INTERNATIONAL
FINANCE
MODULE 1
INTERNATIONAL FINANCIAL SYSTEM STRUCTURE
International financial markets represent monetary and macroeconomic
interrelations between two or more countries. It consists of international
banking services and the global financial markets.
Further, we can say that the financial system worldwide represent the set of
institutions and operations through which resources are transferred from
individuals with available resources to deposit or invest (surplus sector) to
companies that require them for their projects (deficit sector).
BANKING FINANCIAL FINANCIAL
MARKET SYSTEM MARKETS
Increased globalization has magnified the
importance of international finance: allowing
agents to manage risk more efficiently,
increasing opportunities to invest and
assigning more accurately the prices of
financial assets.
BANKING MARKET
In the banking market, the transfer of resources from surplus sectors to
deficit sectors takes place through entities that act as intermediaries, which,
separately and independently, relate to depositors and those who require
financing.
FINANCIAL MARKETS
In capital markets, the transfer of resources
from surplus sectors to deficit sectors takes
place through a direct relationship between
both sectors through the issuance of
securities by companies that require
resources and the subscription of said
securities by the investors.
However, the transfer of resources from the surplus sector to the deficit
sector in the stock market must be carried out in an organized manner,
through authorized professionals that act as stock market intermediaries,
which carry out operations whose purpose or effect is to bring buyers and
sellers closer together in securities trading systems or at the market
counter.
IMPORTANCE OF THE FINANCIAL MARKET
Generates constant growth in the economy.
It creates competition with commercial banks, generating a
decrease in the cost of capital for companies and greater growth.
It attracts foreign investors to come, generating currency
strengthening and liquidity.
FINANCIAL MARKET CLASSIFICATION
According to the asset or financial instrument:
In
INT. FINANCIAL
MARKET
Markets
CAPITAL
FOREX MONEY MARKET
MARKETSMARKETS
DERIVATIVES BOND MARKET
EQUITY
MARKETRKET
FINANCIAL MARKET CLASSIFICATION
According to the phase
to be negotiated:
IPO
Primary
Markets
Exchange
Secondary
Markets
OTC
FOREIGN EXCHANGE MARKET
Functions:
FX markets facilitate international trade in goods and services.
FX markets allow investors to convert between currencies in order to
move funds into (or out of) foreign assets.
Market participants who face exchange rate risk hedge their
risks through a variety of FX instruments.
Other market participants undertake FX transactions to speculate on
currency values.
FOREIGN EXCHANGE MARKET
Market Participants
Exchange rates
An exchange rate represents the price of one
currency in terms of another currency.
It is stated in terms of the number of units of a
particular currency (price currency) required to
purchase a unit of another currency (base
currency).
Stated differently, it is the cost of one unit of the
base currency in terms of the price currency.
To ease the process, we will refer to exchange
rates using the convention “A/B,” that is, number
of units of Currency A (price currency) required to
purchase one unit of Currency B (base currency).
Exchange Rate Quote
Conventions
Example:
Suppose that the USD/GBP exchange rate is currently 1.5125. From this exchange rate quote we can
infer that:
The GBP is the base currency and USD is the price currency.
It will take 1.5125 USD to purchase 1 GBP.
1 GBP will buy 1.5125 USD or 1 GBP costs 1.5125 USD.
A decrease in this exchange rate (e.g., to 1.5120) means that 1 GBP will be able to purchase
fewer USD.
Alternatively, less USD will now be required to purchase 1 GBP (the cost of a GBP has fallen).
This decrease in the exchange rate means that the GBP has depreciated (lost value) against the
USD, or equivalently, the USD has appreciated (gained value) against the GBP.
The numerical value of the exchange rate and the value of the base currency are positively
related.
The numerical value of the exchange rate and the value of the price currency are negatively
related.
EXAMPLE
USD
DAY 1 DAY 2 DAY 3 DAY 4
1.59 1.62 1.65 1.61
We buy £5.500 of USD on day 2 and convert
them back to GBP on day 4. How many GBP
are they worth on day 4?
Would we have profitability? How much?
Exchange Rate Quotations
In a direct currency quote (DC/FC), the domestic currency is
stated as the price currency and foreign currency is stated as
the base currency. For example, for a trader in the United States,
an exchange rate quote of 1.5 USD/GBP is a direct currency
quote.
In an indirect currency quote (FC/DC), the foreign currency is
stated as the price currency and domestic currency is stated as
the base currency. For example, for a trader in the United States,
an exchange rate quote of 0.67 GBP/USD is an indirect currency
quote.
GAIN/LOSS
Suppose that the JPY/USD exchange rate increases from 77.58 to 78.45.
The unannualized percentage increase in the value of the USD against JPY can be
calculated as:
(78.45/77.58)−1= 1.12%
Please note that the percentage increase in the value of the USD against JPY does
not equal the percentage decrease in the value of JPY against USD. In order to
determine the percentage decrease in the value of JPY against USD, we must make
JPY the base currency in the exchange rates that we use in the calculation. The
USD/JPY exchange rate decreases from 1/77.58 = 0.0129 to 1/78.45 = 0.0127.
Therefore, The unannualized percentage decrease in JPY against USD is calculated as:
(0.0127/0.0129)−1=−1.55%
Professional FX markets
In professional FX markets, an exchange rate is usually quoted as a two-
sided price. Dealers usually quote a bid-price (the price at which they are
willing to buy), and an ask-price or offer price (the price at which they are
willing to sell).
Bid-ask prices are always quoted in terms of buying and selling
the base currency.
= CAD/EUR = EUR/CAD
Nominal and Real Exchange Rates
When the value of a currency is stated in terms of units of another
currency (as in the previous slide), it is referred to as a nominal
exchange rate.
Real exchange rates measure changes in the relative purchasing
power of one currency compared with another.
In other words, the rate at which one country’s goods can be traded
for another country´s goods.
Purchasing Power Parity:
If a basket of goods costs 2 GBP in the U.K. and 3 USD in the United States, the
nominal exchange rate should be 1.5 USD/GBP.. Whether she purchases it from the
U.K. or the United States, the exchange rate ensures that it costs her the same (2
GBP × 1.5 USD/GBP = 3 USD).
PPP theory states that, in the long run, currency exchange rates should move toward
equalizing the price of goods and services in different countries.
PPP FACTORS AND ANALYSIS
Suppose you live in Colombia and earn income in COP. As a consumer, you always
want to see an increase in your purchasing power, as it makes you better off in real
terms. The purchasing power of your COP is influenced by the following factors:
The nominal exchange rate: ;
The price level in the foreign country (or foreign inflation):
The price level in the home country (or domestic inflation):
Real exchange rates formulas
1) Real exchange rate regarding Inflation:
RR = NR x ( 1 + πFC/1 + πDC) Foreign Inflation /Domestic Inflation
2) Real exchange rate regarding at which one country’s goods can be
traded for another country’s goods. RR = NR x (PFC/PDC) Foreign
Price Level /Domestic Price Level
NR = Nominal Rate
RR = Real Rate
Example 1 regarding inflation
• We are a Colombian importing company
• We enter into a contract to pay 1m dollars in one year
• The exchange rate today is: $3910
• After one year:
• Inflation in the US is 3%
• Inflation in Cop is 2%
• The exchange rate is $ 4000
• What is the real value of this liability?
Example 2 regarding inflation
Over a period of time, Alexis (a U.S. resident) notes
that the nominal exchange rate (USD/EUR) has
decreased by 3%, the price level in the Eurozone has
increased by 5%, while the price level in the United
States has increased by 6%. Compute the change in
the real exchange rate and interpret your results.
Examples
regarding
Foreign
goods vs
Domestic What would be the rate Mex avocado bags/US
Avocado bags?
goods What would be the rate German Guitar/US
Guitar?
What does it mean?
Q&A
Q&A
Determinants
of exchange
rates
2)Relative Price
levels
(Inflation
rates)
Ej: COP/USD = $4000
The Price level in Colombia
rises relative to United
States
BALANCE OF TRADE
GOVERNMENT CONTROLS
Tariffs
Trump announces tariffs on
Mexico on May 31, 2019
US to place 5% tariff on
goods as Mexico.
MXN/USD From 19.15 to 19.8
3.4% Usd up against mxn.
Determinants of
exchange rates
RELATIVE INTEREST
1)
RATES
Ej: JPY/USD= 76. Japan
engages in an expansionary
monetary policy
Brazil
Interest
rates vs
BRL/USD
Determinants of exchange rates
Others:
SPECULATION
RELATIVE INCOME LEVELS
TASTES AND PREFERENCES
Currency Cross-rates
A cross rate is an exchange rate between two currencies that is
derived from each currency's relationship with a third currency.
For example:
If we have Euro = USD/EUR
If we have Dollar-yen = JPY/USD
if we multiply them = XUSD
JPY JPY
=
EUR USD EUR
For example:
If we have Euro = USD/EUR
If we have Pound Sterling = USD/GBP
If we multiply like above, we must inverse Pound sterling
GBP/USD
So, USD
X GBP
=
GBP
EUR USD EUR
Exercise
Q&A
Currency Rates Arbitrage
Implied cross-rate Triangular
from ≠ arbitrage
Direct exchange rates opportunity
Currency Rates Arbitrage
Suppose you observe the following quotes, and you are an AMERICAN investor with
$100.000 usd. And you can get access to this real information
• Bank in London: GBP/USD = 0.667
• Bank in NY: USD/EUR = 1.02
• Bank in Amsterdam: EUR/GBP = 1.7
Is there an arbitraje opportunity?
How could the American investor take advantage of this?
USD/EUR =
1.02
IMPLIED EUR/GBP = 1.47
1/(1.02 x 0.667)
EUR/GBP = 1.7
GBP/USD = 0.667
Thanks!!!
