GLOBAL INVESTMENT
by Bruno Solnik & Dennis McLeavey
Lecturer: Dr. Nguyen Thi Cuc Hong
Faculty of Economics
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Course Contents
1. INTERNATIONAL CURRENCY MARKET
2. INTERNATIONAL ASSET PRICING
3. EQUITY MARKET & INSTRUMENTS
6 learning
units 4. EQUITY: CONCEPT & TECHNIQUES
5. GLOBAL BOND INVESTING
6. INT’L DIVERSIFICATION & RISKS
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INTERNATIONAL
Unit 1 FOREIGN CURRENCY
MARKET pages 15-88
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Unit 1 Content
1. International Foreign Currency Markets (IFCM) Who trade Forex
and Why?
2. The principles of Ex-rate quotations
3. Convert and calculate different types of exchange rates, cross-rates
4. Calculate forward discount or premium on annual rates
5. Interest rate parity and covered interest arbitrage
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g e
FX market players e nt e d
H ds
tm e s s u n
v
In irm F
Participants from around the F
world buy & sell different
currencies through
E X
OR T
F K E s /
R e r
MA o k
Br stors
n v e
t s I
lie n
i l c /
Re ta n t r al
l
C e rc i a
m s e
m
Co ank
B
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Type of FX Instrument
SPOT FORWARD FUTURE OPTION SWAP
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Forex Market & Quotation Conventions
Forex Market Quote Convention
Foreign exchange market FX Trading Platform
A worldwide Forex center Forex trading screen;
(wholesale, market makers
interbank deal with large Ask-Bid quote for any
transactions); currency
OTC market
A retail market (Investors, Not all exchange rate
corporations <-> local banks) are traded
Large commercial and Description of the
investment banks company’s sub contents
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How IFCM work
• Largest financial market: daily trading volume of $5 trillion
• No single exchange transaction, but global computer network of large banks and
brokers from around the world.
• Facilitate currency exchange for foreign trade.
• Allowing companies to sell their goods globally and get paid in their local
currency.
• Transactions occur directly between parties without an intermediary to ensure that
each party complies with its obligations.
• Currencies do not come with a single price but are priced in terms of other
currencies.
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Major currency pairs
EUR/USD: the Euro of the Eurozone versus the US dollar
USD/JPY: the US dollar versus the Japanese yen
GBP/USD: the Great Britain pound versus the US dollar
USD/CHF: the US dollar versus the Swiss franc of Switzerland
USD/CAD: the U.S. dollar versus the Canadian dollar
AUD/USD: the Australian dollar versus the US dollar
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Most major currency pair
• US$ is world's reserve currency due to this country stable economy and
financial system.
• US$ involved in most of major transactions and currency exchanges since
products, commodities, and investments are transacted in US$.
• Countries with unstable market or currency exchange rate might opt to trade in
dollars to attract investment and facilitate trade.
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Typical FOREX quotations
Symbol Bid Ask Spread Status
EUR:GBP (Euro/British Pound) 0.8471 0.84802 0.00092 SELL BUY
EUR:USD (Euro/US Dollar) 1.13219 1.1329 0.00071 SELL BUY
GBP:USD (British Pound/US Dollar) 1.33492 1.33653 0.00161 SELL BUY
USD:JPY (US Dollar/Japanese Yen) 113.499 113.567 0.068 SELL BUY
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Principles of FX quotation
The formular S =
a: the quoted currency or based currency = the numerator = ĐỒNG YẾT (foreign currency)
b: the currency in which the price is expressed = the denominator = ĐỒNG ĐỊNH (local currency)
S = the price of the quoted currency a in units of currency b
For example: $:€ = 0.8 => 1$ is priced at 0.8€
Conversely, = 1.25 => 1€ is priced at 1.25 => $: ¥ = 120 or ¥: $ = 0.8333
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Direct & Indirect quotation
An = a:b Ex. €:$
Direct (a is foreign, b is domestic currency)
quote
DQ: €:$=1.25 or 1€ costs $1.25
DQ & IQ are reciprocal to each other
IQ: $:€=0.8 or 1$ purchase €0.8
Indirect An = a:b Ex. $:€
costs (a is domestic, b is foreign currency)
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Direct and indirect quotation
Direct: Foreign currency / Domestic currency or a:b
if a = foreign currency and b = domestic currency
Ex: €:$ = 1.25 is direct quote to American investors
Indirect: Domestic currency / Foreign currency or b:a
if a = domestic currency and b = foreign currency
Ex: $:€ = 0.8 is indirect quote to American investors
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DIRECT & INDIRECT QUOTATION
Domestic Currency Foreign Currency Direct Ex. Rate Indirect Ex. rate (Domestic
(Foreign currency quoted) currency quoted)
Appreciates Depreciates Decreases Increases
Depreciates Appreciates Increases Decreases
• Appreciation in domestic currency (DC is strong); and
• Depreciation in foreign currency (FC is weak)
• DC strong -> Indirect exchange rate increases; and
• FC weak -> Direct exchange rate decreases
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Major, Minor, Exotic currency pairs
Pair Currencies
• Major currency pairs are most-
EUR/USD Euro (€) vs. US dollar ($)
USD/JPY US dollar ($) vs. Japanese Yen (¥) traded in the world
GBP/USD British pound (£) vs. US dollar ($) • Minor currency pairs are less
USD/CHF US dollar ($) vs. Swiss Franc (SFr.)
AUD/USD Australian dollar (AU$) vs US dollar ($)
popular than the major pairs
USD/CAD US dollar ($) vv. Canadian dollar (CA$) • Exotic currency pairs are more
NZD/USD New Zealander dollar (NZ$) vs US dollar
volatile and less liquid
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Exchange rate Problem pg#19
On April 1, £:$ = 1.80 when a month later, £:$ = 1.90.
• What are the direct-indirect quote from the viewpoint of American and
British investors?
• Which currency is depreciated or appreciated?
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Solution pg#19
• £:$ = 1.80 is direct quote to American investors and indirect quote to
British investor
• Conversely, $:£ = 0.55556 is indirect to American investors and
direct to British investors
• In £:$, £ is quoted currency; over a month $1.80 $1.90
=> £ is appreciated and $ is depreciated
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Bid-Ask Quotations
• Spot market Price interaction among banks
• Bid/Ask spread of banks
• Bank’s bid (buy) < its ask quote (sell) = difference for bank’s costs
• Ex 1: If you have $1,000 and plan to travel to UK. Before leaving, you should convert $1,000 to
British pound; bid rate is at $1.52 and ask rate is $1.60. The converted amount is calculated at:
= = £625
• Unfortunately, you could not go, so the reconverted amount will be:
£625 x (bank’s bid rate of $1.52/pound) = $950
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Bid-Ask among curriencies
• Charlotte Bank quotes a bid price for Yen of $0.007 and an ask price of $0.0074.
In this case, the nominal bid/ask spread is $0.0074 – $0.007 = $0.004 (chênh
lệch tỷ giá).
• The bid/ask spread in % in the case of the traveler who sells $1,000 for yen at
bank’s ask price $0.0074, he received the amount of $1,000 / 0.0074 = ¥135,135
• The bank may buy back ’s bid price is $0.007 at $946 (¥135,135x0.007) which is
$54 difference or 5.4%
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Bid-Ask quotes & spreads
• Bid price = Buying quote
• Ask price = Selling quote
• Midpoint price = (ask + bid)/2
• Spread = difference between Ask & Bid quotes
• Pip = price interest point (smallest fluctuation in the price of currency)
Ask rate – Bid rate 1.2014 -1.2011
Percentage spread = =
Bid rate 1.2011
= 0.00025 = 0.025% = 2.5 basic point
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Cross-rate calculations
An exchange rate between 2 currencies inferred from each one’s exchange rate with
a 3rd country’s currency (referred currency).
1. (a:b) x (b:c) = a:c
If €:$ = 1.25 and $: ¥ = 120
=> (1) (€:$) x ($: ¥) = €:¥ = 1.25 x 120= 150
2. (a:b) : (a:c) = c:b
If $:won=1012.5 and $:R$=2.297
Þ (2) R$:won = ($:won) : ($:R$) = 1012.5/2.297
= R440.79
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Example 2
A US portfolio manager wants to buy $10 million worth of French bonds.
He wants to know how many euros can be obtained to invest using the $10 million,
then calls several banks to get their €/$ quotation, without indicating whether a sale
or a purchase of euros is desired.
Bank A quotes €:$ = 1.24969 – 1.25
which are consisted of $:€ = 0.80000 – 0.80020
Different quotes from Bank A Bank B Bank C
$:€ = 0.8-20 0.79985-05 0.79995-15
Note that the ask for all three quotes adds 0.00020 to the bid.
How many euros will the portfolio manager get to invest?
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Solution to Ex.2
How many euros will the portfolio manager get to invest?
AMOUNT: Bank A, buying €8 million for $10 million.
AT BANK: The euros should be transferred to an account with Société
Générale in Paris (Citibank in NY is manager’s business bank)
FORMALITIES: Electronic messages and faxes are exchanged to confirm the
oral agreement
PLACE: The settlement of the transaction takes place both in NY and
Paris
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FOREX arbitrage
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What is ARBITRAGE
• The trading that exploits the tiny differences in price between identical assets in
two or more markets;
• Arbitrager buys the asset in one market and sells it in the other market at the same
time in order to pocket the difference between the two prices.
• Arbitragers are usually working on behalf of large financial institutions.
• The transaction involves trading a substantial amount of money, and the split-
second opportunities it offers can be identified and acted upon only with highly
sophisticated software.
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Forex arbitrage: example
• Suppose you have $1 million, and you are provided with the exchange rates:
EUR/USD = 1.1586
GBP/EUR = 1.4600, and
GBP/USD = 1.6939.
• With these exchange rates there is an arbitrage opportunity:
1. Sell dollars to buy euros: $1 million ÷ 1.1586 = €863,110.65
2. Sell euros for pounds: €863,110.65 ÷ 1.46 = £591,171.68
3. Sell pounds for dollars: £591,171.68 x 1.6939 = $1,001,385.71
4. Subtract the initial investment from the final amount: $1,001,385.71 – $1,000,000 = $1,385.71
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Forex arbitrage: example
• The formula:
Profit rate =
• From these transactions, you would receive an arbitrage profit of $1,384 (assuming
no transaction costs or taxes).
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Example 3 – Cross-rate calculations
Calculate the cross rate between €:won based on the following quotes:
$:won = 1012.0-1013.0
€:$ = 1.24969 – 1.25
Since, €:won = (€:$) x ($:won)
Hence, the bid & cross rates are
(€:won)bid = (€:$)bid x ($:won)bid = 1.24969 x 1012.0 =
= 1264.69 won/euro
(€:won)ask = (€:$)ask x ($:won)ask = 1.25 x 1013.0 =
= 1266.25 won/euro
Check 1: Use the right currency symbol
Check 2: Maximize the bid-ask spread by combining bid-ask ex rate to yield the lowest cross rate
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Example 4 – Triangular arbitrage on Cross-rates
American bank quotes: €:$ = 1.2 – 1.205
£:$ = 1.795 – 1.8
British bank quotes £:€ = 1.505 – 1.507
Is there an arbitrage opportunity?
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Example 4 – Solution
AB: (£:€)bid = (£:$)bid : (€:$)ask = 1.7950/1.2050 = €1.4896/GBP
(£:€)ask = (£:$)ask : (€:$)bid = 1.8000/1.2000 = €1.5/GBP
=> £:€ = 1.4896 – 1.500 or £:€ = 1.4896/00
Due to AB quotes < BB quotes, arbitrage on £:€ can be made as follows:
• Buy GBP at €1.5 from AB (£:€)ask €8mil. : 1.5= £5,333,333.33
• Sell GBP at €1.505 from BB (£:€)bid 5.333mil.x 1.505= €8,026,666.66
• Net profit = €1.505 – 1.5 = €0.0050 (€8.026- €8.0)/8.0= 0,33
• €8,026,666.67- € 8,000,000= € 26,666.67
• Profit rate: €26,666.67/8,000,000 3.33%
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Forward quote
Spot exchange rate On the spot rate = S
Forward exchange rate F Today’s contracted rate for future
transactions
One-month quotes €:$ = 1.24688 – 1.24719
In 1 month the bank will buy € at 1.24688 and sell € at 1.24719
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Forward quote
One-month rates F €:$ = 1.24688 EUR/USD
Spot rate S €:$ = 1.25 EUR/USD
Discount = 1.25000 – 1.24688 = 0.00312
Spot rate > Forward rate=> € is weaker (discount)
Premium F $:€ = 1/1.24688=0.802 (forward value)
S $:€ = 0.8 (spot value)
Spot rate < Forward rate=> $ is traded at premium
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Forward rates: Annualized deviation
The forward discount/premium is often calculated as an annualized
forward premium/discount, ex. a:b
Forward rate – Spot rate 12
x 100% (1)
Spot rate No. Month forward
Use the previous example, we have
0.802 - 0.8 12
x 100% = 3%
0.8 1
Another example $:SFr. S = 1.2932-1.2939 (midpoint = 1.2936), F = 1.2823 (3-month forward rate)
Annualized 3-month F premium =
0.0113 12
x 100% = 3.5%
1.2936 3
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Interest rate parity: Forward discount & IR differential
Foreign Exchange Quotations
Dollar spot forward against the Dollar
August 30 Closing Mid Bid/Offer Three Months
point Ex.Rate % per annum
Euro € 0.9841 839-842 0.9802 1.6
UK £ 1.5492 490-494 1.541 2.1
Switzerland SFr. 1.4926 922-929 1.4887 1.1
Canada C$ 1.5612 610-614 1.566 -1.2
Japan ¥ 118.185 160-210 117.655 1.8
Interest rate parity (IRP) = relationship between ex rate, forward ex rate and interest rates.
IRP between 2 currencies is
Forward discount/premium = discounted interest rate (LS chiết khấu)
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Interest rate parity: Forward discount & IR differential
Spot exchange rate $:€ = € 0.8000
1-year forward ex. rate $:€ = € 0.8080
1 year interest rate r€ = 14% and r$ = 10%
For every dollar borrowed, the forward hedge should cover €0.8 + interests rate of 14%, means 0.80
(1.14) = 0.912 (F-S)/S = (rb – ra) / (1+ra)
In which: ra is the interest rate of the quoted currency FC
rb is the interest rate of the measurement currency DC
S and F are the spot and forward exchange rates
=> F(1+ra) = S(1+rb) or F = S(1+rb)/(1+ra)
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Example 5
US$ quoted against EUR, arbitrage ensure that F(1+r$) = S(1+r€)
So, in case S = 1.05 and r$=1.76%(0.0176) and r€=3.39% (0.0339),
What is the forward premium/discount?
SOLUTION
F = S(1+ )/(1+ ) = 1.05(1.0339/1.0176) = 1.0668 or $:€ = 1.0668
= = 1.6%
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Example 6
S = $1.058
Annual risk-free interest rate 3-month maturity
r= 3.39% and r$ = 1.76% => what is 3-month forward ex rate €:$?
SOLUTION
3-month interest rate over the price are: r€ 3.39%(3/12) = 0.8475%
r$ 1.76%(3/12) = 0.44%
3-month forward rate is equal to:
Forward ex rate = spot ex rate x
= 1.058(1.008475/1.0044) = $1.0623
=> 3-month forward rate is 1.0623/USD or $:t = $1.0623
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Forward ex-rate with Bid-Ask Spread
Bid interest rate Rate that bank is willing to borrow money (LSTG)
Ask interest rate Rate that bank is willing to lend money (LSCV)
Usually, Bid interest rate < Ask interest rate
An investor buys forward dollars (pay ask price $:€) with euros = $:t
• Borrowing euro (receiving ask interest rate, ask r€)
• Using bought euro to buy dollars spot (pay ask spot rate, ask spot $:€)
• Lending those dollars (receiving bid interest rate, bid r $)
To obtain the bid forward exchange rate, perform the reverse calculations:
• Borrowing dollars (to pay ask interest rate, ask r$)
• Selling those dollars to buy euro spot (receiving bid spot ex rate, bid spot $:€)
• Lending euros (receiving bid interest rate, bid r€)
In sum, the bid price of the forward exchange rate, bid forward $:€
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Example 7
Consider S = $:SFr. = SFr1.2932-1.2939
Annual risk-free interest rate are
SFr. = 1.42%-1.44%
US$ = 4.5%-4.52%
What should be the bid-ask quote for 1-year forward exchange rate $:SFr.
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Example 7 - Solution
Forward rate formula
Meanings: Borrowing SFr (pay ask interest rSFr)
Buying dollar spot (pay ask spot $:SFr.)
Lending dollar (receive bid interest r$)
Resulting in ask forward rate ($:SFr.) is
• Ask forward rate = = SFr1.2560
• Bid forward ex rate = SFr1.2548
=> 1-year forward rate should be $:SFr. = SFr1.2548-1.2560
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