Your
loss = ($80 - $75) × 1,000 barrels = $5,000 loss
- Your
margin account drops to $0 → Margin Call! Broker
asks for more money.
Risk: Big losses! If oil crashes
to $70, you
owe $10,000
Summary Table
|
Factor |
Advantage |
Risk |
|
Leverage |
Small
money controls big assets. |
Can
lose more than the deposit. |
|
Profit Potential |
High
return if the price moves in your favor. |
High
losses if the price moves against you. |
|
Liquidity |
Easy
to buy & sell. |
Market
moves fast → high volatility. |
|
Margin Calls |
Trade
with less cash upfront. |
Must
add money if the market goes against you. |
Final
Thought
- Futures can make you rich fast OR
wipe you out fast.
- Great for smart traders, terrible for
lazy gamblers.
- Use stop-loss orders to limit risk!
Another
Example: Cryptocurrency Futures Quiz
https://www.investopedia.com/articles/investing/012215/how-invest-bitcoin-exchange-futures.asp
|
Topic |
Summary |
|
Definition |
Cryptocurrency futures are contracts that allow investors to
speculate on crypto prices without owning the underlying asset. |
|
Trading Venues |
Crypto futures trade on regulated exchanges like CME and CBOE,
as well as unregulated platforms like Binance, ByBit, OKX, and XT.COM. |
|
Key Features |
Contracts specify a future price and settlement date, with
cash-settled and margined options available. |
|
History |
First Bitcoin futures launched in Dec 2017 (CBOE, CME); CBOE
discontinued, while CME expanded offerings. |
|
Popular Exchanges |
CME (regulated), Binance, ByBit, OKX, XT.COM (unregulated,
high leverage). |
|
Regulated vs.
Unregulated |
Regulated exchanges (CME, CBOE): Strict margin rules,
government oversight (CFTC). Unregulated exchanges: Higher leverage (up to
125x), greater risk. |
|
Margin Requirements |
Regulated: Margin requirements set by exchanges (e.g., CME
requires 50% for BTC, 60% for ETH). Unregulated: Higher leverage allowed,
leading to increased risk. |
|
Leverage |
CME & brokers: Limited leverage due to regulations.
Binance (unregulated): Originally up to 125x, reduced to 20x in 2021. |
|
Settlement |
Cash-settled (CME, CBOE): No physical crypto transfer. Some
exchanges allow physical settlement. |
|
Trading Process |
Requires broker approval, margin deposit, and futures account
setup. Positions can be rolled over or expire at settlement. |
|
Volatility &
Risk |
Crypto futures are highly volatile and may trade at a premium
or discount to spot prices. |
|
SEC Warning |
The SEC warned in 2021 that crypto futures are highly
speculative investments. |
|
Benefits |
Regulated exposure to crypto (CME); No need for a crypto
wallet; Safer than direct ownership (cash settlement, position limits). |
|
Drawbacks |
Extreme volatility; High leverage risk (especially on
unregulated exchanges); Unregulated markets pose security risks (e.g.,
ByBit hack 2025 - $1.5B lost). |
Crypto
exchange Bybit refills reserves after hackers steal a record $1.5 billion:
CNBC Crypto World
Bybit hack is a 'North
Korea problem' and not inherent to crypto, says Crucible Capital's Demirors
Another
Example: Euro
FX Futures - Contract Specs
Quiz
https://www.cmegroup.com/markets/fx/g10/euro-fx.contractSpecs.html
|
Specification |
Details |
|
Contract Unit |
125,000 Euro |
|
Price Quotation |
U.S. dollars and cents per Euro increment |
|
Trading Hours (CME
Globex) |
Sunday - Friday 5:00 p.m. - 4:00 p.m. CT with a 60-minute
break each day beginning at 4:00 p.m. CT |
|
Trading Hours (BTIC) |
Sunday - Friday 5:00 p.m. - 4:00 p.m. CT with a trading close
from 3:40 p.m. - 4:30 p.m. London time (9:40 a.m. - 10:30 a.m. CT) and a
60-minute break each day beginning at 4:00 p.m. CT |
|
Trading Hours (CME
ClearPort) |
Sunday 5:00 p.m. - Friday 5:45 p.m. CT with no reporting
Monday - Thursday from 5:45 p.m. - 6:00 p.m. CT |
|
Trading Hours (BTIC
- ClearPort) |
Sunday - Friday 5:00 p.m. - 5:45 p.m. CT with a trading halt
9:40 a.m. to 11:30 a.m. CT, and with no reporting Monday - Thursday from
5:45 p.m. - 6:00 p.m. CT |
|
Minimum Price
Fluctuation (CME Globex) |
0.000050 per Euro increment = $6.25 |
|
Minimum Price
Fluctuation (BTIC) |
0.000005 per Euro increment = $0.625 |
|
Minimum Price
Fluctuation (Spreads) |
0.00002 per Euro increment = $2.50 |
|
Minimum Price
Fluctuation (CME ClearPort) |
0.000010 per Euro increment = $1.25 |
|
Minimum Price
Fluctuation (BTIC - ClearPort) |
0.000001 per Euro increment = $0.125 |
|
Product Code (CME
Globex) |
6E |
|
Product Code (CME
ClearPort) |
EC |
|
Product Code
(Clearing) |
EC |
|
Product Code (BTIC) |
6EB |
|
Listed Contracts |
Quarterly contracts (Mar, Jun, Sep, Dec) listed for 20
consecutive quarters and serial contracts listed for 3 months |
|
Settlement Method |
Deliverable |
|
Termination of
Trading |
Trading terminates at 9:16 a.m. CT, 2 business days prior to
the third Wednesday of the contract month. |
|
Termination of
Trading (BTIC) |
Trading terminates at 3:40 p.m. London time (9:40 a.m. CT) one
business day prior to futures last trade date. |
|
Settlement
Procedures |
Physical Delivery |
|
Position Limits |
CME Position Limits |
|
Exchange Rulebook |
CME 261 |
|
Block Minimum |
Block Minimum Thresholds |
|
Price Limit or
Circuit |
Price Limits |
|
Vendor Codes |
Quote Vendor Symbols Listing |
Another Example: Norwegian
Krone Futures - Contract Specs (FYI)
Part b - Calculating Futures Contract Profit or Loss
Short and long position
and payoff (video)
Let’s Play the futures trading
simulator game and learn how PnL is calculated.
Real-Life PnL Calculation in
Futures Trading
Just like in the game:
- Daily PnL is based on the change in price from the previous day.
- Total PnL accumulates all past daily
PnL values over time.
Assume
a trader buys one NOK/USD futures
contract (Long
Position) with:
- Contract Size: 1,000,000 NOK
- Initial Exchange Rate: 0.10 USD/NOK
- Margin Balance: $50,000
Day 1: NOK/USD Rises from 0.10 → 0.105
- Daily PnL = (0.105 - 0.10) ×
1,000,000 = $5,000 profit
- Total PnL = $5,000
Day 2: NOK/USD Drops from 0.105 → 0.095
- Daily PnL = (0.095 - 0.105) ×
1,000,000 = -$10,000 loss
- Total PnL = $5,000 - $10,000 = -$5,000
Day 3: NOK/USD Rises from 0.095 → 0.102
- Daily PnL = (0.102 - 0.095) ×
1,000,000 = $7,000
profit
- Total PnL =
-5,000 + 7,000 = $2,000
This is exactly how futures trading mark-to-market (MTM) settlement
works in real life.
Real-Life Futures Trading Rules
- Mark-to-Market (MTM):
- Every
day, profit or loss is settled based on the price
change.
- If
you lose too much,
you might get a Margin Call (forced to deposit more
money).
- Total PnL = Sum of all Daily PnL
values until you close the position.
- If you hold a futures contract until
expiration, you must settle it in cash or take delivery
(depending on the contract rules).
For a long position， its payoff:
Value at maturity (long position) = principal * (
spot exchange rate at maturity – settlement price)
Value at maturity (short position) = -principal * (
spot exchange rate at maturity – settlement price)
Note: In the
calculator, principal is called contract size
Example:
Suppose a trader enters into a currency futures
contract to buy 10,000 euros (contract size) at a specified exchange rate of
1.2000 USD/EUR. The settlement price at the time of entering the contract is
also 1.2500 USD/EUR. The maturity date of the contract is in three months.
Long Position:
· At maturity, the spot exchange rate is
1.2500 USD/EUR.
· Using the formula for a long position's
payoff:
· Value at maturity (long position) =
Principal * (Spot exchange rate at maturity - Settlement price)
· = 10,000 euros * (1.2500 USD/EUR - 1.2000
USD/EUR)
· = 10,000 euros * 0.0500 USD/EUR
· = 500 USD
· Therefore, the trader receives a payoff of
500 USD from the long position.
Short Position:
· At maturity, the spot exchange rate is
still 1.2500 USD/EUR.
· Using the formula for a short position's
payoff:
· Value at maturity (short position) =
-Principal * (Spot exchange rate at maturity - Settlement price)
· = -10,000 euros * (1.2500 USD/EUR - 1.2000
USD/EUR)
· = -10,000 euros * 0.0500 USD/EUR
· = -500 USD
· Therefore, the trader has to pay 500 USD
as the payoff for the short position.
In
summary, for a long position, the trader benefits from a favorable movement
in the exchange rate, resulting in a positive payoff. Conversely, for a short
position, the trader incurs losses when the exchange rate moves against their
position, leading to a negative payoff.
Exercise 1: Amber
sells a March futures contract and locks in the right to sell 500,000 Mexican
pesos at $0.10958/Ps (peso). If the spot exchange rate at maturity is $0.095/Ps,
the value of Amber’s position on settlement is?
Answer:
-500000*(0.095-0.10958). With this futures contract, Amber should sell
500,000 Mexican pesos to the buyer at $0.10958/ Ps. The market price at
maturity is $0.095/Ps, so Amber can buy 500,000 Mexican pesos at $0.095/Ps,
and then sell to the buyer at $0.10958/ Ps. So Amber wins!
Exercise 2: Amber
purchases a March futures contract and locks in the right to sell 500,000
Mexican pesos at $0.10958/Ps (peso). If the spot exchange rate at maturity is
$0.095/Ps, the value of Amber’s position on settlement is?
Answer:
500000*(0.095-0.10958). With this futures contract, Amber should buy 500,000
Mexican pesos from the seller at $0.10958/ Ps. The market price at maturity
is $0.095/Ps, so Amber can buy 500,000 Mexican pesos at $0.10958/ Ps for
something that worth only $0.095/ Ps. So Amber lost money!
Exercise 3: Amber
sells a March futures contract and locks in the right to sell 500,000 Mexican
pesos at $0.10958/Ps (peso). If the spot exchange rate at maturity is
$0.11/Ps, the value of Amber’s position on settlement is?
Answer:
-500000*(0.11-0.10958). With this
futures contract, Amber should sell 500,000 Mexican pesos to the buyer at
$0.10958/ Ps. The market price at maturity is $0.11/Ps, so Amber can buy
500,000 Mexican pesos at $0.11/Ps, and then sell to the buyer at $0.10958/
Ps. So Amber lost money!
Exercise 4: Amber
purchases a March futures contract and locks in the right to sell 500,000
Mexican pesos at $0.10958/Ps (peso). If the spot exchange rate at maturity is
$0.11/Ps, the value of Amber’s position on settlement is?
Answer: 500000*(0.11-0.10958). With
this futures contract, Amber should buy 500,000 Mexican pesos from the seller
at $0.10958/ Ps. The market price at maturity is $0.11/Ps, so Amber can buy
500,000 Mexican pesos at $0.10958/ Ps, for something that worth $0.11/ Ps. So
Amber wins!
Exercise 5: You
expect peso to depreciate on 4/4. So you sell peso future contract (6/17) on
4/4 with future rate of $0.09/peso. And on 6/17, the spot rate is $0.08/peso.
Calculate the value of your position on settlement
HW of chapter
5 part I (Due with the second mid-term)
1. Consider
a trader who opens a short futures position. The contract
size is £62,500; the maturity is six months, and the settlement price is
$1.60 = £1; At maturity, the price (spot rate) is $1.50 = £1. What is his
payoff at maturity?
(Answer: £6250)
2. Consider
a trader who opens a long futures position. The contract size is £62,500; the maturity
is six months, and the settlement price is $1.60 = £1; At maturity, the price
(spot rate) is $1.50 = £1. What is his payoff at maturity?
(Answer: -£6250)
3. Consider
a trader who opens a short futures position. The contract
size is £62,500, the maturity is six months, and the settlement
price is $1.40 = £1; At maturity, the price (spot rate) is $1.50 = £1. What
is his payoff at maturity?
(Answer: -£6250)
4.
Consider a trader who opens a long futures
position. The contract size is
£62,500, the maturity is six months, and the settlement
price is $1.40 = £1; At maturity, the price (spot rate) is $1.50 = £1. What
is his payoff at maturity?
5. Watch this video and explain the following
concepts.
Understanding Futures
Margin | Fundamentals of Futures Trading Course
· What is margin account?
· What is mark to market?
· What is initial margin?
· What is maintenance margin?
· What is margin call?
· How is margin call triggered?
· What will happen after a margin call is
received?
6.
A Jacksonville-based seafood company
plans to import NOK 1,000,000 worth of salmon in the summer. Concerned about
the potential appreciation of the NOK in the coming months due to trade
tensions, the company seeks to hedge against exchange rate fluctuations. To
mitigate this risk, they approach Deutsche Bank to establish a forward
contract, securing the exchange rate at present. As the market maker for this
forward contract, you observe that the current interest rates are 2% in the
U.S. and 6% in Norway. How should you determine the forward rate, and what is
the reasoning behind your calculation?
Cryptocurrency
Futures: Definition and How They Work on Exchanges
By
Prableen Bajpai Updated October 11, 2024
Reviewed
by Erika Rasure
Fact checked
by Suzanne Kvilhaug
https://www.investopedia.com/articles/investing/012215/how-invest-bitcoin-exchange-futures.asp
What Are Cryptocurrency
Futures?
Cryptocurrency futures are contracts between two investors who
bet on a cryptocurrency's future price, giving them exposure to
cryptocurrencies without purchasing them. Crypto futures resemble standard
futures contracts because they allow traders to bet on the price trajectory
of an underlying asset.
These contracts specify that one party must deliver a
cryptocurrency's fiat value to another party at a specific price by a certain
date.
Crypto futures contracts trade on the Chicago Mercantile Exchange
(CME) and cryptocurrency exchanges. Margined futures for Bitcoin and Ether
also trade on the Chicago Board Options Exchange (CBOE).
Key Takeaways
·
Cryptocurrency futures
allow investors to speculate on the future price of cryptocurrencies.
·
You can choose from a
variety of venues to trade monthly cryptocurrency futures. Some are
regulated; others are not.
·
Cryptocurrency is known
for its volatile price swings, which makes investing in cryptocurrency
futures risky.
·
You can trade
cryptocurrency futures at brokerages approved for futures and options trading
and on many decentralized exchanges.
Cryptocurrency Futures
History
The first Bitcoin futures contracts were listed on the CBOE in
early December 2017, but were discontinued.
In January 2024, the
exchange announced that margined Bitcoin and Ether futures began trading.
According to the exchange, this made it the "first U.S. regulated crypto
native exchange and clearinghouse to offer both spot and leveraged
derivatives trading on a single platform."
The CME introduced Bitcoin futures contracts in December 2017.
The contracts are traded on the Globex electronic trading platform and are
settled in cash. Bitcoin and Ether futures are based on the CME CF Bitcoin
Reference Rate and the CME CF Ether Reference Rate.
The CME also has reference rates for many other
cryptocurrencies, although futures for these cryptos are not available on the
exchange for trading. These rates are published for traders using other
exchanges. There are 17 cryptocurrency rates (including bitcoin and ether),
four DeFi token rates, and three Metaverse token rates.
Cryptocurrency Futures on CME
The table below highlights the contract details for Bitcoin
and ETH futures offered by the CME:
Popular Exchanges for Cryptocurrency Futures
According to data from crypto aggregation site CoinGecko, some
prominent crypto derivative trading platforms are:
·
Binance: The world’s
biggest cryptocurrency exchange by trading volume also accounted for $60.30
billion of the total trading volume in Bitcoin futures.
·
ByBit: While it may not
be as well-known as Binance to U.S. audiences, ByBit ranks among the world’s
biggest cryptocurrency exchanges and has 469 cryptocurrency futures
available. It had a trading volume of $19.98 billion on Oct. 10, 2024. Due to
regulatory compliance reasons, ByBit is not available to U.S. customers.
·
OKX: OKX offers 178
cryptocurrency futures. Trading volume was $21.15 billion on Oct. 10, 2024.
·
XT.COM: Another
lesser-known exchange, XT.COM was created in 2018 and has 472 crypto futures
available. Its 24-hour trading volume is $21.15 billion, and open interest is
$4.74 billion.
·
On Feb. 21, 2025, Bybit CEO Ben Zhou announced that hackers
infiltrated the exchange’s Ethereum multi-signature
cold wallet, draining nearly $1.5 billion in crypto. Zhou also went on to
state that the breach was isolated to Bybit’s Ethereum cold wallet, and that “All withdrawals are NORMAL.” Investopedia will continue to monitor the situation and
provide updates when conditions warrant it.
Trading on Regulated vs.
Unregulated Exchanges
Regulated Exchanges
Consider the following example for a CME Group Bitcoin futures
contract. Suppose an investor purchases two Bitcoin futures contracts
totaling 10 bitcoin. The price of a single bitcoin when the futures contract
was purchased was $5,000 each, totaling $50,000 for both futures contracts.
The exchange calls for a 50% margin for Bitcoin (60% for
Ether) futures trading, so they would need to place $25,000 in their margin
account. The rest could be funded by leverage.
Brokerages offer
futures products from many companies but can have different margin
requirements over and above the amount the provider charges.
For example, CME has a base margin requirement for Bitcoin
futures; brokerages like TD Ameritrade, which offers CME Bitcoin futures
trading as part of their product suite, can set margin rates on top of the
base rate set by the exchange.
The contract's value varies based on the underlying asset's
price (i.e., Bitcoin). CME uses the Bitcoin Reference Rate, which is the
volume-weighted average price for Bitcoin sourced from multiple exchanges and
is calculated daily between 3 p.m. and 4 p.m. London time.
To trade futures, you must have an account with a registered
futures commission merchant or introducing broker.
Depending on Bitcoin’s price fluctuations, you
can either hold onto the futures contracts or sell them to another party. At
the end of your contracts’ duration, you have the
option to roll them over to new ones or let them expire and collect the cash
settlement due.
The steps to conduct a trade in Bitcoin futures are the same
as those for a regular futures contract. You begin by setting up an account
with the brokerage or exchange where you plan to trade. Once your account is
approved, you will need another approval from the trading service provider to
start futures trading. Generally, the latter approval is a function of
funding requirements and the account holder’s experience with derivatives trading.
The same criteria also play an essential role in determining
leverage and margin amounts for your trade. Futures trading makes heavy use
of leverage to execute trades. Government agencies regulate the maximum
leverage amount allowed at regulated exchanges and trading venues.
Bitcoin’s risky and volatile nature
means that the margin amounts required for trading their futures are
generally higher than those for other commodities and assets.
Unregulated Exchanges
The story is different at unregulated exchanges. They have the
freedom to allow excessive risk-taking for their trades. For example, Binance
offered leverage of up to 125 times the trading amount when it launched
futures trading on its platform in 2019.
That figure was revised to 20 times the trading amount in July 2021.
Remember that higher leverage amounts translate to more volatility for your
trade. Thus, the promise of high profits is offset by the risk of losing
significant amounts of money.
The amount you can trade depends on the margin amount
available to you. Margin is the minimum collateral you must have in your
account to execute trades. The higher the amount of the trade, the greater
the margin amount required by the broker or exchange to complete the trade.
You can also gain exposure to cryptocurrency futures by
trading cryptocurrency ETFs. There are several Bitcoin ETFs that are linked
to Bitcoin futures.
Benefits of Cryptocurrency Futures Trading
The main advantage of trading Bitcoin futures contracts is
that they offer regulated exposure to cryptocurrencies. That is a significant
point in a volatile ecosystem with wild price swings. In the U.S., bitcoin
futures contracts at CME are regulated by the Commodity Futures Trading
Commission (CFTC). This offers a measure of confidence and recourse to
institutional investors, who compose the majority of traders in such
contracts.
Simplicity: Bitcoin futures also simplify the process of
investing in Bitcoin. You do not need to create a Bitcoin wallet or put money
into custody solutions for storage and security while trading because there
is no bitcoin exchange. An added benefit of cash-settled contracts is
eliminating the risk of physical ownership of a volatile asset.
Safer Than Owning Crypto: Bitcoin futures contracts are
relatively safer for dabbling in bitcoin without getting burnt because
futures contracts have positions and price limits that enable you to curtail
your risk exposure to the asset class.
Position Limits: Position limits differ between exchanges. For
example, CME allows a maximum of 8,000 front-month futures contracts for
bitcoin and micro bitcoin and 8,000 for ether and micro ether. Binance, the
world’s biggest cryptocurrency exchange by
trading volume, has a position limit adjustment feature that enables manual
reconfiguration of limits based on past trading history and margin amounts.
The further out the futures contract expiration date is, the higher the
account maintenance amount will generally be.
What to Consider When
Trading Cryptocurrency Futures
The number of venues offering cryptocurrency futures trading
is growing, as are the numbers of participants and trading volumes compared
to other commodities. Cryptocurrency futures trading has its own set of
peculiarities.
Trading Volume
Trading volumes in cryptocurrency futures can mimic those of
its spot markets counterparts. Price fluctuations can also be high,
especially during volatile stretches regarding price. During these times,
cryptocurrency futures may appear to follow spot market prices or trade at a
significant premium or discount to spot prices.
This means that Bitcoin futures may not offer sufficient
protection against the volatility of the underlying futures market. The SEC
warned investors about the pitfalls of trading cryptocurrency futures in June
2021. "Among other things, investors should understand that [bitcoin],
including gaining exposure through the [bitcoin] futures market, is a highly
speculative investment."
Most Exchanges Are Unregulated
Except for select trading venues, such as CME, cryptocurrency
futures trading occurs mainly on exchanges outside the purview of regulation.
Among the world’s biggest platforms for Bitcoin futures,
only CME is regulated by the CFTC.
Class
Discussion on Russian – Ukraine War
Prepare by using the
discussion platform on the class website:
https://www.jufinance.com/fin415_25s/russian_ukrain_war_discussion_2025.html
Homework (due with the second midterm exam)
When do you think the
war will end and why?
Part
b: Call and Put Option
Bears Trading 101: Call
& Put Options Explained! (Fun for Beginners)
1. What is Call and put option?
Difference between the two?
American call option (video, khan academy)
American put option (video, khan academy)
Refer to What is Is Options
Trading? A Beginner's Overview
Learn the benefits and risks
of options and how to start trading options
https://www.investopedia.com/options-basics-tutorial-4583012
Call vs. Put Options - Key
Insights & Examples
Quiz
|
Feature |
Call Option |
Put Option |
|
Definition |
A
call option
gives the right to buy
an asset at a set price before expiration. |
A
put option
gives the right to sell
an asset at a set price before expiration. |
|
Market Outlook |
Bullish
(Expect the asset price to rise) |
Bearish
(Expect the asset price to fall) |
|
Profit Potential |
Unlimited
(As the asset price rises, the value of the call increases) |
Limited to the strike
price (As the asset price falls, the value of
the put increases) |
|
Maximum Loss |
The premium paid
(If the asset price does not increase above the strike price, the option
expires worthless) |
The premium paid
(If the asset price does not decrease below the strike price, the option
expires worthless) |
|
When to BUY (Go Long)? |
When you expect the
price of the asset to increase.
Example: Buying a Call
Option on NOK/USD when expecting NOK to strengthen (1 USD =
11 NOK now, expect 1 USD = 9 NOK). |
When you expect the
price of the asset to decrease.
Example: Buying a Put
Option on NOK/USD when expecting NOK to weaken (1 USD = 11
NOK now, expect 1 USD = 13 NOK). |
|
When to SELL (Go Short)? |
When you think the
asset will NOT rise much or will fall.
Example: Selling a Call
Option on Tesla stock if you believe it will stay the same
or decline. |
When you think the
asset will NOT fall much or will rise.
Example: Selling a Put
Option on NOK/USD if you believe NOK will strengthen
against USD. |
|
Best Used For |
Speculation
(Profiting from a price increase) or hedging
short positions. |
Speculation
(Profiting from a price decrease) or hedging
long positions. |
|
Example 1 (Stock) |
You
buy a Call Option
on Apple stock
at $150. If the price rises to $180, you profit. |
You
buy a Put Option
on Apple stock
at $150. If the price drops to $120, you profit. |
|
Example 2 (Currency) |
You
buy a Call Option on NOK/USD
(strike price: 11
NOK per USD). If NOK strengthens (1 USD = 9 NOK), you profit. |
You
buy a Put Option on NOK/USD
(strike price: 11
NOK per USD). If NOK weakens (1 USD = 13 NOK), you profit. |
|
Example 3 (Commodities) |
You
buy a Call Option on Oil at
$80/barrel. If oil rises to $100, you profit. |
You
buy a Put Option on Oil at
$80/barrel. If oil drops to $60, you profit. |
Summary
- Calls = Make money if price goes up
- Puts = Make money if price goes down
- Buy a Call if you think the price will rise
(bullish).
- Buy a Put if you think the price will fall
(bearish).
- Sell a Call if you think the price won’t
rise much (neutral/bearish).
- Sell a Put if you think the price won’t
fall much (neutral/bullish).
- https://money.tmx.com/en/quote/$NOKUSD/options
Norway Krone / USA Dollars Options (inactive)
- https://www.eurex.com/ex-en/markets/fx/listed-fx/currency-pairs/Options-on-EUR-USD-Futures-950954 EUR / USD Options
2. Calculate the payoff for
both call and put?
· For call: Profit = Spot rate – strike
price – premium; if option is exercised (when spot rate > strike price)
Or, Profit
= -premium, if option is not exercised (expired when spot
rate < strike
price)
In general, profit = max((spot rate – strike price -
premium), -premium ) ---------- Excel syntax
Calculator of Call and Put Options
Call and Put Options Payoff Game
1.
Jim is a speculator . He buys
a British pound call option with a strike of $1.4 and a December settlement
date. Current spot price as of that date is $1.39. He pays a premium of $0.12
per unit for the call option. Just before the expiration date, the spot rate
of the British pound is $1.41.At that time, he exercises the call option and
sells the pounds at the spot rate to a bank. One option contract specifies
31,250 units. What is Jim’s profit or loss? Assume Linda is the seller of the
call option. What is Linda’s profit or loss?
(refer to ppt.
Answer:
Spot rate is
$1.41, Jim’s total profit: (1.41-1.4-0.12)*31250=(-0.11)*31250
Spot rate is
$1.39, Linda’s total profit: 0.12*31250
Spot rate is
$1.41, Linda’s total profit: -((1.41-1.4-0.12)*31250)=0.11*31250
*** the loss
of taking the long position of the option is just the gain of taking the
short position. It is a zero sum game.
· For put: Profit = strike price - Spot rate –
premium, if option is exercised (when spot rate < strike price)
2.
A speculator bought a put option (Put premium
on £ = $0.04 / unit, X=$1.4, One contract specifies £31,250 )
He exercise the option shortly
before expiration, when the spot rate of the pound was $1.30. What is his
profit? What is the profit of the seller? (refer to ppt) When spot rate was $1.5, what are the profits of
seller and buyer?
Answer:
Spot rate is
$1.50, option buyer’s total profit: -0.04*31250
Spot rate is
$1.30, option seller’s total profit: -(1.4 - 1.3 – 0.04) *31250
Spot rate is
$1.50, option seller’s total profit: 0.04*31250
*** the loss
of taking the long position of the option is just the gain of taking the
short position. It is a zero sum game.
www.jufinance.com/option_diagram
Summary
|
Strike Price < Current Price |
Strike Price = Current Price |
Strike Price > Current Price |
|
Call Option: In the Money |
Call Option: At the Money |
Call Option: Out of the Money |
|
Put Option: Out of the Money |
Put Option: At the Money |
Put Option: In the Money |
Payoff for Call
Option (X = Strike, S = Current Price):
·
In the Money: S - X
·
At the Money: 0
·
Out of the Money: 0
Payoff
for Put Option (X = Strike, S = Current Price):
·
In the Money: X - S
·
At the Money: 0
·
Out of the Money: 0
EUR/USD
Options Analysis In Class Exercise
Objective:
This exercise will help you understand how currency options work and how they
are priced in the market. You will use Investing.com’s EUR/USD Options page to analyze current
market data.
Instructions:
1.
Access
the Data:
- Go
to EUR/USD
Options on Investing.com.
- Familiarize
yourself with the interface.
2.
Observe
the Key Elements:
- Strike Prices: Identify the range of strike
prices available.
- Call vs. Put Options: Understand the difference in their
pricing.
- Expiration Dates: Note the available contract
durations.
3.
Compare
Different Expiration Dates:
- Pick
two different expiration dates and compare their pricing.
- What
patterns do you see in how prices change over time?
4.
Scenario
Analysis:
- If
you expect the EUR/USD exchange rate to rise, which option
(call or put) should you buy?
- If
you expect it to fall, which would be the better choice?
5.
Discussion
Questions:
- What
factors influence the pricing of these options?
- Why
might traders use options instead of simply trading the currency pair?
Submission Requirement:
Prepare a short report (1 page)
summarizing your findings. Include:
- Your
selected options data.
- Explanation
of your observations.
- Answers
to the discussion questions.
What is Is Options
Trading? A Beginner's Overview
Learn the benefits and
risks of options and how to start trading options
https://www.investopedia.com/options-basics-tutorial-4583012
By Lucas Downey Updated November 15, 2024; Reviewed by
Samantha Silberstein; Fact checked by Vikki Velasquez
Options are financial contracts that give the holder the
right to buy or sell a financial instrument at a specific price for a certain
period of time. Options are available for numerous financial products, such
as stocks, funds, commodities, and indexes. Like most other asset classes,
options can be purchased with brokerage investment accounts.
Options trading may seem overwhelming at first, but it’s
easy to understand if you know a few key points. Investor portfolios are
usually constructed with several asset classes. These may be stocks, bonds,
exchange-traded funds (ETFs), and mutual funds. Options are another asset
class, and when used correctly, they offer many advantages that trading stocks
and ETFs alone cannot.
There are three key features of options:
· Strike price: This is the price at which an option can be
exercised.
· Expiration date: This is the date at which an option
expires and becomes worthless.
· Option premium: This is the price at which an option is
purchased.
Key Takeaways
· An option is a contract giving the buyer the right—but not
the obligation—to buy (in the case of a call) or sell (in the case of a put)
the underlying asset at a specific price on or before a certain date.
· People use options for income, to speculate, and to hedge
risk.
· Options are known as derivatives because they derive their
value from an underlying asset.
· A stock option contract typically represents 100 shares of
the underlying stock, but options may be written on any sort of underlying
asset from bonds to currencies to commodities.
Why Trade Options?
Options are powerful because they can enhance an
individual’s portfolio, adding income, protection, and even leverage.
Depending on the situation, there is usually an option scenario appropriate
for an investor’s goal.
Options can be used as a hedge against a declining stock
market to limit downside losses. In fact, options were really invented for
hedging purposes. Hedging with options is meant to reduce risk at a
reasonable cost. Just as you insure your house or car, options can be used to
insure your investments against a downturn.
Imagine that you want to buy technology stocks, but you
also want to limit losses. By using put options, you could limit your
downside risk and cost-effectively enjoy all the upside. For short sellers,
call options can be used to limit losses if the underlying price moves
against their trade—especially during a short squeeze.
Options can also be used for speculation. Speculation is a
wager on future price direction. A speculator might think the price of a
stock will go up, perhaps based on fundamental analysis or technical
analysis.
A speculator might buy the stock or buy a call option on
the stock. Speculating with a call option—instead of buying the stock
outright—is attractive to some traders because options provide leverage. An
out-of-the-money call option may only cost a few dollars or even cents
compared with the full price of a $100 stock.
Options Are Derivatives
Options belong to the larger group of securities known as
derivatives. A derivative’s price is dependent on or derived from the price
of something else. Options are derivatives of financial securities—their
value depends on the price of some other asset. Examples of derivatives
include calls, puts, futures, forwards, swaps, and mortgage-backed
securities, among others.
How to Trade Options
Many brokers today allow access to options trading for
qualified customers. If you want access to options trading, you will have to
be approved for both margin and options with your broker.
Once approved, there are four basic things you can do with
options:
· Buy (long) calls
· Sell (short) calls
· Buy (long) puts
· Sell (short) puts
Buying stock gives you a long position. Buying a call
option gives you a potential long position in the underlying stock.
Short-selling a stock gives you a short position. Selling a naked or
uncovered call gives you a potential short position in the underlying stock.
Buying a put option gives you a potential short position in
the underlying stock. Selling a naked or unmarried put gives you a potential
long position in the underlying stock. Keeping these four scenarios straight
is crucial.
People who buy options are called holders, and those who
sell options are called writers of options. Here is the important distinction
between holders and writers:
Call holders and put holders (buyers) are not obligated to
buy or sell. They have the choice to exercise their rights. This limits the
risk of buyers of options to only the premium spent.
Call writers and put writers (sellers), however, are
obligated to buy or sell if the option expires in the money. This means that
a seller may be required to make good on a promise to buy or sell. It also
implies that option sellers have exposure to more—and in some cases,
unlimited—risks. This means writers can lose much more than the price of the
options premium.
Options can also generate recurring income. Additionally,
they are often used for speculative purposes, such as wagering on the
direction of a stock.
How Do Options Work?
In terms of valuing option contracts, it is essentially all
about determining the probabilities of future price events. The more likely
something is to occur, the more expensive an option that profits from that
event would be. For instance, a call value goes up as the stock (underlying)
goes up. This is the key to understanding the relative value of options.
The less time there is until expiry, the less value an
option will have. This is because the chances of a price move in the
underlying stock diminish as we draw closer to expiry. This is why an option
is a wasting asset. If you buy a one-month option that is out of the money,
and the stock doesn’t move, the option becomes less valuable with each
passing day.
Because time is a component of the price of an option, a
one-month option is going to be less valuable than a three-month option. This
is because with more time available, the probability of a price move in your
favor increases, and vice versa.
Accordingly, the same option strike that expires in a year
will cost more than the same strike for one month. This wasting feature of
options is known as time decay. The same option will be worth less tomorrow
than it is today if the price of the stock doesn’t move.
Volatility also increases the price of an option. This is
because uncertainty pushes the odds of an outcome higher. If the volatility
of the underlying asset increases, larger price swings increase the
possibility of substantial moves both up and down.
Greater price swings will increase the chances of an event
occurring. Therefore, the greater the volatility, the greater the price of
the option. Options trading and volatility are intrinsically linked to each
other in this way.
On most U.S. exchanges, a stock option contract is the
option to buy or sell 100 shares; that’s why you must multiply the contract
premium by 100 to get the total amount you’ll have to spend to buy the call.
Call Options
A call option gives the holder the right, but not the
obligation, to buy the underlying security at the strike price on or before
expiration. A call option will therefore become more valuable as the
underlying security rises in price (calls have a positive delta).
A long call can be used to speculate on the price of the
underlying rising since it has unlimited upside potential, but the maximum
loss is the premium (price) paid for the option.
Call Option Basics
Call Option Example
A potential homeowner sees a new development going up. That
person may want the right to purchase a home in the future but will only want
to exercise that right after certain developments around the area are built.
The potential homebuyer would benefit from the option of
buying or not. Imagine they can buy a call option from the developer to buy
the home at, say, $400,000 at any point in the next three years. Well, they
can—you know it as a non-refundable deposit.
Naturally, the developer wouldn’t grant such an option for
free. The potential homebuyer needs to contribute a down payment to lock in
that right.
With respect to an option, this cost is known as the
premium. It is the price of the option contract. In our home example, the
deposit might be $20,000 that the buyer pays the developer.
Let’s say two years have passed, and now the developments
are built and zoning has been approved. The homebuyer exercises the option
and buys the home for $400,000 because that is the contract purchased.
The market value of that home may have doubled to $800,000.
But because the down payment locked in a predetermined price, the buyer pays
$400,000.
Now, in an alternate scenario, say the zoning approval
doesn’t come through until year four. This is one year past the expiration of
this option. Now the homebuyer must pay the market price because the contract
has expired. In either case, the developer keeps the original $20,000
collected.
Put Options
Opposite to call options, a put gives the holder the right,
but not the obligation, to instead sell the underlying stock at the strike
price on or before expiration.
A long put, therefore, is a short position in the
underlying security, since the put gains value as the underlying price falls
(they have a negative delta). Protective puts can be purchased as a sort of
insurance, providing a price floor for investors to hedge their positions.
Put Option Basics
Put Option Example
Now, think of a put option as an insurance policy. If you
own your home, you are likely familiar with the process of purchasing
homeowner’s insurance. A homeowner buys a homeowner’s policy to protect their
home from damage.
They pay an amount called a premium for a certain amount of
time—let’s say a year. The policy has a face value and gives the insurance
holder protection in the event the home is damaged.
What if, instead of a home, your asset was a stock or index
investment? Similarly, if an investor wants insurance on their S&P 500
index portfolio, they can purchase put options.
An investor may fear that a bear market is near and may be
unwilling to lose more than 10% of their long position in the S&P 500
index. If the S&P 500 is currently trading at $2,500, they can purchase a
put option giving them the right to sell the index at $2,250, for example, at
any point in the next two years.
If in six months the market crashes by 20% (500 points on
the index), they have made 250 points by being able to sell the index at
$2,250 when it is trading at $2,000—a combined loss of just 10%.
In fact, even if the market drops to zero, the loss would
only be 10% if this put option is held. Again, purchasing the option will
carry a cost (the premium), and if the market doesn’t drop during that period,
the maximum loss on the option is just the premium spent.
How To Buy and Sell Bitcoin
Options
Learn what it takes to buy
and sell Bitcoin options
By ALEX LIELACHER
Updated February 11, 2024, Fact checked by SUZANNE KVILHAUG
https://www.investopedia.com/how-to-buy-and-sell-bitcoin-options-7378233
Bitcoin options are financial derivatives that enable
investors to speculate on the price of the digital currency with leverage or
hedge their digital asset portfolios. Available on both
traditional derivatives exchanges and on crypto trading platforms, Bitcoin
options have emerged as a popular investment product among advanced crypto
traders.
KEY TAKEAWAYS
· Bitcoin options are financial derivatives contracts
that allow you to buy or sell Bitcoin at a predetermined price on a specific
future date.
· Trading Bitcoin and other cryptocurrency options
works much the same as other options, except they're typically less liquid.
· There are some trading platforms and crypto
exchanges where you can trade Bitcoin options; but you'll need to set up and
fund an account first.
· Trading Bitcoin options is riskier and more complex
than trading spot Bitcoin, which is itself risky and speculative.
· Traders should conduct as much research as possible
(including consulting with a financial advisor) before trading Bitcoin
options, and must select a reputable reputable crypto derivatives exchange
with strong security for their trades.
· Understanding Bitcoin Options
Options are financial
derivatives contracts that give holders the right but not the obligation to
buy or sell a predetermined amount of an asset at a specified price, and at a
specific date in the future.
In the case of Bitcoin options, the underlying asset is the
cryptocurrency Bitcoin (BTC). While the
cryptocurrency options market is still fairly new, you can already trade
Bitcoin and Ethereum options on a handful of traditional securities exchanges
and crypto trading platforms.
Traders who wish to
gain exposure to Bitcoin now have additional choices. The 11 recently launched spot Bitcoin exchange-traded funds (ETFs),
which were approved by the U.S. Securities and Exchange Commission in January
2024, each offer a basket of cryptocurrency securities and can be traded on
Cboe BZX, NYSE Arca, and Nasdaq.
From a technical
point of view, cryptocurrency options and options contracts on assets like
stocks, indexes, or commodities function in essentially the same way. However,
crypto options are generally less
liquid than options on leading stock indexes or commodities like gold.
That’s a result of the crypto markets still being a lot smaller than
traditional investment markets.
European vs. American
There are two main types
of options contracts: European and American. The key difference between the
two is that European-style options can only be exercised at expiration, while
American-style options can be exercised at any time up until the expiry date.
ITM vs. ATM vs. OTM
An options position
can either be in the money, at the money, or out of the money.
· An in-the-money (ITM) option refers to the situation
when the option has intrinsic value. If you exercised an in-the-money option
you would profit. For call options, this is when the market price is higher
than the strike price. Put options are in-the-money when the market price is
below the strike price.
· An out-of-the-money (OTM) option refers to a
situation when you would lose money if you exercised the option, meaning the
option currently has no intrinsic value. In the case of call options, this is
when the market price is lower than the strike price. For put options, this
is when the market price is higher than the strike price.
· An at-the-money (ATM) option is currently trading at
the strike price.
Calls vs. Puts
You can either buy a call or a put option. A call gives the
holder the right to buy the underlying asset, while a put option gives the
holder the right to sell the underlying asset.
Whether you buy or
sell a Bitcoin put option or call option depends on whether you want to
speculate on a rising or falling price or whether you are looking to hedge
crypto exposure.
Physical vs. Cash Settle
Options can either be cash settled or physically settled. For example, if you trade cocoa options, you could—if the options
contract determines it—receive shipments of cocoa once the options contract
expires.
When bitcoin options are settled physically, the bitcoin is
transferred between the two parties. When cash settlement is used, the
parties would exchange dollars or another currency.
Investing in cryptocurrencies, decentralized finance
(DeFi), and initial coin offerings (ICOs) is highly risky and speculative, and the markets can be extremely
volatile. Consult with a qualified professional before making any
financial decisions.
Options Are Riskier Than Spot Trading
Trading Bitcoin options is generally riskier than buying
and selling Bitcoin in the spot market.
For example, suppose you buy a call option on Bitcoin with
a strike price of $35,000 and an expiry date that is three months away. If
the price of Bitcoin doesn’t surpass $35,000 by the expiration date, you will
lose the options premium (the price you paid for the option) in full.
Options Are More Complex Than Spot Trading
When trading Bitcoin
options, the price of Bitcoin is not the only factor affecting the value of
options contracts. There are several key factors that affect the value of the
options you buy or sell, but time decay is by far the most critical. That’s
because as the time moves closer to the expiry date, the value of an options
contract decreases because the time remaining to trade or exercise the
options diminishes.
The Bitcoin Options Market Is Less Established
While Bitcoin options
can be found on traditional securities exchanges, like the Chicago Mercantile
Exchange (CME), and on dedicated crypto trading platforms, the BTC options market is still quite
young and doesn’t have the deep liquidity found in mature options markets. This
can affect price slippage, especially in options with longer maturities.
HW
Chapter 5 Part II (Due with the
second midterm exam)
4. You purchase a put option
on Swiss francs for a premium of $.05, with an exercise price of $.50. The
option will not be exercised until the expiration date, if at all. If the
spot rate on the expiration date is $.58,
how much is the payoff of this long option? And your profit? (And
also, please draw the payoff diagram to both the long and short put option
holders, optional, for extra credits. www.jufinance.com/option_diagram).
(Answer: -$0.05; 0)
5. Optional assignment for critical thinking: Set up a
practice account at https://www.cmegroup.com/education/practice.html
and click on the “trading simulator” to start trading on the future market.
Choose a specific future contract, such as euro future contract expired in
March, and you can start the game.
Second Midterm
Exam ---- 3/27(Closed Book Closed Notes)
·
Solution
Study Guide
40 t/f questions from the
following topics (40*2=80)
SWIFT Overview
- SWIFT = Society for Worldwide Interbank
Financial Telecommunication
- Function: A global messaging system
for secure communication between financial institutions
SWIFT's
Role in Global Finance
- Connects
11,000+
institutions in over 200 countries
- Handles
millions of
financial messages daily
- Essential
for international
banking and trade
SWIFT and International Sanctions
- Used
as a tool to enforce
sanctions
- Russia cut off in 2022 due to Ukraine
invasion
- Iran removed in 2012, reconnected in 2016 after nuclear
deal
Alternatives to SWIFT
- SPFS: Russia’s domestic system
- CIPS: China’s international payment
system
Impact of Being Cut Off from SWIFT
- Severe disruption to trade and global payments
- Loss
of foreign revenue and
access to global finance
- Encourages
development of
alternative systems
U.S. Influence on SWIFT
- U.S. and EU heavily influence SWIFT decisions
- Disconnection
via SWIFT = major economic penalty
- Affects
targeted banks,
not entire countries
Common Misconceptions
- SWIFT
= messaging system,
not a money-transfer service
- Not all banks in sanctioned countries are disconnected—only specific ones
Cryptocurrency as an Alternative
- Russia & Iran exploring digital currencies
- Used
to bypass SWIFT
sanctions and maintain transactions
II. Forward vs. Futures Contracts
|
Feature |
Forward |
Futures |
|
Trading
Venue |
OTC
(Bank-to-Bank) |
Exchange-traded
(e.g., CME) |
|
Customization |
Fully
customizable |
Standardized
contracts |
|
Regulation |
Not
regulated |
Regulated
by exchanges |
|
Counterparty
Risk |
High
(credit risk) |
Low
(guaranteed by clearinghouse) |
|
Margin
Requirements |
No
daily margin; credit line needed |
Requires
margin + daily mark-to-market |
|
Flexibility
& Liquidity |
Flexible
but less liquid |
Less
flexible but highly liquid |
III. Futures Contracts and Margin Basics
|
Term |
Meaning |
|
Initial Margin |
Deposit
to open position |
|
Maintenance Margin |
Minimum
balance to keep it open |
|
Mark-to-Market (MTM) |
Daily
profit/loss adjustment |
|
Margin Call |
Add
funds if margin falls below required |
IV. Call vs. Put Options (Currency Focus)
|
Feature |
Call Option |
Put Option |
|
Right
to... |
Buy
asset at strike price |
Sell
asset at strike price |
|
Market
Expectation |
Bullish
(expect price to rise) |
Bearish
(expect price to fall) |
|
Max
Profit |
Unlimited
(if price rises) |
Limited
(to strike price) |
|
Max
Loss |
Premium
paid |
Premium
paid |
V.
5 calculation questions based on futures payoff and call/put options (long
position only), similar to the homework questions. Total:
5 questions, 4 points each, for a total of 20 points.
|
Q# |
Type |
Details |
Formula / Explanation |
Payoff |
|
1 |
Futures – Long |
Buy 800,000 NOK @ $0.098 |
800,000 × (0.102 − 0.098) |
$3,200 profit |
|
Spot at maturity = $0.102 |
||||
|
2 |
Futures – Long |
Buy 1,000,000 NOK @ $0.100 |
1,000,000 × (0.093 − 0.100) = -7,000 |
$7,000 loss |
|
Spot at maturity = $0.093 |
||||
|
3 |
Call Option – Long |
Strike = $0.10, Spot = $0.11, Premium = $0.007 |
Spot > Strike → exercised. Payoff = (0.11 − 0.10) × 1,000,000 = 10,000 = 10,000 Profit = (0.11 − 0.10 − 0.007) * 1,000,000 = 3,000 |
$3,000 profit |
|
Contract size = 1,000,000 NOK |
||||
|
4 |
Call Option – Long |
Strike = $0.10, Spot = $0.095, Premium =$ 0.006 |
Spot < Strike → Not exercised. Payoff = 0 |
$3,000 loss |
|
Contract size = 500,000 NOK |
Profit = −0.006 × 500,000 = 3,000 |
|||
|
5 |
Put Option – Long |
Strike = $0.105, Spot = $0.120, Premium = $0.006 Contract size = 750,000 NOK |
Spot > Strike → Not exercised. Payoff = 0. Profit = -−0.006 × 750,000 = 4,500 |
$4,500 loss |
|
6 |
Put Option – Long |
Strike = $0.105, Spot = $0.09, Premium = $0.006 |
Spot < Strike → exercised. Payoff = (0.105 − 0.09) × 750,000 =11,250 Profit = (0.105 − 0.09 − 0.006) × 750,000 = 0.009
× 750,000 = 6,750 |
$6,750 profit |
|
Contract size = 750,000 NOK |
Chapter
8 Purchasing Power Parity
· Quiz
1) Purchasing power parity (PPP)
Purchasing power parity (cartoon) https://www.youtube.com/watch?v=i0icL5zlQww
|
|
|
·
A
theory which states that exchange rates between currencies are in equilibrium
when their purchasing power is the same in each of the two countries. ·
This
means that the exchange rate between two countries should equal the ratio
of the two countries' price level of a fixed basket of goods and services. ·
When
a country's domestic price level is increasing (i.e., a country experiences
inflation), that country's exchange rate must depreciated in order to
return to PPP. ·
The
basis for PPP is the "law of one price": In the absence of transportation and
other transaction costs, competitive markets will equalize the price of an
identical good in two countries when the prices are expressed in the same
currency. |
|
Concept |
Explanation |
|
Definition |
In the absence of transaction costs, the same product should
have the same price in all
markets when expressed in a common currency. |
|
Condition |
No transportation costs, tariffs, or other barriers to trade. |
|
Implication |
Exchange rates adjust so identical goods cost the same across
countries. |
|
Formula |
𝑃$ = 𝑃¥ × Spot Rate ($/¥) |
|
Or Rearranged |
Spot Rate ($/¥) = 𝑃$ / 𝑃¥ |
|
Example |
If a laptop costs $1,000 in the US and ¥120,000 in Japan →
Spot Rate = $1,000 / ¥120,000 = $0.0083/¥;
or Spot Rate = ¥120,000 / $1,000 = ¥120/$ |
· Law of One Price – When
It Holds vs. When It Doesn’t
|
Condition |
Holds |
Does NOT Hold |
|
Identical Products |
Products are exactly the same |
Products differ in features, brand perception, etc. |
|
No Transportation Costs |
Shipping is free or negligible |
Shipping, logistics costs vary across countries |
|
No Tariffs or Trade Barriers |
No import/export taxes |
Countries impose tariffs or quotas |
|
No Transaction Costs or Taxes |
No middlemen fees or sales taxes |
Presence of local taxes, fees, or dealer markups |
|
Perfect Competition |
Many sellers, no price manipulation |
Monopolies or oligopolies influence local pricing |
|
Free Market Exchange Rates |
Currencies can float freely |
Government intervention distorts exchange rate equilibrium |
· Limitations of the
Law of One Price
|
Limitation |
Explanation |
|
Transportation Costs |
Shipping and handling can drive up local prices |
|
Non-traded Goods |
Services or perishable goods aren’t easily traded across
borders |
|
Government Policies |
Tariffs, subsidies, and capital controls distort prices |
|
Market Segmentation |
Different markets may have unique demand and cost structures |
|
Exchange Rate Volatility |
Short-term fluctuations may prevent price equalization |
|
Menu Costs |
Firms may not adjust prices frequently due to cost or pricing
strategy |
|
Branding and Consumer Preferences |
Local consumer behavior or brand loyalty can affect pricing
power |
In Class Discussion: Can Bitcoin Obey the
Law of One Price? Game Quiz
|
Factor |
Can Bitcoin Hold the Same Price Globally? |
Why / Why Not? |
|
Global Accessibility |
Yes, in theory |
Bitcoin is decentralized and traded 24/7 across global
platforms. Prices should converge across borders. |
|
No Trade Barriers |
Yes |
There are no tariffs or borders for digital assets—Bitcoin
doesn’t need to be shipped or cleared through customs. |
|
Exchange Rate Influence |
Partially |
Bitcoin trades in local currencies. If local fiat currencies
fluctuate, BTC's local price can vary temporarily. |
|
Arbitrage |
Helps Maintain |
Traders exploit price differences across exchanges, which
tends to bring global BTC prices back into alignment. |
|
Transaction Fees |
❌ Distortion |
Blockchain and exchange fees can vary country to country and
reduce arbitrage efficiency. |
|
Government Regulations |
❌ Major Obstacle |
Countries like China, Nigeria, or India have restricted access
to crypto, causing market fragmentation and price differentials. |
|
Liquidity Differences |
❌ Limited in Some Places |
Smaller exchanges in emerging markets may have lower
liquidity, resulting in price discrepancies. |
|
Capital Controls |
❌ Distortion |
In some countries, it’s hard to convert BTC to local fiat due
to banking regulations. |
Conclusion:
·
Bitcoin does not always
obey the Law of One Price perfectly, but it comes closer than most physical goods,
especially in liquid markets
(like the US, EU, Japan).
·
Price gaps exist but are usually small and
short-lived due to arbitrage.
·
? What is your opinion?
|
https://www.jufinance.com/ppp
|
|
· No. · Exchange rate movements in the short
term are news-driven. · Announcements about interest rate
changes, changes in perception of the growth path of economies and the like
are all factors that drive exchange rates in the short run. · PPP, by comparison, describes the long
run behaviour of exchange rates. · The economic forces behind PPP will eventually
equalize the purchasing power of currencies. This can take many years,
however. A time horizon of 4-10 years would be typical. · · What
else? Your opinion? |
4) How to calculate PPP?
---- Use big mac index Big Mac Game
·
PPP
states that the spot exchange rate is determined by the relative prices of
similar basket of goods.
·
The
simplest way to calculate purchasing power parity between two countries is to
compare the price of a "standard" good that is in fact identical
across countries.
·
Every
year The Economist magazine publishes a light-hearted
version of PPP: its "Hamburger Index" that compares the price
of a McDonald's hamburger around the world. More sophisticated versions of
PPP look at a large number of goods and services.
·
One
of the key problems is that people in different countries consumer very
different sets of goods and services, making it difficult to compare the
purchasing power between countries.
·
How to Understand
the Global Economy with a Burger (The Big Mac Index) (video)
·
Comparison: Big Mac PRICE
by Country. Big Mac index 2022 (video)
Example 1: 1£=1.6$.
US inflation rate is 9%. UK inflation is 5%. What will happen? Calculate the
new exchange rate using the following equation.
Math equation: ef= Ih-
If or ((1+ Ih)/(1+If)
-1= ef; ef: change in exchange rate
(1+ 9%) /(1+5%)
-1 = ef = 4% , and 1£=1.6$, so the new
rate of £ =1.6*(1+4%) = 1.66 $/£.
Or use the calculator at: https://www.jufinance.com/ife/
Let's
consider an example where a product costs £1 in the UK and $1.6 in the US. If
there's a 5% increase in prices in the UK, the new price becomes £1 * (1 +
5%). Simultaneously, with a 9% inflation rate in the US, the new price in the
US should be $1.6 * (1 + 9%).
According
to the theory of Purchasing Power Parity (PPP), these adjusted prices should
reflect the same purchasing power across currencies. Thus, we can equate the
new prices and solve for the new exchange rate:
·
New Price in UK = £1 * (1 + 5%)
·
New Price in US = $1.6 * (1 + 9%)
To
find the new exchange rate:
New
Exchange Rate = New Price in US / New Price in UK
Substituting
the values:
New
Exchange Rate = ($1.6 * (1 + 9%)) / (£1 * (1 + 5%))
This
simplifies to:
·
New Exchange Rate = $1.6 * (1 + 9%) / (£1
* (1 + 5%))
·
New Exchange Rate = $1.6 * 1.09 / (£1 *
1.05)
·
New Exchange Rate = $1.744 / £1.05
·
New Exchange Rate ≈ $1.66 per £
So,
based on PPP theory, the new exchange rate would be approximately $1.66 per
£.
Example
2: 1£=1.6$. US inflation rate is 5%. UK
inflation is 9%. What will happen? Calculate the new exchange rate using the
PPP equation.
ef = Ih – If, Ih=
5%, If =9%, so ef =
5%-9% = -4%, so the old rate is that 1£=1.6$. The new rate should be 4%
lower. So new rate is that 1£=1.6*(1-4%) = 1.54$
Or, https://www.jufinance.com/ife/
Let's
reconsider the scenario with the US experiencing a 5% inflation rate and the
UK facing a 9% inflation rate. In this case, the new prices in both countries
would adjust accordingly:
·
Original price in the UK: £1
·
Original price in the US: $1.6
After
a 9% inflation rate in the UK and a 5% inflation rate in the US:
·
New price in the UK = £1 * (1 + 9%)
·
New price in the US = $1.6 * (1 + 5%)
According
to the theory of Purchasing Power Parity (PPP), these adjusted prices should
be equalized by the exchange rate:
New
Exchange Rate = New Price in US / New Price in UK
Substituting
the values:
New
Exchange Rate = ($1.6 * (1 + 5%)) / (£1 * (1 + 9%))
This
simplifies to:
·
New Exchange Rate = $1.6 * (1 + 5%) / (£1
* (1 + 9%))
·
New Exchange Rate = $1.6 * 1.05 / (£1 *
1.09)
·
New Exchange Rate = $1.68 / £1.09
·
New Exchange Rate ≈ $1.54 per £
So,
based on PPP theory, the new exchange rate would be approximately $1.54 per
£.
Homework
– (due with final)
1.
A product costs £1 in the UK and 16 NOK in Norway.
Next year, the inflation rate in the
UK is 5%, and the inflation
rate in Norway is 9%.
According to the Purchasing Power Parity (PPP)
theory:
- Calculate the new price
of the product in both countries.
- Using the PPP formula,
calculate the new exchange rate
(NOK/£) based on relative price levels.
- What is the implied
percentage change in the exchange rate?
2. Suppose the current exchange rate is 1€ = $1.10.
The inflation rate in the Eurozone is
expected to be 6%, while the inflation rate in the US is expected to be 3% over the next year.
Questions:
- Using the Relative PPP formula (ef ≈
Ih − If), calculate the expected percentage change in the exchange rate.
- Estimate the new exchange rate (USD/€)
based on this expected change.
- According to PPP, will the euro appreciate or depreciate relative to the
dollar? Explain why.
Homework:
Critical Thinking Challenge
Arbitrage involves buying a product
in one market where it's cheaper and simultaneously selling it in another
market where it's more expensive—profiting from the
price difference. While this is often discussed with currencies or financial
instruments, physical products
(like gold, crude oil, or luxury goods) can also present arbitrage
opportunities.
Scenario:
You notice that the price of gold in Dubai is $3,000 per ounce, while in
New York, the price is $3,100 per ounce.
Transportation and insurance costs per ounce are $20.
Questions:
- Is an arbitrage opportunity possible in this case? Show your calculation
and justify your answer.
- What
are some real-world physical products
where international arbitrage is common? Why are these products
suitable?
- What
barriers might prevent
someone from executing such physical arbitrage (e.g., regulations,
tariffs, logistics, perishability)?
- Can
arbitrage of physical goods contribute to market efficiency? Why or why not?
Sam Bankman
Fried Explains His Arbitrage Techniques
https://finance.yahoo.com/news/sam-bankman-fried-explains-arbitrage-132901181.html
Nicholas
Pongratz
April
9, 2021 3 min read
A
former ETF trader at Jane Street, Sam Bankman-Fried developed a net worth of
$9 billion from trading crypto in three and a half years. He explained his
success comes from lucrative arbitrage opportunities in crypto.
Bankman-Fried
launched a crypto-trading firm called Alameda Research in 2017. The company
now manages over $100 million in digital assets. The firm’s large-scale
trades made Bankman-Fried a self-made billionaire by the age of 29. He is
also the CEO and founder of the FTX Exchange, a cryptocurrency derivatives
trading exchange.
Upon
entering the crypto markets, he discovered that Bitcoin was growing very rapidly
in trading volumes. This meant there would also be large price discrepancies,
making it ideal for arbitrage, taking advantage of the price differences.
The
Kimchi Premium
One
opportunity he exploited was what is known as the kimchi premium. While Bitcoin
was pricing at around $10,000 in the US, it traded for $15,000 on Korean
exchanges. This was because of a huge demand for Bitcoin in Korea,
Bankman-Fried said.
Around
its peak, there was a vast spread of around 50%, he said. However, because
the Korean won is a regulated currency, it was difficult to scale this
arbitrage. Bankman-Fried said:
“Many
found a way to do it for small size. Very, very hard to do it for big size,
even though there are billions of dollars a day volume trading in it because
you couldn’t offload the Korean won easily for non-crypto.”
Although
nowhere near as significant, the premium still exists today. According to
CryptoQuant, the premium is listed at 18%.
10%
Daily Returns in Japan
Bankman-Fried
then sought a similar opportunity in other markets, which he found in Japan.
He said:
“It
wasn’t trading quite the same premium. But it was trading at a 15% premium or
so at the peak, instead of 50%.”
After
buying Bitcoin for $10,000 in the US, investors could send it to a Japanese
exchange. There they could sell it for $11,500 worth of Japanese yen. At that
point, they could convert the amount back to dollars.
Because
of the trade’s global nature and the wire transfers involved, it would take
up to a day to perform. ”But it was doable, and you could scale it, making
literally 10% per weekday, which is just absolutely insane,” Bankman-Fried
said.
Bankman-Fried
was successful where others were not because he managed to facilitate all the
different components involved in the trade. For example, finding the right
platform to buy Bitcoin at scale, then getting approval to use Japanese
exchanges and accounts. There was also the difficulty of even getting
millions of dollars out of Japan and into the US every day.
“You do
have to put together this incredibly sophisticated global corporate framework
in order to be able to actually do this trade,” Bankman-Fried said. “That’s
the real task, the real hard part.”
High
Edge, Low Risk
The decentralized
aspect of the crypto ecosystem enables these large arbitrage premiums to
exist. With other financial markets, there is a cross merging between
exchanges and central clearing firms or brokers, Bankman-Fried explained. “So
it’s really capital-intensive, and also you have to worry about counterparty
risk,” he added.
But
once investors and traders come to understand the crypto space intimately,
they can figure out where the counterparty risk is close to zero, but the
edge is still high.
According
to Bankman-Fried:
“There’s
a lot of money to be made, if you can really figure out and pinpoint when
there is and isn’t a ton of edge and when there is and isn’t a ton of actual
counterparty risk.”
Takeaway
- Arbitrage opportunities in crypto arise from regional
price discrepancies, such as Bitcoin trading higher in Korea or
Japan.
- Sam Bankman-Fried capitalized
on these spreads (e.g., Kimchi Premium) to earn daily profits of
up to 10%.
- The real barrier wasn't
identifying opportunities - but executing them at scale across
global markets.
- Success required building a complex
international infrastructure: securing exchange access, navigating
regulations, and moving large sums across borders.
- Low counterparty risk + high
edge = profitable arbitrage,
but only if operational hurdles can be managed.
Chapter 7 Interest Rate Parity
· Interest rate parity calculator https://www.jufinance.com/irp/
· The interest rate parity implies that
the expected return on domestic assets = the exchanged rate adjusted expected
return on foreign currency assets.
· Currencies
with higher interest rates
should depreciate in the future
— enough to offset the interest
rate advantage.
IRP is based on that “Investors cannot earn
arbitrage profits” by
- Borrow an amount in a currency with a lower interest
rate.
- Convert the borrowed amount into a currency with a
higher interest rate.
- Invest the proceeds in an interest-bearing instrument
in this higher-interest-rate currency.
- Simultaneously hedge exchange risk by buying a forward
contract to convert the investment proceeds into the first (lower
interest rate) currency.
|
Feature |
Interest Rate Parity (IRP) |
International Fisher Effect (IFE) |
Purchasing Power Parity (PPP) |
|
Core Idea |
Interest rate differences determine the forward rate
premium/discount. |
Interest rate differences reflect expected currency
depreciation. |
Inflation differences drive exchange rate changes. |
|
Key Variables |
Interest rates, spot & forward rates |
Interest rates, expected future spot rate |
Inflation rates, spot & future exchange rates |
|
Equation (Approx.) |
(Forward Rate - Spot
Rate) / Spot Rate ≈ Interest Rate (quoted) - Interest Rate (base); Or (F - S0) / S0 ≈ i_quoted - i_base Eg: USD/NOK = 10è 1 USD = 10 NOK è USD is the base currency; NOK is the quoted
currency |
(Expected Spot Rate
- Spot Rate) / Spot Rate ≈
Interest Rate (quoted) - Interest Rate (base); Or (E[S1]
- S0) / S0 ≈ i_quoted - i_base Eg: USD/NOK = 10è 1 USD = 10 NOK è USD is the base currency; NOK is the quoted
currency |
(Expected Spot Rate
- Spot Rate) / Spot Rate ≈ Inflation Rate (Home) - Inflation Rate
(Foreign); Or (E[S1] - S0) / S0 ≈ π_quoted -
π_base Eg: USD/NOK = 10è 1 USD = 10 NOK è USD is the base currency; NOK is the quoted
currency |
|
What it compares |
Forward exchange rate vs. interest rate difference |
Expected future spot rate vs. interest rate difference |
Expected future spot rate vs. inflation difference |
|
Assumption |
Arbitrage-free forward FX market |
Equal real returns across countries |
Law of one price holds across borders |
|
Used for |
Forward FX pricing and hedging |
Forecasting currency movements |
Long-run real exchange rate alignment |
|
Prediction Type |
Forward rate |
Expected future spot rate |
Expected future spot rate |
Given
Data (USD vs NOK)
- USD
interest rate = 5%
- NOK
interest rate = 3%
- USD inflation = 3%
- NOK inflation = 1%
- Assuming real interest rate is
proximally 2% in both countries.
- Spot exchange rate (S0) = 1 USD = 10
NOK (USD is the base currency; NOK is the quoted currency)
- Real interest rate ≈ 2% in both countries
- Spot
exchange rate (S₀) = 1 USD = 10 NOK
- USD
is the base currency, NOK is the quoted currency)
1.
Interest
Rate Parity (IRP)
·
Formula:
(F - S0) / S0 = i_NOK - i_USD (hint: 1
USD = 10 NOK; so USD is the base currency and NOK is the quoted currency)
·
(Forward Rate - 10) / 10 = 0.03 - 0.05
(Forward Rate - 10) = 10 * (-0.02) = -0.20
Forward Rate = 10 - 0.20 = 9.8
NOK/USD
2.
International
Fisher Effect (IFE)
·
Formula:
(Expected Spot Rate - S0) / S0 = i_NOK - i_USD
·
Step-by-step:
(Expected Spot Rate - 10) / 10 = 0.03 - 0.05
(Expected Spot Rate - 10) = 10 * (-0.02) =-0.20
Expected Spot Rate = 10 - 0.20 = 9.8 NOK/USD
3. Purchasing Power Parity (PPP)
·
Formula:
(Expected Spot Rate - S0) / S0 = Inflation_NOK - Inflation_USD
·
Step-by-step:
(Expected Spot Rate - 10) / 10 = 0.01 - 0.03
(Expected Spot Rate - 10) = 10 * (-0.02) = -0.20
Expected Spot Rate = 10 - 0.20 = 9.8 NOK/USD
For discussion:
Interest Rate Parity:
Should You Invest in the U.S. or the U.K.? Answer: No Difference.
Given:
- Spot exchange rate: 1.5 USD/GBP
- U.S. interest rate: 5%
- U.K. interest rate: 10%
- Initial investment: $1,500
Question:
Should you invest in the U.S. for 5% or the U.K. for 10%?
Answer:
It makes no difference
at all!
Thanks to Interest Rate Parity
(IRP), returns should be equal when forward contracts are
used — meaning no
arbitrage opportunity exists.
Explanation:
Option 1: Invest in the U.S.
- $1,500 invested at 5%
- Future value = 1500
× ( 1 + 0.05 ) = $1575
Option 2: Invest in the U.K.
with forward contract
• Step 1: Convert USD to GBP
1500/1.5=1000
GBP
• Step 2: Invest at 10% in UK
1000×(1+0.10)=1100
GBP
• Step 3: Use forward rate to lock in
USD return
1100×1.4318=$1575,
so the forward rate has to be $1.4318 per GBP.
Forward Rate Derivation:
· To prevent arbitrage, the forward rate (F)
must satisfy IRP:
· F=S×(1+i_quoted) / (1+i_base)
· F =1.5×(1+0.05) / (1+0.10)=$1.4318 per GBP.
Conclusion:
Whether
you:
- Invest in the U.S. at 5%
- Or convert to GBP and invest in the U.K. at 10% with a
forward contract...
Your return = 5% in USD either way
This
demonstrates covered interest rate
parity (CIRP) - ensuring no arbitrage in efficient global
markets.
Equation:
Forward Rate = Spot
Rate * [(1 + Interest Rate of quoted currency) / (1 + Interest Rate of
base currency)]
Spot rate:
¥/$, or USD/YEN (Yen is the quoted and $ is the base)
Or,
Forward Rate = Spot
Rate * ( Interest Rate of quoted
currency - Interest Rate of base currency +1 )
Implications of IRP Theory
·
If IRP theory holds, then it can negate the possibility of
arbitrage. It means that even if investors invest in domestic or foreign
currency, the ROI will be the same as if the investor had originally invested
in the domestic currency.
·
When domestic interest rate is below foreign interest
rates, the foreign currency must trade at a forward discount. This is
applicable for prevention of foreign currency arbitrage.
·
If a foreign currency does not have a forward discount or
when the forward discount is not large enough to offset the interest rate advantage,
arbitrage opportunity is available for the domestic investors. So, domestic
investors can sometimes benefit from foreign investment.
·
When domestic rates exceed foreign interest rates, the
foreign currency must trade at a forward premium. This is again to offset
prevention of domestic country arbitrage.
·
When the foreign currency does not have a forward premium
or when the forward premium is not large enough to nullify the domestic
country advantage, an arbitrage opportunity will be available for the foreign
investors. So, the foreign investors can gain profit by investing in the
domestic market.
https://www.tutorialspoint.com/international_finance/interest_rate_parity_model.htm
Exercise 1: i$ is
8%; iSF is 4%; If spot rate S
=0.68 $/SF, then how much is F90 (90 day forward rate)?
Answer:
S =0.68 $/SF è CHF/USD = 0.68, so CHF is base currency
and USD is the quoted currency.
So, F = 0.68*(1+8%/4) / (1+4%/4) = 0.6867
$/CHF (or CHF/USD = 0.6867)
Exercise 2: i$ is
8%; iyen is 4%; If spot rate S =
0.0094 $/YEN, then how much is F180 (180 day forward rate)?
Answer:
S = 0.0094 $/YEN, so $ is the quoted
currency, Yen is the base currency.
F = S *(1+
interest rate of quoted currency) / (1+ interest rate of base)è F=0.0094*(1+8%/2)/(1+4%/2) = 0.0096 $/YEN
Exercise 3: i$ is 4% and i£ is
2%. S is $1.5/£ and F is $2/£. Does IRP hold? How can you arbitrage? What is
the forward rate in equilibrium?
Answer:
S = $1.5/£, so $ is the quoted currency,
£ is the base currency.
F = S *(1+
interest rate of quoted currency) / (1+ interest rate of base)è F=(1.04/1.02)*1.5 = $1.529/£, F at $2/£
is too high.
When F=$2/£, what can US investors do to make arbitrage profits?
For example, US investor
·
can borrow 1,000 $, and pay back
$1,040 a year later.
·
Convert to £ now at spot rate and get $1,000/1.5$/£ = 666.67 £
·
deposit in UK @ 2%
·
so one year later, get back
666.67 £*(1+2%)=680£
·
convert to $ at F rate
·
so get back 680 £ * 2$/£ =
$1,360
·
So the investor can make a
profit of 1,360 -1040 = $320 profit.
The forward rate is set too high. It
should be set around $1.529/£, so that the arbitrage opportunity will be
eliminated.
Exercise 4: i$ is 2%
and i£ is 4%. S is $1.5/£ and F is $1.1/£.
Does IRP hold? How can you arbitrage? What is the forward rate in
equilibrium?
Answer:
S = $1.5/£, so $ is the quoted currency,
£ is the base currency.
F = S *(1+
interest rate of quoted currency) / (1+ interest rate of base)è F=(1.02/1.04)*1.5 = $1.471/£, so F at
$1.1/£ is too low.
When F=$1.1/£, what can US investors do to make arbitrage profits?
For example, US investor
·
can borrow 1,000 $, and pay back
$1,040 a year later.
·
Convert to £ now at spot rate and get $1,000/1.5$/£ = 666.67 £
·
deposit in UK @ 4%
·
so one year later, get back
666.67 £*(1+4%)=693.33£
·
convert to $ at F rate
·
so get back 693.33 £ * 1.1$/£ =
$762.67
·
So the investor will lose
money: $762.67 -1040 = -247.33, a loss.
The forward rate is set too low. It
should be set around $1.471/£.
SO US investors should let this CIA
(covered interest rate arbitrage) go, but UK investor could consider borrow
money in UK to generate risk free profits. So the trade by UK investors will
force forward rate to drop to its equilibrium price based on IRP.
In class exercises
1. Locational arbitrage
Exercise 1: Bank1
– bid Bank1-ask Bank2-bid
Bank2-ask
£ in
$: $1.60 $1.61 $1.62 $1.63
How can you arbitrage?
Answer: Buy pound at bank1’s ask price and sell pound at bank2’s
bid price. Profit is $0.01/pound
For instance, with $1,610, you can buy £
at bank 1 @ $1.61/£ and get back £1,000.
Then, you can sell £ at bank 2 @ $1.62/£
and get back $1,620, and make a profit of $10.
Pound is cheaper in bank 1 but more
expensive in bank 2. Therefore, you can arbitrage.
Hint: Always buy from dealer at ask
price, and sell to dealer at bid price.
Bank1
–
bid Bank1-ask Bank2-bid
Bank2-ask
£ in
$: $1.6 $1.61 $1.61 $1.62
How can you arbitrage?
(Answer: Buy pound at bank1’s ask price and sell pound at
bank2’s bid price. No Profit )
For instance, with $1,610, you can buy £
at bank 1 @ $1.61/£ and get back £1,000.
Then, you can sell £ at bank 2 @ $1.61/£
and get back $1,610, and make a profit of $0.
Pound is cheaper in bank 1 but more
expensive in bank 2. However, there is a bid ask spread, or fees charged by
dealers. So no arbitrage opportunities.)
Hint: Always buy from dealer at ask
price, and sell to dealer at bid price.
Exercise 2: If you start with $10,000 and conduct one round
transaction, how many $ will you end up with ?
(Answer: ($10000
/ 0.64($/NZ$)) – the amount obtained from north bank.
($10000 / 0.64($/NZ$)) * 0.645
($/NZ$) = $10078.13)
Hint: Always buy from dealer at ask
price, and sell to dealer at bid price.
2. Triangular arbitrage
Exercise 1: £ is quoted at $1.60. Malaysian Rinnggit (MYR)
is quoted at $0.20 and the cross exchange rate is £1 = MYR 8.1. How can you
arbitrage?
Answer: Either $ è MYR è £ è $, or $ è £ è MYR è $, one way or another, you should make money. In this
case, it is the latter one. Imagine you have $1,600 è 1,000
Approach one: Yes, $ è GBP è MYR è $ could make a profit of $20.
Approach two: No, $ è MYR è GBP è $ does not work.
Special Topic:
Currency Carry Trade
What is the
carry trade and why did it cause market chaos? (video)
Carry trade basics |
Money, banking and central banks | Finance & Capital Markets | Khan
Academy (video)
|
Feature |
Covered Interest Rate Parity (IRP / CIRP) |
Uncovered Interest Rate Parity (UIP) |
|
Uses Forward Contract? |
Yes — forward rate is
locked in |
No — relies on expected
future spot rate |
|
Exchange Rate Risk |
Hedged — no exposure |
Exposed — risk of
unexpected FX movements |
|
Key Assumption |
No arbitrage in covered markets |
Investors expect equal returns across currencies, even with FX
risk |
|
Theory Predicts |
Forward premium/discount reflects interest rate differential |
High-interest-rate currency will depreciate to offset
higher return |
|
Common Application |
Hedging, FX arbitrage, pricing forward contracts |
Explains expected FX movement (theoretical) |
|
Real Market Behavior |
Usually holds —
enforced by arbitrage |
Often fails — leads to carry
trade opportunities |
|
Investor Action |
Arbitrageurs exploit forward mispricing |
Traders borrow low-rate currency, invest in high-rate one |
|
Example (2024–2025) |
Use forward contracts to hedge USD/JPY exposure |
Carry trade: borrow JPY (~0%), invest in USD (~5.5%), earn
spread |
Currency Carry Trade –
The “Easy Yield” Strategy
What is it?
·
Borrow cheap money
in a low-interest country, convert to a high-interest currency,
invest, and profit from the interest rate spread.
·
No need for complicated trades — just ride the interest rate gap.
The 3 Major Currencies in Carry Trade
|
Currency |
Used For |
When It Was Popular |
Why It's (Not) Popular Now |
|
Japanese Yen (JPY) |
Borrowing
(funding) |
Popular
for 20+ years
(since 1990s) |
Still
very popular – near
0% rate, very stable |
|
Swiss Franc (CHF) |
Borrowing
(funding) |
Gained
popularity in 2000s–2010s |
Still
used, but less than JPY – slightly higher rates,
still low risk |
|
U.S. Dollar (USD) |
Investing
(target) |
Always
in demand, but especially
2022–2024 |
Very
popular now – high yield, strong
economy |
Why It’s
Popular:
- Low-rate currencies stay weak (or stable)
- You
earn 3–5%+ spread
just by holding the position
- Easy to scale — big hedge funds love it
Why It
Sometimes Stops:
- Central
banks raise rates suddenly (e.g.,
Japan surprises market)
- Global panic =
safe-haven rush = yen or CHF appreciates fast
- FX risk kills profits
(currency you borrowed becomes expensive to repay)
Bottom Line:
·
Carry trade works when the market is calm and rates are wide
apart.
·
It fails when FX volatility returns or central banks surprise.
Homework chapter 7 (due with
final)
1. Suppose
that the one-year interest rate is 5.0 percent in the United States and 3.5
percent in Germany, and the one-year forward exchange rate is $1.3/€. What
must the spot exchange rate be? (Hint: the question is asking for the
spot rate, given forward rate. ~~ $1.2814/€ ~~)
2. Imagine that can
borrow either $1,000,000 or €800,000 for one year. The one-year interest rate
in the U.S. is i$ = 2%
and in the euro zone the one-year interest rate is i€ =
6%. The one-year forward exchange rate is $1.20 = €1.00; what must the spot
rate be to eliminate arbitrage opportunities? (1.2471$/€. It does not
matter whether you borrow $ or euro)
3. Image that the future
contracts with a value of €10,000 are available. The
information of one year interest rates, spot rate and forward rate available
are as follows.
Question: profits that you
can make with one contract at maturity?
Exchange
rate Interest
rate APR
So($/€) $1.45=€1.00 Interest
rate of $ 4%
F360($/€) $1.48=€1.00 Interest
rate of € 3%
Hint: The future contract is available, so you
can buy 10,000 euro in the future to buy the
futures contract. So at present, you can
borrow €9,708.3 (=10,000 euro /
1.03) euro and use the money 360 days later to purchase the future contract
of €10,000, since € interest rate is 3%. Let’s see you can make money or not.
Convert €9,708.3 to $ at spot rateè get back €9,708.3
*1.45 $/€= $14,077.67 è deposit at US @4% interest rate, and get back
$14,077.67 *(1+4%) = $14,640.78 è convert at F rate, and get back $14,640.78 / 1.48 $/€ =9,892.417 euro
, less than 10,000 euro è so this round of trading is not a good
idea.
However, if the F rate is $1.46/euro or even less, then you can get
back $14,640.78 / 1.46 $/€ > 10,000 euro, so you can do better by doing so
than simply depositing money in euro with 3% interest rate.
4. Image that you find
that interest rate per year is 3% in Italy. You also realize that the spot
rate is $1.2/€ and forward rate (one year maturity) is $1.18/€.
Question: Use IRP to calculate the interest rate per year in
US. (1.28%)
5) Suppose
the exchange rates for three currencies - US dollars (USD), Euros (EUR), and
British pounds (GBP) - are as follows:
·
1 USD = 0.85 EUR
·
1 EUR = 0.75 GBP
· 1 USD = 0.63 GBP
Assume that there
are no transaction costs or other barriers to arbitrage.
Questions: a) Is there an
opportunity for triangular arbitrage starting with US dollars (USD)? If so,
what is the potential profit and how would you execute it?
b) What effect would
this arbitrage have on the exchange rates between the three currencies?
Hint: a) There is an
opportunity for triangular arbitrage starting with USD. To execute the
arbitrage, an investor would use the three exchange rates to create a
triangular loop that begins and ends with the same currency. The investor
would do the following:
Buy EUR with USD:
Convert 1 USD to EUR at the rate of 1 USD = 0.85 EUR.
Buy GBP with EUR:
Convert the €0.85 to GBP at the rate of 1 EUR = 0.75
GBP.
Buy USD with GBP:
Convert the £0.6375 to USD at the rate of 1 USD = 0.63 GBP
Calculate the
profit: The profit from this transaction is the difference between the
initial and final USD amounts, which is …
b) This arbitrage
would have the effect of increasing the demand for GBP and decreasing the
demand for USD and EUR in the London market, while increasing the demand for
USD and EUR and decreasing the demand for GBP in the New York and Frankfurt
markets. This would cause the exchange rates to adjust until the profit
opportunity from the arbitrage is eliminated. Specifically, the USD/EUR rate
in New York would decrease, the EUR/GBP rate in London would increase, and
the USD/GBP rate in Frankfurt would decrease.
6. You are a global
investor in early 2025. You notice that:
- The Japanese Yen (JPY)
interest rate is near 0%
- The U.S. Dollar (USD)
interest rate is around 5.5%
- The exchange rate is stable, and the yen has been slowly weakening
- There are no signs
that the Bank of Japan will raise interest rates soon
Part A. Would it be profitable to use a carry trade strategy in this situation?
Explain your answer clearly in 1–2
sentences, using the concepts of interest rate differential and exchange rate risk.
Part B. If suddenly Japan raises its interest rate from 0% to 3%, what could
happen to carry trade positions involving JPY/USD?
Explain in your own words how
this affects investor profits.
Special Topic:
What are
the domestic and global economic and political implications of the 2025 U.S.
tariff policy?
Play the “Tariff Policy
Announcement by President Trump - April 2, 2025” game
Home
Questions (due with final)
·
What economic effects
will the 10% blanket tariff have on consumers and businesses?
·
How might affected
countries respond to these tariffs?
·
Do you think tariffs are
effective tools for strengthening national economies? Why or why not?
·
Which U.S. reactions do
you find most compelling or concerning, and why?
Chapter 11: Managing Transaction Exposure
·
Play
this Importing Transaction Exposure Game
·
Play
this Exporting Transaction Exposure Game
·
Quiz on Importing Transaction Exposure
·
Quiz on Exporting Transaction Exposure
Summary Table:
Transaction Exposure & Hedging Tools
|
What is Transaction Exposure? |
The risk from exchange rate fluctuations after entering a
financial obligation involving foreign currency. |
|
Who is affected? |
The party that must settle in foreign currency — usually the
buyer or borrower. |
|
Example |
A U.S. firm agrees to pay €100,000 in 30 days. If EUR
appreciates, it costs more USD at settlement. |
|
Types of FX Exposure |
- Transaction: Short-term contract risk |
|
- Operating (Economic): Long-term impact on cash flows |
|
|
- Translation: Accounting adjustments |
|
|
How to Hedge |
See below — different strategies depending on whether you will
pay or receive foreign currency. |
Hedging Strategies
Overview
|
Hedging Tool |
Use Case |
Action |
Explanation |
|
Forward Contract |
Pay or receive foreign currency |
Lock in exchange rate today |
Eliminates future uncertainty by setting the rate upfront |
|
Money Market Hedge |
Pay or receive foreign currency |
Borrow/invest based on timing |
Use interest rates + spot rate to lock in future value |
|
Call Option |
Importing: Must pay foreign currency |
Buy call option on foreign currency |
Protects against appreciation of foreign currency (you can buy
at strike price) |
|
Put Option |
Exporting: Will receive foreign currency |
Buy put option on foreign currency |
Protects against depreciation of foreign currency (you can
sell at strike price) |
In Class exercise 1:
Hedging Currency Risk - Importing Salmon from Norway.
Scenario:
You are a U.S.-based seafood distributor. You’ve
agreed to import 10,000 NOK worth
of fresh salmon from a Norwegian supplier.
The payment is due 30
days from today, and the current spot rate is 1 NOK = 0.10 USD (so expected
cost ≈ $1,000).
Your Goal:
Avoid paying more than $1,000 due to
exchange rate fluctuations.
Question: How can you
hedge your currency risk?
Currency
Risk:
If the Norwegian krone (NOK) appreciates (e.g., 1 NOK
= 0.11 USD in 30 days), you will need more dollars:
10,000 NOK × 0.11 = $1,100 è
you lose $100 unexpectedly.
Student Task:
Answer the following:
- What
happens if you do nothing and NOK strengthens?
- How
does a forward contract
eliminate this risk?
- What
does a call option
protect you from, and when would you let it expire?
- How
does the money market hedge
use interest rates to fix your future payment?
·
For reference: Play
the Importing Game
In Class exercise 2:
Hedging Currency Risk - Exporting US Made Bike to Norway.
Scenario:
You are a U.S. bicycle manufacturer. You’ve signed a
contract to sell bikes worth 10,000
NOK to a Norwegian retailer.
You’ll receive
payment in 30 days in NOK. The current spot rate is 1 NOK = 0.10 USD
(so you expect to receive $1,000).
Your Goal:
Avoid receiving less than $1,000 due to foreign currency
depreciation.
Question: How can you
hedge your currency risk?
Currency
Risk:
If the Norwegian krone (NOK) weakens (e.g., 1 NOK =
0.09 USD in 30 days), you receive:
10,000 NOK × 0.09 = $900 è you lose $100 in value.
Answer
the following:
- What
happens if you do nothing and NOK weakens?
- How
does a forward contract
protect your revenue?
- What
does a put option
let you do if NOK drops?
- How
does a money market hedge
convert future foreign cash flow into guaranteed USD now?
·
For reference: Play
the Exporting Game
In Class Exercise 3: Hedging
currency payable as a Importer
A
U.S.–based importer of Italian bicycles
· In
one year owes €100,000 to an Italian supplier.
· The
spot exchange rate is $1.18 = €1.00
· The
one year forward rate is $1.20 = €1.00
· The
one-year interest rate in Italy is i€ =
5%
· The
one-year interest rate in US is i$ = 8%
— Call option exercise
price is $1.2/ € with premium of $0.03.
How to
hedge the currency payable risk
a. With
forward contract?
b. With
money market?
c. With
call option? Can we use put option?
Answer: Need €100,000
one year from now to pay the payable and plan to hedge the risk of overpaying
for the payable one year from now.
1) With
forward contract:
Buy the
one year forward contract @$1.20 = €1.00. So need
100,000€*1.2$/€ = $120,000
one year from now. So the company needs to come up with $120k for this
payable obligation.
2) With
money market:
Need €100,000 one year from now, and the rate is 5% in Italy, so
can deposit €100,000/(1+5%) = €95238.10
now.
For
this purpose, need to convert from € to
$: €95238.10*$1.18 /€=$112380.98.
Imagine
the company does not have that much of cash and it borrows @8%. So one year
from now, the total $ required to pay back to the banks is: $112380.98
*(1+8%) = $121371.43. So the company needs to come up
with $121371.43for this payable obligation.
Summary: Borrow
$112380.98 @8% and convert to €95238.10 at present;
One year later, the company can get the €100,000 and
needs to pay back to the bank a total of $121371.43.
3) With
call option:
Imagine
the rate one year later is $1.25/€. So should
exercise the call option and the cost one year later should be
€100,000
*(1.2+0.03) $/€ = $123000, lower than the actual cost
without the call option. So $123k is the most that the company needs to
prepare for this payable obligation. USING CALL OPTION, THE ACTAUL PAYMENT
COULD BE A LOT LESS, DEPENDING ON THE ACTAUL EXCHANGE RATE ONE YEAT LATER.
In Class Exercise 2: Hedging
currency receivable as an Exportor
· A
U.S.–based exporter of US bicycles to Swiss
distributors
· In
6 months receive SF200,000 from an Swiss distributor
· The
spot exchange rate is $0.71 = SF1.00
· The
6 month forward rate is $0.71 = SF1.00
· The
one-year interest rate in Swiss is iSF = 5%
· The
one-year interest rate in US is i$ = 8%
· Put
option exercise price is $0.72/ SF with premium of $0.02.
How to
hedge the currency payable risk
a. With
forward contract?
b. With
money market?
c. With
call option? Can we use put option?
Answer: Will
receive SF200000 six month from now as receivable and plan to
hedge the risk of losing value in the receivable six month from now.
1) With
forward contract:
Sell
the one year forward contract @$0.71 = €1.00. So get
200,000SF * 0.71$/SF = $142,000 six month from now. So the company could
receive $142k with forward contract.
2) With
money market:
Get
SF200000 six month from now, and the rate is 5% in Swiss (or 2.5% for six
months), so can borrow SF 200,000/(1+2.5%) = SF195121.95 now.
And can
convert @ spot rate to SF195121.95 * 0.71$/SF = $138536.59. This is
the money you have now.
So six
month from now, the total you have in the bank is: $138536.59*(1+4%) =
$144078.05. And you can use the SF200000 receivable to pay back the
loan. So the company could receive $144078.05 with money
market.
Summary: Borrow SF195121.95
@5% at present; six month later, the company can get
the SF200,000 receivable and payback the loan. Meanwhile, convert
the borrowed SF to $ and deposit in US banks @ 8%.
3) With
put option: With SF200000 received six month later, need
to converting it back to $. So can buy put option which allows to sell SF for
$ at the exercise price $0.72/ SF.
Imagine
the rate one year later is $0.66/ SF. So should exercise the put option
and the total amount of $ six month later should be SF
200,000 *(0.72-0.02) $/ SF = $140000. So $140k is the LEAST that
the company CAN OBTAIN. USING PUT OPTION, THE ACTAUL INCOME COULD
BE A LOT MORE, DEPENDING ON THE ACTAUL EXCHANGE RATE ONE YEAT LATER.
Homework of Chapter 11 (due with final)
1. Suppose that your company will be
billed £10 million payable in one year. The money market interest
rates and foreign exchange rates are given as follows. How to hedge the risk
for parable using forward contract. How to hedge the risk using money market?
How to hedge risk using call option?
|
Call option exercise price The U.S. one-year interest
rate: |
$1.46/ €
with premium of $0.03 6.10% per annum |
|
The U.K. one-year interest rate: |
9.00% per annum |
|
The spot exchange rate: |
$1.50/£ |
|
The one-year forward exchange rate |
$1.46/£ |
(Answer: With forward contract: $14.6
million; Money market: $14.6million; Call option: $14.9million)
2. Suppose that your company will be
billed £10 million receivable in one year. The money market
interest rates and foreign exchange rates are given as follows. How to hedge
the risk for parable using forward contract. How to hedge the risk using
money market? How to hedge risk using put option?
|
put option exercise price The U.S. one-year interest
rate: |
$1.46/ €
with premium of $0.03 6.10% per annum |
|
The U.K. one-year interest rate: |
9.00% per annum |
|
The spot exchange rate: |
$1.50/£ |
|
The one-year forward exchange rate |
$1.46/£ |
(Answer: With forward contract: $14.6 million; Money market: $14.6million; Put option: $14.3million)
Chapter 18 Long Term Debt Financing
· Interest rate swap
· Currency Swap
· Video:
o
How Swaps work – the basics: https://www.youtube.com/watch?v=-aXRZ6xN3bk
o
Interest rate
swap 1 | Finance & Capital Markets | Khan Academy
SalmonCo AS (Norway)
- Has: floating NOK loan (pays floating
NOK to their bank)
- Wants: fixed USD payments (to match USD
revenues)
- In the swap, SalmonCo:
- Receives fixed USD from SeaFoods Inc.
- Pays floating NOK to SeaFoods Inc.
This offsets their floating NOK loan and
gives them effective fixed USD cost.
SeaFoods Inc. (USA)
- Has: fixed USD loan (but pays supplier
in NOK)
- Wants: floating NOK exposure (to match
supplier payments, and benefit if NOK rates fall)
- In the swap, SeaFoods:
- Receives floating NOK from SalmonCo
- Pays fixed USD to SalmonCo
This mimics having a floating NOK loan — which fits their needs.
So the
Correct Arrows Should Be:
|
Party |
Pays (Swap) |
Receives (Swap) |
|
SalmonCo |
Floating NOK |
Fixed USD |
|
SeaFoods |
Fixed USD |
Floating NOK |
Example: Consider a firm facing three debt strategies
v
Strategy #1: Borrow $1 million
for 3 years at a fixed rate
v
Strategy #2: Borrow $1 million
for 3 years at a floating rate, SOFR + 2% to be reset annually (
SOFR (Secured Overnight Financing Rate))
v
Strategy #3: Borrow $1 million
for 1 year at a fixed rate, then renew the credit annually
v
Although the lowest cost of funds
is always a major criterion, it is not the only one
• Strategy
#1 assures itself of funding at a known rate for the three years
o
Sacrifices the ability to
enjoy a fall in future interest rates for the security of a fixed rate of
interest should future interest rates rise
• Strategy
#2 offers what #1 didn’t, flexibility (and,
therefore, repricing risk)
v
It too assures funding for the
three years but offers repricing risk
when SOFR changes
v
Eliminates credit risk as its
spread remains fixed
• Strategy
#3 offers more flexibility but more risk;
o
In the second year the firm
faces repricing and credit
risk, thus the funds are not guaranteed for the three years and neither is
the price
o
Also, firm is borrowing on the
“short-end” of the yield
curve which is typically upward sloping—hence, the
firm likely borrows at a lower rate than in Strategy #1
What is interest rate swap?
Swaps are contractual agreements to exchange or swap a
series of cash flows
– Whereas a forward rate
agreement or currency forward leads to the exchange of cash flows on just one
future date, swaps lead to cash flow exchanges on several future dates
• If the agreement is to swap
interest payments—say, fixed for a floating—it is termed an interest rate swap
– An agreement between two
parties to exchange fixed-rate for floating-rate financial obligations is
often termed a plain vanilla swap
Why
Interest-rate Swaps Exist
• If company A (B)
wants a floating- (fixed-) rate loan, why doesn’t it just do it from the
start? An explanation commonly put forward is comparative
advantage!
• Example: Suppose that two
companies, A and B, both wish to borrow $10MM for 5 years and have been
offered the following rates:
Fixed Floating
Company
A 10% 6
month LIBOR+0.3%
Company
B 11.2% 6month
LIBOR+1.0%
Note:
·
Company A anticipates the
interest rates to fall in the future and prefers a floating rate loan. However, company A can get a better deal in
a fixed rate loan.
·
On the contrary, company B
anticipates the interest rates to rise and therefore prefers a fixed rate
loan. Company B’s comparative advantage is in getting a floating rate loan.
·
So both companies could be
better off with a interest rate swap contract.
– The difference between the
two fixed rates (1.2%) is greater than the difference between the two
floating rates (0.7%)
• Company B has a comparative
advantage in floating-rate markets
• Company A has a comparative
advantage in fixed-rate markets
• In fact, the combined
savings for both firms is 1.2% - 0.70% = 0.50%
Solution:
A: Receive fixed rate 10.5% from B, pay LIBOR + 0.55% to B, and
pay 10% to bank
è
Final outcome: A could pay the
debt at 10% interest rate to the bank with the10.5% interest received from Bè leaving A
with 0.5% under A’s control.
è
Since A needs to pay B at
LIBOR + 0.55% and A has kept 0.5% previously
è
A’s net result = LIBOR + 0.55%
- 0.5% = LIBOR + 0.05% = LIBOR + 0.05%
è
A anticipates the rates to go
down and prefers to pay at a flexible rate.
è
Eventually, A gets LIBOR +
0.05%, better than the rate A could obtain from the bank directly which is
LIBOR + 0.3%, so A would benefit from this interest rate swap deal.
B: Receive
LIBOR + 0.55% from A, pay 10.5% to A,
and pay LIBOR + 1% to bank
è
Final outcome: B could pay the
debt at LIBOR + 1% interest rate to
the bank with the LIBOR + 0.55%
interest received from Aè leaving B with -0.45%.
è
Since B needs to pay A at
10.5% and B still have -0.45% debt previously
è
B’s net result = 10.5% + 0.45%
= 10.95%
è
B anticipates the rates to go
up and prefers to pay at a fixed rate.
è
Eventually, B gets 10.95%,
better than the rate B could obtain from the bank directly which is 11.2%, so
B would benefit from this interest rate swap deal.
Plain
vanilla swap: An agreement between two parties to exchange fixed-rate
for floating-rate financial obligations
https://www.thenation.com/article/archive/goldmans-greek-gambit
· Game
· Quiz
Homework of
chapter 18 (due with final, optional)
1.
How did
Goldman Sacks help Greece to cover its debt using currency swap? (Hint: Goldman Sachs helped the Greek government to mask the
true extent of its deficit with the help of a derivatives deal (Goldman Sachs arranged a secret loan of 2.8
billion euros for Greece, disguised
as an off-the-books “cross-currency swap”.—a
complicated transaction in which Greece's foreign-currency debt was converted
into a domestic-currency obligation using a fictitious market exchange rate.) that legally
circumvented the EU Maastricht deficit rules. At some point the so-called cross currency
swaps will mature, and swell the country's already bloated deficit https://www.thenation.com/article/archive/goldmans-greek-gambit/)
2.
Explain what
is an interest rate swap using an example.
3. Company AAA will borrow $1,000,000 for ten years at a floating rate. Company BBB will borrow for ten years at a fixed rate for $1,000,000. Refer to the following for details.
|
|
Fixed-Rate Borrowing Cost |
Floating-Rate Borrowing Cost |
|
|
|
Company AAA |
10% |
SOFR |
|
|
|
Company BBB |
12% |
SOFR + 1.5% |
|
|
|
Note: ·
Company AAA anticipates
the interest rates to fall in the future and prefers a floating rate
loan. However, company AAA can get a
better deal in a fixed rate loan. ·
On the contrary, company
BBB anticipates the interest rates to rise and therefore prefers a fixed
rate loan. Company BBB’s comparative advantage is in getting a floating
rate loan. ·
So both companies could be
better off with a interest rate swap contract. Assume that a swap bank help the
two parties. 1 According to the swap contract, Firm BBB will pay the swap
bank on $1,000,000 at a fixed rate of 10.30% 2 The swap bank will pay firm
BBB on $1,000,000 at the floating
rate of ( SOFR - 0.15%). 3 Firm AAA needs to pay the swap bank
on $1,000,000 at the floating rate of ( SOFR - 0.15%); 4 The swap bank will pay firm AAA on
$10,000,000 at a fixed rate of 9.90%. Please answer the following
questions. · Show the value of this swap to firm
AAA? (answer: Firm AAA can save $500
each year) · Show the value of this swap to firm
BBB? ( answer:
Firm BBB will save $500 per year) · Show the value of the swap to the swap bank. (answer: The swap bank can earn $4,000 each year) |
|
||||
Hint: Just write down all relevant transactions for each player,
and sum them up. For example, AAA pays 10% and SOFR -0.15%, and receive 9.9% è net result: 10% - 9.9% + SOFR -0.15% = SOFR -0.05%, a saving of
0.05%, since if AAA gets the debt from the bank, AAA’s interest rate would be
SOFR . Similarly, for BBB, pay SOFR + 1.5% - (
SOFR -0.15%) + 10.3% = 11.95%, a saving of 0.5%,
since BBB could get 12% interest rate if BBB gets the loan from the bank
directly; To the SWAP Bank, its net result = Receive 10.3% from BBB, and pays
9.9% to AAA, and receive SOFR -0.15% from AAA and pays SOFR -0.15% to BBB, so net result = 10.3% - 9.9% +( SOFR -0.15%) – ( SOFR =0.15%) = 0.4%, the profit of the SWAP bank.)
Final Exam and
Term Project due
Term Project Review on 4/24/2025
·
Class
Video Word Session (in class
4/24/2025) Part I
·
Class
Video Excel Session (in class
4/24/2025)
Final Exam (during final week, in class,
non-cumulative)
- 5/1, from 3pm to 5:30 pm, in
#288
You
may also arrange to meet and take the final exam at a different time by appointment
Study Guide
Part I - 50 t/f questions (total 75 points, closed book closed notes)
Chapter 8 PPP and IFE
1. What is Purchasing Power
Parity (PPP)?
2. What is the law of one
price?
3. What is inflation's effect
under PPP?
If a country has higher inflation, its currency should depreciate
to restore PPP.
4. What is a Big Mac Index?
A fun way to compare PPP using the price of a McDonald's Big Mac in different
countries.
5. What is the limitation of
PPP in the short run?
PPP doesn't explain short-term exchange rates, which are affected by news,
interest rates, and speculation.
6. What is an example of
arbitrage with physical goods?
Buying gold cheaper in Dubai and selling it in New York—if price differences
exceed transport costs.
7. What is a major barrier to
PPP working perfectly?
Things like tariffs, shipping costs, taxes, and brand differences can prevent
equal prices across countries.
8. What
is IFE (International Fisher Effect)?
A theory stating that currencies with higher
interest rates will depreciate,
because high rates usually reflect higher
expected inflation.
9. What is currency carry trade?
A trading strategy where investors borrow in a low-interest-rate currency
and invest in a high-interest-rate currency to earn the interest rate
difference (the "carry"). It works if exchange rates remain stable
or move favorably.
Chapter 7 IRP
1. What is Interest Rate Parity (IRP)?
A theory that forward exchange rates adjust to offset interest rate
differentials between two countries, eliminating arbitrage.
2. What is International Fisher Effect (IFE)?
A theory that currencies with higher interest rates will depreciate,
reflecting higher expected inflation.
3. What is Purchasing Power Parity (PPP)?
A theory stating that exchange rates move to equalize the purchasing power of
different currencies based on inflation differences.
4. What is the difference between IRP, IFE, and PPP?
- IRP: Links interest rates to forward
rates
- IFE: Links interest rates to expected
future spot rates
- PPP: Links inflation to expected exchange
rate changes
5. What is Covered vs. Uncovered IRP?
- Covered IRP: Uses forward contracts to hedge
exchange rate risk.
- Uncovered IRP: Assumes expected spot rate equals
future spot rate; no hedging used.
6. What is arbitrage?
A riskless profit opportunity that arises from price differences in different
markets, usually corrected quickly by traders.
7. When does a currency trade at a forward premium?
When its interest rate is lower than the base currency’s rate.
8. When does a currency depreciate under IFE or PPP?
When the currency's country has a higher interest rate or higher inflation.
9. When do arbitrage opportunities arise under IRP?
When the actual forward rate
differs from the IRP-implied
rate.
10. How does covered interest arbitrage work?
Borrow in the low-interest-rate country, convert to the high-interest-rate currency,
invest, and lock in the forward rate to hedge FX risk.
11. What is triangular arbitrage?
Exploiting mispricing among three
exchange rates to make a riskless profit by converting
through a loop of three currencies.
12. What are the risks of carry trade?
FX risk: If the borrowed currency appreciates, the cost of repayment rises.
Also, unexpected rate hikes can wipe out profits.
13. Which currencies are commonly used?
- JPY, CHF (funding currencies)
- USD, AUD, NZD (target/investment currencies)
14. What happens when IRP fails?
Traders can perform covered
interest arbitrage to earn riskless profit —
and their actions help restore parity.
Chapter 11 – Risk Management for Receivable and Payable
1. What is transaction exposure?
The risk of loss due to exchange rate changes between the time a transaction
is agreed and when it is settled.
2. Who faces transaction exposure?
Any company that must pay or receive foreign currency in the
future (importers or exporters).
3. What happens if a company does nothing?
The firm is exposed — it may lose money if the exchange rate moves
unfavorably before payment/receipt.
4. What is a forward contract?
A tool to lock in an exchange rate today
for a future transaction. It removes exchange rate uncertainty.
·
Buy
a forward contract for payables.
·
Sell
a forward contract for receivables.
5. What is a money market hedge?
A hedging strategy using borrowing
and investing in domestic and foreign interest-bearing accounts to
lock in the future value.
6. What is a call option used for?
For importers — it gives the
right to buy foreign currency
at a fixed rate. It protects against the foreign currency appreciating. (Useful for payables.)
7. What is a put option used for?
For exporters — it gives the
right to sell foreign currency
at a fixed rate. It protects against the foreign currency depreciating. (Useful for receivables.)
8. What is the goal of hedging?
To eliminate or reduce exchange rate
risk and protect the value of future cash flows.
9. What is the difference between options and forward
contracts?
- Forwards: Must be settled at the
agreed rate — no flexibility.
- Options: Can be used only if favorable — you can let
them expire.
10. What are the costs of
options?
You must pay a premium upfront, even if you don’t use the option later.
Chapter 18 – Interest Rate Swap
1. What is an interest rate swap?
An agreement between two parties to exchange
interest payments — usually one pays fixed and the other pays floating.
2. Why do firms use interest rate swaps?
To manage interest rate risk
and lower borrowing costs by
using their comparative advantage
in different markets.
3. What is a plain vanilla interest rate swap?
A basic swap where one party pays a fixed
rate and the other pays a floating
rate (e.g., SOFR + spread) on the same notional amount.
4. What is comparative advantage in swaps?
One firm borrows at better terms in the fixed market, another in the floating market — they swap to get the type they actually want
and both save.
5. How do both sides benefit in a swap?
Each firm gets the preferred loan
type (fixed or floating) at a
better rate than they could get on their own.
6. What is the role of the swap bank?
To match the two firms, manage
risk, and earn a small spread
(profit) from the difference in rates exchanged.
7. What is the risk of interest rate swaps?
- Counterparty
risk: The other party may
default.
- Market
risk: Interest rate changes may
make one side worse off if not
managed well.
8. What is a currency swap (briefly)?
A separate type of swap where parties exchange
interest and principal in two
different currencies — used to hedge FX and interest rate risk.
9. Why do swaps matter in long-term debt financing?
They help companies customize their
interest rate exposure and reduce financing costs without changing the
original loan contract.
Part II – 2
Calculation Questions (25 points, closed book closed notes)
·
Similar
to chapter 11 in class exercises on Hedging Receivables and payables using
forward contract, options, and money market.
·
Refer
to
o
https://www.jufinance.com/game/importing_transaction_exposure.html
(Payable, as an importer)
o
https://www.jufinance.com/game/exporting_transaction_exposure.html
(receivable, as an exporter)
Happy Summer!
