FIN415 Class Web Page, Spring '17
Instructor: Maggie Foley
Weekly SCHEDULE, LINKS, FILES and Questions
Coverage, HW, Supplements
Week 1 –
Marketwatch Stock Trading
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Part I: Review of the global economy
Is Fed powerful?
Part II: Chapter 2 International Flow of Funds
Chapter 2 (PPT)
· What is BOP? What is current account?
Balance of payments (BoP) accounts are an accounting record of all monetary transactions between a country and the rest of the world. These transactions include payments for the country's export and imports of goods, services, financial capital, and financial transfers.
A country's current account is one of the two components of its balance of payments, the other being the capital account. The current account consists of the balance of trade, net factor income (earnings on foreign investments minus payments made to foreign investors) and cash transfers
A current account surplus increases a country's net foreign assets by the corresponding amount, and a current account deficit does the reverse.
A country's balance of trade is the net or difference between the country's export of goods and services and its imports of goods and services, ignoring all financial transfers, investments and other components. A country is said to have a trade surplus if its exports exceed its imports, and a trade deficit if its imports exceed its exports.
Source: indexmundi.com and world bank (2015)
For Class Discussion:
1. Can President Trump’s policy help improve US economy? Who will benefit most from his reforms?
2. Can US devaluate currency to eliminate current account deficit? Why does US raise interest rate?
· $ devalued, then export become cheaper and increased; imports more expensive and decreased; seems like current account deficit could disappear.
· However, in short run, demand is not so flexible and thereby current account might get worsen.
· Demand will improve with time, so current account improves with time, but not immediately.
· $ depreciated, it becomes less attractive to foreign government and investors. The borrowing cost to cover the deficit will increase.
· $ depreciated, living standard might drop.
· Competitor can drop price; Countries can devalue their currencies.
· Your idea?
· Evolution of international monetary system
1. Bimetallism: Before 1875
2. Classical Gold Standard: 1875-1914
International value of currency was determined by its fixed relationship to gold.
Gold was used to settle international accounts, so the risk of trading with other countries could be reduced.
3. Interwar Period: 1915-1944
Countries suspended gold standard during the WWI, to increase money supply and pay for the war.
Countries relied on a partial gold standard and partly other countries’ currencies during the WWII
4. Bretton Woods System: 1945-1972
All currencies were pegged to US$.
US$ was the only currency that was backed by gold.
US$ was world currency at that time.
5. The Flexible Exchange Rate Regime: 1973-Present
If the dollar is pegged to gold at U.S. $30 = 1 ounce of gold, and the British pound is pegged to gold at £6 = 1 ounce of gold. What should be the exchange rate between U.S. $ and British £? What will happen if this exchange rate does not hold, such as £1 = $4?
· What is European union? What is Euro zone? Who is ECB? You think EU will collapse? What about British exit from EU?
EU: free movement of goods, people, services, and capital.
EU: an economic and political union of 28 member states in Europe.
Euro zone: or euro area, is an economic and monetary union of 18 EU member states that have adopted euro.
ECB: in charge of monetary policy of euro zone.
Video: The European Debt Crisis Visualized (well explained)
Brexit, Briefly (well explained)
HW – Chapter 2 (Due on 1/19, Thursday)
1. If the dollar is pegged to gold at U.S. $30 = 1 ounce of gold, and the British pound is pegged to gold at £6 = 1 ounce of gold. What should be the exchange rate between U.S. $ and British £?
How much can you make without any risk, if this exchange rate is £1 = $6? Assume that your initial investment is $1,200. (Answer: $240)
2. What is your opinion about Trump’s tax cut plan? His policy reform to bring jobs back to US? Will that work?
3. What is your opinion about UK’s leaving European union? Watch this video Brexit, Briefly (well explained)
4. What is your opinion about US monetary policy? Shall Fed continue increasing interest rate to make $ stronger and other currencies weaker? Why or why not?
5. Internet exercises (not required, for interested 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. Using these website, you can summarize the economic outlook for each country.
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: research.stlouisfed.org/publications
Balance of Payments statistics: research.stlouisfed.org/fred2/categories/125
Reference of useful websites for global economy
Current Account (BOP) Data – World Bank
IMF, world bank and UN are only a few of the major organizations that track, report and aid international economic and financial development. Using these website, you can summarize the economic outlook for each country.
World bank: www.worldbank.org
Bank of international settlement: www.bis.org/index.htm
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: research.stlouisfed.org/publicaitons/iet
** Euro Crisis for reference***
ECB Time Line of Financial Crisis
The great Euro crisis 2012
Video: The European Debt Crisis Visualized (well explained)
Brexit, Briefly (well explained)
Week 2, 3
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.
· US is using floating exchange rate system. What is the advantage and disadvantage of this system? Did US government intervene the foreign exchange market? How? DO we need Cheap $ or strong $?
· Chinese currency is pegged to US$. What is the advantage and disadvantage of this system? What about let it float, instead of holding its value at a fixed rate? Can Chinese government control its currency? How? Is cheap RMB always better than Strong RMB, to Chinese government?
· Germany is part of the Euro Zone. Can Germany manipulate Euro?
· Who are the major players in the FX market?
· What is direct and indirect quote and cross rate
1. Direct quote is the local currency price of one unit of foreign currency. e.g. In New York City $1.38/€.
2. Indirect quote is the inverse of the direct quote. It is the quotations that represent the number of units of a foreign currency per dollar. e.g. In New York City €0.72/$.
3. Cross Exchange Rates: it is the quotations that represent the number of units of a foreign currency per another foreign currency. e.g. In New York City: €0.90/£.
4. You can get the cross exchange rates at www.forex.com
“The Forex Bid Price and Ask price”
The Forex bid is the price at which you can sell a certain Forex currency pair for (for base currency)..
Bid price represents what will be obtained in the quote currency when selling one unit of the base currency.
The ask price represents what has to be paid in the quote currency to obtain one unit of the base currency.
For instance, EUR/USD then EUR is the base and USD is the quote currency.
The bid price is seen on the left side of the Forex quote. For example, for the EUR/USD quote 1.2728/31, the bid price is 1.2728. This means you can sell one Euro for $1.2728. The ask price is 1.2731. It means you can buy 1 Euro for $1.2731.”
Assume you have $1000 and bid rate is $1.52/£ and ask rate is $1.60 /£. Meanwhile, the bid rate is quoted as 0.625 £/$ and the ask rate is quoted as 0.6579 £/$. If you convert it to £ and then convert it back to $, what will happen?
Answer: Sell at bid and buy at ask price (ask is always higher than bid so you buy high and sell low, since you are dealing with the bank). So here with $1000, you sell at bid 0.625 £/$ so you get 625£
($1000* 0.625 £/$ = 625£). With 625£, you sell at bid $1.52/£, so you get $950 (625£ * $1.52/£ = $950)
you buy at ask price. So here with $1000, you want to buy £ @ 0.6579 £/$, so you get 657.9£
($1000* 0.6579 £/$ = 657.9£). With 657.9£, you buy $ at ask $1.60/£, so you get $950 (657.9£ * $1.60/£ = $950)
Note that the two sets of quotes are just inverse of each other. So it does not matter which set you are using.
1. Bid/Ask Spread
Compute the bid/ask percentage spread for Mexican peso retail transactions in which the ask rate is $.11 and the bid rate is $.10. HINT: BID ASK SPREAD = (ASK-BID)/ASK (Answer: 9.09%)
2. Indirect Exchange Rate
If the direct exchange rate of the euro is worth $1.25, what is the indirect rate of the euro? That is, what is the value of a dollar in euros? (Answer: 0.8€)
3. Cross Exchange Rate
Assume Poland currency (the zloty) is worth $.17 and the Japanese yen is worth $.008. What is the cross rate of the zloty with respect to yen? That is, how many yen equal a zloty? (Answer: 21.25¥)
4. Foreign Exchange
You just came back from Canada, where the Canadian dollar was worth $.70.
You still have C$200 from your trip and could exchange them for dollars at the airport, but the airport foreign exchange desk will only buy them for $.60. Next week, you will be going to Mexico and will need pesos. The airport foreign exchange desk will sell you pesos for $.10 per peso. You met a tourist at the airport who is from Mexico and is on his way to Canada. He is willing to buy your C$200 for 1,300 pesos. Should you accept the offer or cash the Canadian dollars in at the airport? Explain. (Answer: You can only get $1,200 peso if you accept the offer in the airport)
5. Do you anticipate China to adopt floating exchange system? Why or why not? Do you expect US to go back to fixed exchange rate system? Why or why not?
The impossible trinity
A country cannot be on all three sides of the triangle at once.
It must give up one of the three attributes if it is to achieve one of the states described by the corner of the triangle.
Assume that world interest rate is at 5%. If the home central bank tries to set domestic interest rate at a rate lower than 5%, for example at 2%, there will be a depreciation pressure on the home currency, because investors would want to sell their low yielding domestic currency and buy higher yielding foreign currency. If the central bank also wants to have free capital flows, the only way the central bank could prevent depreciation of the home currency is to sell its foreign currency reserves. Since foreign currency reserves of a central bank is limited, once the reserves are depleted, the domestic currency will depreciate.
Hence, the all three of the policy objectives mentioned above cannot be pursued simultaneously. A central bank has to forgo one of the three objectives. Therefore a central bank has three policy combination options.
a) Fixed Exchange Rate and Free Capital Flow (pure float) – monetary independence
b) Independent Monetary Policy and Free Capital Flow (pure float) – full financial integration
c) Fixed Exchange Rate and Independent Monetary Policy – exchange rate stability
Class discussion: find a country that fits the following regimes and then discuss for the rational of that country’s adoption of the system based on the “impossible trinity”.
Exchange Rate Regimes from http://www.imf.org/external/np/mfd/er/2004/eng/0604.htm (IMF)
Chicago bank expects the exchange rate of the NZ$ 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)
◦ 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 later.
◦ Your borrowed $20m should be paid back for
20m *(1+7.2%* 30/360)=$20.12m. This equals to $20.12m / 0.52 $/NZ$=NZ$ 38,692,308.
◦ So the profit is:
40,206000-38,692,308 = NZ$1,523,692.
Your $ profit is: NZ$1,523,692 *0.52$/NZ$=$792,320.
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:2: Blue Demon
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.
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:
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:
$10,500,000 × [1 + (8% × 10/360)] = $10,500,000 × [1.002222] = $10,523,333
4. Repay the peso loan. The repayment amount on the peso loan is:
MXP70,000,000 × [1 + (8.7% × 10/360)] = 70,000,000 × [1.002417]=MXP70,169,167
5. Based on the expected spot rate of $.14, the amount of dollars needed to repay the peso loan is:
MXP70,169,167 × $.14 = $9,823,683
6. After repaying the loan, Blue Demon Bank will have a speculative profit (if its forecasted exchange rate is accurate) of:
$10,523,333 – $9,823,683 = $699,650
Part b: Blue Demon Bank can capitalize on its expectations as follows:
1. Borrow $10 million
2. Convert the $10 million to pesos (MXP):
$10,000,000/$.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: MXP66,666,667 × [1 + (8.5% × 30/360)] = 66,666,667 × [1.007083] = MXP67,138,889
Repay the dollar loan. The repayment amount on the dollar loan is:
$10,000,000 × [1 + (8.3% × 30/360)] = $10,000,000 × [1.006917] = $10,069,170
4. 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: MXP67,138,889 × $.17 = $11,413,611
5. The profits are determined by estimating the dollars available after repaying the loan:
$11,413,611 – $10,069,170 = $1,344,441
Question 1. Choose between increase / decrease.
US Inflation goes up, $ will ________increase / decrease____________in value__.
US Real interest rate goes up, $ will ________increase / decrease___________ in value__.
US Domestic resident’s income goes up, $ will ________increase / decrease________ in value__.
US Current account goes up, $ will ________increase / decrease________ in value__.
US Recession or crisis, $ will ________increase / decrease________ in value__.
Question 2: 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)
Question 3: If the dollar is pegged to gold at U.S. $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 U.S. $ and British £ ? How much can you make without any risk, if this exchange rate is £1 = $1.6? Assume that your initial investment is $1,800. Hint: start from convert to £ from $ ($1200 = ? £) (Answer: £1 = $1.5; Your profit is $120)
Assume you have £1000 and bid rate is 1.60$/£ and ask rate is 1.66$/£. If you convert it to £ and then convert it back to $, what will happen? (Answer: $963.86 and lose $36.14. Sell low and buy high here. So sell £ at bid and buy £ at ask )
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%)
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 $5 million. If Baylor Bank’s forecast if correct, what will its dollar profit be from speculation over the five‑day period (assuming it does not use any of its existing consumer deposits to capitalize on its expectations)? (Answer: 0.44 million NZ$ profit)
What is margin call
F = forward rate
S = spot rate
r1 = simple interest rate of the term currency
r2 = simple interest rate of the base currency
T = tenor (calculated to the appropriate day count conversion)
Euro FX Futures Prices Wednesday, Jan 25th, 2017
Euro Future Contract Specifications
For long position’s payoff: Value at maturity (short position) = principal * (spot-futures)
For short position’s payoff: Value at maturity (short position) = -principal * (spot-futures)
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? (refer to ppt)
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? (refer to ppt)
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 (refer to ppt)
NASDAQ OMX PHLX (Philadelphia Stock Exchange) trades more than 2,600 equity options, sector index options and U.S. dollar-settled options on major currencies. PHLX offers a combination of cutting-edge electronic and floor-based options trading.
· For call: Profit = Spot rate – (strike price + premium)
Example: 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 $1.39, Jim’s total profit: -0.12*31250
Spot rate is $1.41, Jim’s total profit: (-0.12+(-1.4+1.41))*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: (0.12+(1.4-1.41))*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)
Example 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)
(refer to ppt. Answer:
Spot rate is $1.30, long position’s total profit: (-0.04+1.4-1.3)*31250=0.06*31250
Short position’s total profit: (0.04-1.4+1.3)*31250=-0.06*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.
chapter 5 (Due 2/2)
1. Consider a trader who opens a short futures position. The contract size is £62,500, the maturity is six months, and the initial price is $1.50 = £1. The next day, the settlement price is $1.60 = £1. What is the amount of his gain or loss?
2. Consider a trader who opens a long futures position. The contract size is £62,500, the maturity is six months, and the initial price is $1.50 = £1. The next day, the settlement price is $1.60 = £1. What is the amount of his gain or loss?
3. Consider a trader who opens a short futures position. The contract size is £62,500, the maturity is six months, and the initial price is $1.50 = £1. The next day, the settlement price is $1.40 = £1. What is the amount of his gain or loss?
4. Consider a trader who opens a long futures position. The contract size is £62,500, the maturity is six months, and the initial price is $1.50 = £1. The next day, the settlement price is $1.40 = £1. What is the amount of his gain or loss?
6. You purchase a call 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, your net profit per unit, is?
8. 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, your net profit per unit is?
Million Dollar Pips The Life Of A Day Trader
Foreign Exchange Market
UFXMarkets Weekly Forex Currency Trading News
Currency war explained – bear talk cartoon
Mid Term Study Guide
Mid Term – 2/1 covering chapter 1-5
True / False close book (20*1=20)
1. balance of trade concept question: what is BOT and how is the status of BOT in US.
2. Current account deficit and currency value
3. Current account concept
4. The factor for currecy value (depreciation / appreciation)
5. The factor for currecy value (depreciation / appreciation)
6. The factor for currecy value (depreciation / appreciation)
7. What is cross exchange rates?
8. What is bid quote and what is ask quote?
9. Another cross exchange rate question. You need to work on simple calculations.
10. What is currecy deprecation / appreciation? You need to work on simple calculations
11. When a country’s interest rate changes, what will happen to its currey value and why?
12. When a country’s currecy gets cheaper, what will happen to the supply and demand of that currency?
13. When a country’s interest rate changes, what will happen to the supply and demand of that currency?
14. Concept of fixed exchange rate system.
15. When a country’s inflation changes, what will happen to its currey value and why?
16. When a country’s importing changes, what will happen to the supply and demand of that currency?
17. When a country’s importing changes, what will happen to its currency value?
18. Concept of freely floating exchange rate system
19. What is EURO and Euro zone?
Short answer questions (14*5=70, and one question is worth 10 points) – open book
1. Given bid rate and ask rate, calculate bid ask spread
2. Calcuate cross exchange rate
3. Calcuate cross exchange rate
4. Like the exercise in the website, if you anticipate the exchange rate to change in the near future, can you arbitrage to make money? (10 points)
5. You observe the exchange rates for three countries, and can you make money? Similar to HW exercise.
6. The gold, $, and pound question. Simialr to the HW exercise.
7. You know bid rate and ask rate and can you make money? Simialr to the HW exercise.
8. The future contract question. Simialr to the HW exercise.
9. The gold, $, and pound question. Simialr to the HW exercise.
10. Convert indirect quote, given direct quote. Simialr to the HW exercise.
11. Cross exchange rate question.
12. Call / put question. Simialr to the HW exercise.
13. Call / put question. Simialr to the HW exercise.
14. WSJ paper question (please bring your own copy or read the paper online)
15. WSJ paper question (please bring your own copy or read the paper online)
Chapter 7 International Arbitrage And Interest Rate Parity
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)
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 )
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)
2. Triangular arbitrage
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 $1.6 è 1 pound (£1 = MYR 8.1) è MYR8.1 è $1.62(1MYR = 0.2$, so 8.1
*0.2= 1.62$) è profit of $0.2 from an
initial investment of $1.6
How can you arbitrage with the above information?
(Answer: Same as above but sell at bid and buy at ask.
$1.61 è buy pound 1 pound è sell pound for rinngit @ 1 pound = 8.1 MYR; so get 8.1MYR è sell Rinngit for $ @ bid price. 8.1MYR = 8.1 * 0.20 = $1.62, a profit of $0.01 out of $1.61 initial investment)
3. Covered Interest Arbitrage (CIA):
Exercise 1: Assume you have $800,000 to invest. Current spot rate of pound is $1.60. 90 day forward rate of pound is $1.60. 90 day interest rate in US is 2%. 90 day interest rate in UK is 4%. How can you arbitrage?
(Answer: Convert at spot rate for pound and then deposit pound in UK bank. 90 days later, convert back to $ at forward rate. Refer to the above graph for details)
Exercise 2: You have $100,000 to invest for one year. How can you benefit from engaging in CIA?
Interest rate parity (IRP)
· The interest rate parity implies that the expected return on domestic assets = the exchanged rate adjusted expected return on foreign currency assets.
· Investors cannot earn arbitrage profits by
1. borrowing in a country with a lower interest rate
2. exchanging for foreign currency
3. and investing in a foreign country with a higher interest rate
4. due to gains or losses from exchanging back to their domestic currency at maturity.
Equation of IRP:
Exercise 1: ih is 5%; if is 6%; If the foreign currency’s spot rate is $0.10. Then what is the foreign currency’s forward rate?
(Answer: Fh/f / Sh/f = (1+ ih)/(1+if) = (1+5%)/(1+6%) S= $0.1, so F=(1.05/1.06)*0.1 = $0.099)
Exercise 2: i$ is 8%; iSF is 4%; If spot rate S =0.68 $/SF, then how much is F90 (90 day forward rate)?
(Answer: Fh/f / Sh/f = (1+ ih)/(1+if) = (1+8%/4)/(1+4%/4) S=0.68, F=(1.02/1.01)*0.68 = 0.6867 $/SF)
Exercise 3: i$ is 8%; iyen is 4%; If spot rate S = 0.0094 $/YEN, then how much is F180 (180 day forward rate)?
(Answer: Fh/f / Sh/f = (1+ ih)/(1+if) = (1+8%/2)/(1+4%/2) S=0.0094, F=(1.04/1.02)*0.0094 = 0.0096 $/YEN)
Exercise 4: i$ is 4% and i£ is 2%. S is $1.5/£ and F is $2/£. Does IRP hold? How can you arbitrage? What is the forward rate in equilibrium?
(Answer: F$/£ / S$/£= (1+ i$)/(1+i£) = (1+4%)/(1+2%) S= 1.5, so F=(1.04/1.02)*1.5 = $1.529/£, so F is too high and should sell forward contract not buy it. So UK residents can make profits from CIA and US residents should deposit in US)
Exercise 5: i$ is 2% and i£ is 4%. S is $1.5/£ and F is $1.1/£. Does IRP hold? How can you arbitrage? What is the forward rate in equilibrium?
(Answer: F$/£ / S$/£= (1+ i$)/(1+i£) = (1+2%)/(1+4%) S= 1.5, so F=(1.02/1.04)*1.5 = $1.471/£, so F is too low and should buy forward contract. So US residents should arbitrage)
Rule of Thumb:
· All that is required to make a covered interest arbitrage profit is for interest rate parity not to hold.
· The key to determining whether to start CIA is to compare the differences in interest rate to the forward premium.
Arbitrage rule of thumb:
· If the difference in interest rates is greater than the forward premium, invest in the higher interest yielding currency.
· If the difference in interest rates is less than the forward premium, invest in the lower interest yielding currency.
1. With above information and $1,000 in hand, any opportunities?
2. When F360($/£) = $2.50/£?
3. When F360($/£) = $1.90/£
(Answer: 1. Either CIA make 3% or deposit in US also 3%. F is priced correctly.
2. F is too high for US residents and should keep money in US.
3. F is too low and arbitrage opportunity. )
Chapters 7 (due on 2/16/2007)
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? (With 10,000 euro and the future contract, you will lose 110.81. So better to deposit €10,000 in European bank)
Exchange rate Interest rate APR
So($/€) $1.45=€1.00 Interest rate of $ 4%
F360($/€) $1.48=€1.00 Interest rate of € 3%
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. You observed the following quotes.
Spot rate of Singapore dollar in $= $.32 / Singapore dollar
Spot rate of £ in U.S. $= $1.50 /£
Spot rate of £ in Singapore dollars = S$4.50 / £
Question: Use triangular arbitrage, figure out a strategy to make profits. And how much is your profit? (with $1,000, you can make a profit of $41.667)
6. You observed the following bid and ask rates of £ from two local banks as follows:
Bank C $1.61 $1.63
Bank D $1.58 $1.60
Question: Use locational arbitrage approach to figure out a profitable strategy. And how much is your profit?(with $1,000, you can make a profit of $6.25)
The followings are useful websites
Exchange rate forecast
Daily FX News(has news, technical analysis and live rates):http://www.dailyfx.com/
Technical analysis _ chart example book
Forex Trend lines
Historical currency rate
Historical currency chart
Forex trading demo
Purchasing power parity (cartoon)
Chapter 8 Purchasing Power Parity, International Fisher Effect
1) The Law of one price THEORY:
All else being equal (no transaction costs), a product’s price should be the same in all markets
So price in $ sold in US = price in $ sold in Japan after conversion to $ from ¥
P$ = P ¥ * Spot Rate $/¥
Where the price of the product in US dollars (P$), multiplied by the spot exchange rate (S, dollar per yen), equals the price of the product in Japanese yen (P¥)
Or, S = P$/ P ¥
2) Purchasing power parity (PPP)
Purchasing power parity (cartoon) https://www.youtube.com/watch?v=i0icL5zlQww
PPP states that the spot exchange rate is determined by the relative prices of similar basket of goods.
Question: calculate the exchange rate of China, Canada, Russia, Turkey, Egypt, and New Zealand based on the above big mac index. Find the actual exchange rate and explain why there is a gap.
3) Relative purchasing power parity: Calculate changes in exchange rate based on inflation in two countries
◦ the relative change in prices between countries over a period of time determines the change in exchange rates
◦ if the spot rate between 2 countries starts in equilibrium, any change in the differential rate of inflation between them tends to be offset over the long run by an equal but opposite change in the spot rate
Example 1: 1£=1.6$. 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)
Answer: (1+ 9%) /(1+5%) -1 = ef = 4% , and 1£=1.6$, so the new rate of £ =1.6*(1+4%) = 1.66 £/$.
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%) = 1.536$
Answer: ef = Ih – If, Ih= 5%, If =9%, so ef = 5%-9% = -4%, so the old rate is that 1£=1.6$. The new rate should be 4% lower. So new rate is that 1£=1.6*(1-4%) = 1.536$
Example 3: 1£=1.2€. Inflation rate in Germany is 4%. UK inflation is 9%. What will happen? Calculate the new exchange rate using the PPP equation.
Answer: Home currency is euro and foreign currency
is pound. ef
= Ih – If,
Ih= 4%, If =9%, so ef = 4%-9% = -5%, so the old rate
is that 1£=1.2€. The new rate should be 5% lower. So
new rate is that 1£=1.2*(1-5%) = 1.14€
Answer: Home currency is euro and foreign currency is pound. ef = Ih – If, Ih= 4%, If =9%, so ef = 4%-9% = -5%, so the old rate is that 1£=1.2€. The new rate should be 5% lower. So new rate is that 1£=1.2*(1-5%) = 1.14€
4) International Fisher Effect
Fisher Effect: Nominal interest rate (R) = real interest rate (r) + inflation (I)
By assuming real interest rates in two countries are the same, we conclude that inflation moves along with the nominal interest rate which is observable and reported.
International fisher effect: ef= Rh- Rf or ((1+ Rh)/(1+Rf) -1= ef)
Example 4: If the interest rate of US is 10% and that of UK is 5%, which country’s currency will appreciate, by how much? Imagine 1£=1.6$.
Answer: Home currency is $ and foreign currency is €. ef
= Rh – Rf, Rh=
10%, Rf =5%, so ef
= 10%-5% = 5%, so the old rate is that 1£=1.6$. The new rate should be
5% higher. So new rate is that
1£=1.6*(1+5%) = 1.68$
Answer: Home currency is $ and foreign currency is €. ef = Rh – Rf, Rh= 10%, Rf =5%, so ef = 10%-5% = 5%, so the old rate is that 1£=1.6$. The new rate should be 5% higher. So new rate is that 1£=1.6*(1+5%) = 1.68$
Example 5: If the interest rate of US is 5% and that of UK is 10%, which country’s currency will appreciate, by how much? Imagine 1£=1.6$.
Chapters 8 Homework (due on 3/1/2007)
1. If a Big Mac costs $2 in the United States and 300 yen in Japan, what is the estimated exchange rate of yen/ $ as hypothesized by the Big Mac index? (Answer: 150 yen /$)
2. Interest rates are currently 2% in the US and 3% in Germany. The current spot rate between the € and $ is $1.5/€. What is the expected spot rate in one year if the international Fisher effect holds? (Answer:1.4854$/€)
3. You find that inflation in Japan just reduced to 1.3%, while in US, the inflation rate just increased to 3%. You also observed that the spot rate for yen was $0.0075 before the adjustment by economists. With new inflation released, the demand and supply for currencies will drive the exchange rate to a new equilibrium price.
Question: Use PPP to estimate the new exchange rate for yen. (Answer:0.0076$/yen)
4. You observed the nominal interest rate (annual) just increased to 6% in China, while the nominal annual interest rate is 3% in US. The spot rate for Chinese Yuan is $6.8 before the adjustment.
Question: Use IFE to estimate the new spot rate for Chinese Yuan after the interest rate changes. (Answer:6.6075$/RMB. Note: Dollar is more valuable. In this example, RMB becomes the more valuable currency. Sorry for the mistake)
Chapter 11: Managing Transaction Exposure
2. Types of foreign exchange exposure
5. Transaction Exposure – measures changes in the value of outstanding financial obligations incurred prior to a change in exchange rates but not to be settled until after the exchange rate changes
6. Operating (Economic)Exposure – also called economic exposure, measures the change in the present value of the firm resulting from any change in expected future operating cash flows caused by an unexpected change in exchange rates
Translation Exposure – also called accounting exposure, is the potential for accounting derived changes in owner’s equity to occur because of the need to “translate” financial statements of foreign subsidiaries into a single reporting currency for consolidated financial statements
Tax Exposure – the tax consequence of foreign exchange exposure varies by country, however as a general rule only realized foreign losses are deductible for purposes of calculating income taxes
What is transaction exposure
Example of transaction exposure
Purchasing or selling on credit goods or services when prices are stated in foreign currencies
Borrowing or lending funds when repayment is to be made in a foreign currency
Being a party to an unperformed forward contract and
Otherwise acquiring assets or incurring liabilities denominated in foreign currencies
How to reduce the transaction exposure risk?
1. 1. Forward (Future) Market Hedge
2. 2. Money Market Hedge
3. 3. Options Market Hedge: call and put
· To hedge a foreign currency payable buy calls on the currency.
· To hedge a foreign currency receivable buy puts on the currency.
Exercise 1: Hedging currency payable (refer to the PPT for answers)
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.
2) With money market:
Need €100,000one 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 €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.
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.
Exercise 2: Hedging currency receivable (refer to the PPT for answers)
· 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 = $142,000 six month from now.
2) With money market:
Get SF200000 six month from now, and the rate is 5% in Swiss (or 2.5% for six months), so can borrow SF 200,000/(1+2.5%) = SF195121.95 now.
And can convert @ spot rate to SF195121.95 * 0.71$/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.
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.
Homework (Due 3/1/2017)
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?
(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?
(Answer: With forward contract: $14.6 million; Money market: $14.6million; Put option: $14.3million)
Warrant Buffet Loves cheap airline
Published Feb 15th 2017
By Philipvan Doorn
Chapter 18 Interest rate swap
Interest Rate Swap Explained
• All firms—domestic or multinational, small or large, leveraged, or unleveraged—are sensitive to interest rate movements in one way or another.
• The single largest interest rate risk of the nonfinancial firm (our focus in this discussion) is debt service
– The multicurrency dimension of interest rate risk for the MNE is a complicating concern.
• The second most prevalent source of interest rate risk for the MNE lies in its portfolio holdings of interest-sensitive securities
Example: Consider a firm facing three debt strategies
– Strategy #1: Borrow $1 million for 3 years at a fixed rate
– Strategy #2: Borrow $1 million for 3 years at a floating rate, LIBOR + 2% to be reset annually (LIBOR: London Interbank Offered Rate,)
– Strategy #3: Borrow $1 million for 1 year at a fixed rate, then renew the credit annually
– 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
– 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)
– It too assures funding for the three years but offersrepricing risk when LIBOR changes
– Eliminates credit risk as its spread remains fixed
• Strategy #3 offers more flexibility but more risk;
– 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
– 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
Volatility, however, is far greater on the short-end than on the long-end of the yield curve.
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
– Most commonly, interest rate swaps are associated with a debt service, such as the floating-rate loan described earlier
– An agreement between two parties to exchange fixed-rate for floating-rate financial obligations is often termed a plain vanilla swap
– This type of swap forms the largest single financial derivative market in the world.
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:
Company A 10% 6 month LIBOR+0.3%
Company B 11.2% 6month LIBOR+1.0%
– 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%
Plain vanilla swap: An agreement between two parties to exchange fixed-rate for floating-rate financial obligations
Exercise 1: Party A has a debt obligation with a floating interest rate of LIBOR+1.5%; Party B has a debt obligation with a fixed rate of 7.3%. Party A anticipates of future increases in interest rate; Party B just sees differently. How can the two parties hedge again their foreseeable risk in interest rate?
Party A is paying floating rate on its obligation, but wants to pay fixed rate. Party B is paying fixed rate, but wants to pay floating rate. They can enter into an interest rate swap, and the net result will be that each party can ‘swap’ their existing obligation for their desired obligation.
Exercise 2: Quality can borrow at a fixed interest rate of 9% or a floating rate of LIBOR+0.5%; Risky can borrow at a floating rate of LIBOR+1% or a fixed rate of 10.5%. The two parties want to enter an interest rate swap agreement. Set up one for the two companies.
Quality borrow at fixed 9% from market and pays LIBOR + 0.5% to Risky as part of the swap à Risky borrow at LIBOR+1% from market and pays 9.5% fixed to Quality as part of the swapà Quality’s net is 0.5% and Risky’s nest is also 0.5% (it pays back 9.5% in place of 10.5%, so net 1%; but it receives LIBOR+0.5% but pays LIBOR+1%, so net -0.5%; Overall, net of 0.5%) à This plain vanilla swap benefits both parties à Depending on the LIBOR rate, both parties settle the net transactions of the swap, which is: Risky pays Quality fixed 9.5% and Quality pays Risky floating LIBOR+0.5%.
LIBOR Quality Payment Risky Payment Net
8% 8%+0.5% 9.5% Risky pays Quality 1%
7% 7%+0.5% 9.5% Risky pays Quality 2%
5.5% 5.5%+0.5% 9.5% Risky pays Quality 3.5%
9% 9%+0.5% 9.5% No payment
10% 10%+0.5% 9.5% Quality pays Risky 1%
HW requirement (DUE on 3/1/2017)
Company X and company Y want to exchange debt. Currently, Company X has a debt at fixed rate of 10%, but it prefers a debt with floating rate. Company Y is the opposite.
A swap bank proposes the following interest only swap: X will pay the annual payments on that debt with the coupon rate of LIBOR – 0.15%; in exchange Y will pay to company X interest payments on the debt at a fixed rate of 9.90%. What is the final net rate that Company X is obligated of? And company Y? (Answer: X: LIBOR-0.05%; Y: 11.55%
For X: Obligation is 10%, receive 9.9% and pays LIBOR-0.15%, so total net obligation is LIBOR-0.05%.
For Y: Obligation is LIBOR+1.5%, pays 9.9%, receives LIBOR-0.15%, so there is a gap of (LIBOR+1.5% - (LIBOR-0.15%)=1.65%. Y needs to pay 9.9% plus this 1.65% of gap, so Y pays 9.9%+1.65% = 11.55%))
Wall St. Helped to Mask Debt Fueling Europe’s Crisis
Published: February 13, 2010
As worries over Greece rattle world markets, records and interviews show that with Wall Street’s help, the nation engaged in a decade-long effort to skirt European debt limits. One deal created by Goldman Sachs helped obscure billions in debt from the budget overseers in Brussels.
Even as the crisis was nearing the flashpoint, banks were searching for ways to help Greece forestall the day of reckoning. In early November — three months before Athens became the epicenter of global financial anxiety — a team from Goldman Sachs arrived in the ancient city with a very modern proposition for a government struggling to pay its bills, according to two people who were briefed on the meeting.
The bankers, led by Goldman’s president, Gary D. Cohn, held out a financing instrument that would have pushed debt from Greece’s health care system far into the future, much as when strapped homeowners take out second mortgages to pay off their credit cards.
It had worked before. In 2001, just after Greece was admitted to Europe’s monetary union, Goldman helped the government quietly borrow billions, people familiar with the transaction said. That deal, hidden from public view because it was treated as a currency trade rather than a loan, helped Athens to meet Europe’s deficit rules while continuing to spend beyond its means.
Athens did not pursue the latest Goldman proposal, but with Greece groaning under the weight of its debts and with its richer neighbors vowing to come to its aid, the deals over the last decade are raising questions about Wall Street’s role in the world’s latest financial drama.
As in the American subprime crisis and the implosion of the American International Group, financial derivatives played a role in the run-up of Greek debt. Instruments developed by Goldman Sachs, JPMorgan Chase and a wide range of other banks enabled politicians to mask additional borrowing in Greece, Italy and possibly elsewhere.
In dozens of deals across the Continent, banks provided cash upfront in return for government payments in the future, with those liabilities then left off the books. Greece, for example, traded away the rights to airport fees and lottery proceeds in years to come.
Critics say that such deals, because they are not recorded as loans, mislead investors and regulators about the depth of a country’s liabilities.
Some of the Greek deals were named after figures in Greek mythology. One of them, for instance, was called Aeolos, after the god of the winds.
The crisis in Greece poses the most significant challenge yet to Europe’s common currency, the euro, and the Continent’s goal of economic unity. The country is, in the argot of banking, too big to be allowed to fail. Greece owes the world $300 billion, and major banks are on the hook for much of that debt. A default would reverberate around the globe.
A spokeswoman for the Greek finance ministry said the government had met with many banks in recent months and had not committed to any bank’s offers. All debt financings “are conducted in an effort of transparency,” she said. Goldman and JPMorgan declined to comment.
While Wall Street’s handiwork in Europe has received little attention on this side of the Atlantic, it has been sharply criticized in Greece and in magazines like Der Spiegel in Germany.
“Politicians want to pass the ball forward, and if a banker can show them a way to pass a problem to the future, they will fall for it,” said Gikas A. Hardouvelis, an economist and former government official who helped write a recent report on Greece’s accounting policies.
Wall Street did not create Europe’s debt problem. But bankers enabled Greece and others to borrow beyond their means, in deals that were perfectly legal. Few rules govern how nations can borrow the money they need for expenses like the military and health care. The market for sovereign debt — the Wall Street term for loans to governments — is as unfettered as it is vast.
“If a government wants to cheat, it can cheat,” said Garry Schinasi, a veteran of the international Monetary Fund’s capital markets surveillance unit, which monitors vulnerability in global capital markets.
Banks eagerly exploited what was, for them, a highly lucrative symbiosis with free-spending governments. While Greece did not take advantage of Goldman’s proposal in November 2009, it had paid the bank about $300 million in fees for arranging the 2001 transaction, according to several bankers familiar with the deal.
Such derivatives, which are not openly documented or disclosed, add to the uncertainty over how deep the troubles go in Greece and which other governments might have used similar off-balance sheet accounting.
The tide of fear is now washing over other economically troubled countries on the periphery of Europe, making it more expensive for Italy, Spain and Portugal to borrow.
For all the benefits of uniting Europe with one currency, the birth of the euro came with an original sin: countries like Italy and Greece entered the monetary union with bigger deficits than the ones permitted under the treaty that created the currency. Rather than raise taxes or reduce spending, however, these governments artificially reduced their deficits with derivatives.
Derivatives do not have to be sinister. The 2001 transaction involved a type of derivative known as a swap. One such instrument, called an interest-rate swap, can help companies and countries cope with swings in their borrowing costs by exchanging fixed-rate payments for floating-rate ones, or vice versa. Another kind, a currency swap, can minimize the impact of volatile foreign exchange rates.
But with the help of JPMorgan, Italy was able to do more than that. Despite persistently high deficits, a 1996 derivative helped bring Italy’s budget into line by swapping currency with JPMorgan at a favorable exchange rate, effectively putting more money in the government’s hands. In return, Italy committed to future payments that were not booked as liabilities.
“Derivatives are a very useful instrument,” said Gustavo Piga, an economics professor who wrote a report for the Council on Foreign Relations on the Italian transaction. “They just become bad if they’re used to window-dress accounts.”
In Greece, the financial wizardry went even further. In what amounted to a garage sale on a national scale, Greek officials essentially mortgaged the country’s airports and highways to raise much-needed money.
Aeolos, a legal entity created in 2001, helped Greece reduce the debt on its balance sheet that year. As part of the deal, Greece got cash upfront in return for pledging future landing fees at the country’s airports. A similar deal in 2000 called Ariadne devoured the revenue that the government collected from its national lottery. Greece, however, classified those transactions as sales, not loans, despite doubts by many critics.
These kinds of deals have been controversial within government circles for years. As far back as 2000, European finance ministers fiercely debated whether derivative deals used for creative accounting should be disclosed.
The answer was no. But in 2002, accounting disclosure was required for many entities like Aeolos and Ariadne that did not appear on nations’ balance sheets, prompting governments to restate such deals as loans rather than sales.
Still, as recently as 2008, Eurostat, the European Union’s statistics agency, reported that “in a number of instances, the observed securitization operations seem to have been purportedly designed to achieve a given accounting result, irrespective of the economic merit of the operation.”
While such accounting gimmicks may be beneficial in the short run, over time they can prove disastrous.
George Alogoskoufis, who became Greece’s finance minister in a political party shift after the Goldman deal, criticized the transaction in the Parliament in 2005. The deal, Mr. Alogoskoufis argued, would saddle the government with big payments to Goldman until 2019.
Mr. Alogoskoufis, who stepped down a year ago, said in an e-mail message last week that Goldman later agreed to reconfigure the deal “to restore its good will with the republic.” He said the new design was better for Greece than the old one.
In 2005, Goldman sold the interest rate swap to the National Bank of Greece, the country’s largest bank, according to two people briefed on the transaction.
In 2008, Goldman helped the bank put the swap into a legal entity called Titlos. But the bank retained the bonds that Titlos issued, according to Dealogic, a financial research firm, for use as collateral to borrow even more from the European Central Bank.
Edward Manchester, a senior vice president at the Moody’s credit rating agency, said the deal would ultimately be a money-loser for Greece because of its long-term payment obligations.
Referring to the Titlos swap with the government of Greece, he said: “This swap is always going to be unprofitable for the Greek government.”
Final and project due
Final Exam Study Guide
Part I - Multiple choices and True / False (22 questions, and 2 points each)
1. Interest rate swap concept.
3. Plain vanilla swap concept
4. Plain vanilla swap concept
5. Purchasing power parity concept
6. The international Fisher effect (IFE) concept
7. The international Fisher effect (IFE) concept
8. Concept of interest rate parity, locational arbitrage, and purchasing power parity.
9. How to hedge receivables?
10. How to hedge receivables?
12. How to hedge payable?
13. How to hedge payable?
14. Interest rate parity concept
15. Interest rate parity concept
16. Purchasing power parity concept
18. How to hedge payable?
19. Purchasing power parity concept
20. Purchasing power parity concept
5: using PPP, given spot rate inflation rates in both countries, calculate new spot rate.
6. Using big Mac index and figure out the exchange rate.
7: Similar to exercise in class (Chapter 11), what is the hedged value if using a forward market hedge? What is the hedged value if using a money market hedge?
8: Similar to exercise in class (Chapter 11), how to hedge using forward, money market and option market?
9. Similar to HW of chapter 18, a plain vanilla swap question
10. Qs from WSJ paper
11. Qs from WSJ paper
Yellen may have offered the clearest explanation for the stock market’s record run