Table of Content International Finance
CHAPTER 1: THE FOREIGN EXCHANGE MARKET (INTRODUCTION) ........................................................................... 1
1.1. HOW DO FOREX MARKETS WORK? ........................................................................................................................ 1
1.1.1. MARKET STRUCTURE ................................................................................................................................................ 1
1.1.2. MARKET PARTICIPANTS – INTERBANK MARKETS ............................................................................................................ 1
1.1.3. TRANSACTION TYPES ................................................................................................................................................ 1
1.2. SETTLEMENT RISK – HERSTATT RISK........................................................................................................................ 2
1.2.1. NETTING ARRANGEMENTS......................................................................................................................................... 2
1.3. EXCHANGE RATE QUOATATIONS ............................................................................................................................ 3
1.3.1. QUOTING CONVENTIONS .......................................................................................................................................... 3
1.3.2. BID AND ASK QUOTES ............................................................................................................................................... 3
1.3.3. CROSS RATES .......................................................................................................................................................... 4
1.4. FOREX TRADING ................................................................................................................................................ 5
1.4.1. ARBITRAGE (TWO WAY) ............................................................................................................................................ 5
1.4.2. SHOPPING AROUND (ONE-WAY)................................................................................................................................. 5
CHAPTER 2: THE BALANCE OF PAYMENTS ................................................................................................................ 6
2.1. CONCEPTS AND TERMINOLOGY.............................................................................................................................. 6
2.2. BOP ACCOUNTS ................................................................................................................................................. 6
2.2.1. SURPLUSES AND DEFICITS IN THE BOP ......................................................................................................................... 7
2.2.2. THE NATIONAL INCOME ACCOUNTS............................................................................................................................. 8
2.3. SAVING, INVESTING, INCOME, CA AND THE BOP ....................................................................................................... 9
2.3.1. SO WHAT EXPLAINS CA DEFICIT AND SURPLUSES?.......................................................................................................... 9
CHAPTER 3: EXCHANGE RATE SYSTEMS ................................................................................................................. 10
3.1. ALTERNATIVE EXCHANGE RATE ARRANGEMENTS...................................................................................................... 10
3.1.1. EXCHANGE RATE SYSTEMS AROUND THE WORLD ......................................................................................................... 10
3.1.2. CURRENCY RISK ..................................................................................................................................................... 10
3.2. FOREIGN EXCHANGE MARKETS AND CENTRAL BANKS ................................................................................................ 11
3.2.1. CENTRAL BANK’S BALANCE SHEET ............................................................................................................................. 11
3.2.2. ASSETS, LIABILITIES AND MONEY SUPPLY ................................................................................................................... 12
3.2.3. STERILIZATION ...................................................................................................................................................... 12
3.2.4. THE EFFECTS OF CENTRAL BANK INTERVENTIONS ......................................................................................................... 13
CHAPTER 4: THE INTEREST RATE PARITY ................................................................................................................ 14
4.1. UNCOVERED INTEREST RATE PARITY (UIRP) .......................................................................................................... 14
4.2. COVERED INTEREST RATE PARITY (CIRP) .............................................................................................................. 15
4.3. CARRY TRADING (IRP IN PRACTICE) ..................................................................................................................... 16
CHAPTER 5: PURCHASING POWER PARITY (PPP) AND REAL EXCHANGE RATE ........................................................ 17
5.1. TERMINOLOGY ................................................................................................................................................ 17
5.2. LAW OF ONE PRICE (LOP) ................................................................................................................................. 17
5.3. ABSOLUTE PURCHASING POWER PARITY (APPP) .................................................................................................... 18
5.3.1. DEVIATIONS FROM PPP.......................................................................................................................................... 19
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,5.3.2. PROBLEMS WITH APPP .......................................................................................................................................... 19
5.4. RELATIVE PURCHASING POWER PARITY (RPPP) ..................................................................................................... 20
5.5. PARITY CONDITIONS AND EXCHANGE RATE FORECAST ............................................................................................... 21
5.5.1. THE FISHER HYPOTHESIS ......................................................................................................................................... 21
CHAPTER 6: EXCHANGE RATE DETERMINATION AND FORECASTING ...................................................................... 22
5.1. FUNDAMENTAL EXCHANGE RATE DETERMINATION .................................................................................................. 22
5.1.1. THE MONETARY MODEL .......................................................................................................................................... 23
5.1.2. THE MUNDELL-FLEMING MODEL ............................................................................................................................. 25
5.1.3. THE OVERSHOOTING MODEL .................................................................................................................................. 29
5.1.4. PPP-BASED FORECASTS .......................................................................................................................................... 31
5.2. TECHNICAL ANALYSIS ........................................................................................................................................ 31
5.2.1. CHARTISM............................................................................................................................................................ 31
5.2.2. FILTER RULES ........................................................................................................................................................ 32
CHAPTER 7: THE FINANCING DECISION IN INTERNATIONAL FIXED-INCOME MARKETS ........................................... 33
7.1. THE GLOBAL SOURCES OF FUNDS FOR INTERNATIONAL FIRMS ..................................................................................... 33
7.2. THE CHARACTERISTICS OF DEBT INSTRUMENTS ........................................................................................................ 33
7.2.1. CURRENCY DENOMINATION..................................................................................................................................... 33
7.2.2. MATURITY ........................................................................................................................................................... 34
7.2.3. INTEREST RATE PAYMENTS: FIXED VS. FLOATING .......................................................................................................... 34
7.2.4. TRADABILITY OF DEBT ............................................................................................................................................. 35
7.2.5. INTERNATIONAL CHARACTER OF DEBT........................................................................................................................ 35
7.3. A TOUR OF THE WORLD’S BOND MARKETS ............................................................................................................. 35
7.3.1. DOMESTIC BONDS VS. INTERNATIONAL BONS........................................................... FOUT! BLADWIJZER NIET GEDEFINIEERD.
7.4. INTERNATIONAL BANKING .................................................................................................................................. 36
7.5. INTERNATIONAL BANK LOANS ............................................................................................................................. 36
7.6. COMPARING COST OF DEBT ............................................................................................................................... 36
7.6.1. THE ALL-IN-COST PRINCIPLE .................................................................................................................................... 37
CHAPTER 8: INTERNATIONAL EQUITY FINANCING.................................................................................................. 38
8.1. A TOUR OF INTERNATIONAL STOCK MARKETS.......................................................................................................... 38
8.1.1. CASE STUDY: CHINESE STOCK MARKETS .................................................................. FOUT! BLADWIJZER NIET GEDEFINIEERD.
8.2. INTERNATIONAL CROSS-LISTING AND DEPOSITARY RECEIPTS ....................................................................................... 39
8.3. THE ADVANTAGES AND DISADVANTAGES OF CROSS-LISTING ....................................................................................... 40
CHAPTER 9: FOREIGN EXCHANGE PRODUCTS ........................................................................................................ 41
9.1. FORWARD CONTRACTS...................................................................................................................................... 41
9.1.1. FORWARD RATES ................................................................................................................................................... 41
9.1.2. FORWARD PREMIUM AND DISCOUNT ........................................................................................................................ 41
9.1.3. MARKET VALUE OF A FORWARD CONTRACT ................................................................................................................ 41
9.2. CURRENCY OPTIONS ......................................................................................................................................... 41
9.2.1. CURRENCY OPTIONS QUOTATION AND PRICES ............................................................................................................. 41
9.2.2. USING FOREIGN CURRENCY OPTIONS ......................................................................................................................... 41
9.2.3. OPTION PRICING AND VALUATION ............................................................................................................................ 41
9.3. CURRENCY SWAPS ........................................................................................................................................... 41
9.3.1. MODERN CURRENCY SWAPS .................................................................................................................................... 41
9.3.2. CURRENCY SWAP VALUATION .................................................................................................................................. 41
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CHAPTER 1: THE FOREIGN EXCHANGE MARKET (INTRODUCTION) ........................................................................... 1
1.1. HOW DO FOREX MARKETS WORK? ........................................................................................................................ 1
1.1.1. MARKET STRUCTURE ................................................................................................................................................ 1
1.1.2. MARKET PARTICIPANTS – INTERBANK MARKETS ............................................................................................................ 1
1.1.3. TRANSACTION TYPES ................................................................................................................................................ 1
1.2. SETTLEMENT RISK – HERSTATT RISK........................................................................................................................ 2
1.2.1. NETTING ARRANGEMENTS......................................................................................................................................... 2
1.3. EXCHANGE RATE QUOATATIONS ............................................................................................................................ 3
1.3.1. QUOTING CONVENTIONS .......................................................................................................................................... 3
1.3.2. BID AND ASK QUOTES ............................................................................................................................................... 3
1.3.3. CROSS RATES .......................................................................................................................................................... 4
1.4. FOREX TRADING ................................................................................................................................................ 5
1.4.1. ARBITRAGE (TWO WAY) ............................................................................................................................................ 5
1.4.2. SHOPPING AROUND (ONE-WAY)................................................................................................................................. 5
CHAPTER 2: THE BALANCE OF PAYMENTS ................................................................................................................ 6
2.1. CONCEPTS AND TERMINOLOGY.............................................................................................................................. 6
2.2. BOP ACCOUNTS ................................................................................................................................................. 6
2.2.1. SURPLUSES AND DEFICITS IN THE BOP ......................................................................................................................... 7
2.2.2. THE NATIONAL INCOME ACCOUNTS............................................................................................................................. 8
2.3. SAVING, INVESTING, INCOME, CA AND THE BOP ....................................................................................................... 9
2.3.1. SO WHAT EXPLAINS CA DEFICIT AND SURPLUSES?.......................................................................................................... 9
CHAPTER 3: EXCHANGE RATE SYSTEMS ................................................................................................................. 10
3.1. ALTERNATIVE EXCHANGE RATE ARRANGEMENTS...................................................................................................... 10
3.1.1. EXCHANGE RATE SYSTEMS AROUND THE WORLD ......................................................................................................... 10
3.1.2. CURRENCY RISK ..................................................................................................................................................... 10
3.2. FOREIGN EXCHANGE MARKETS AND CENTRAL BANKS ................................................................................................ 11
3.2.1. CENTRAL BANK’S BALANCE SHEET ............................................................................................................................. 11
3.2.2. ASSETS, LIABILITIES AND MONEY SUPPLY ................................................................................................................... 12
3.2.3. STERILIZATION ...................................................................................................................................................... 12
3.2.4. THE EFFECTS OF CENTRAL BANK INTERVENTIONS ......................................................................................................... 13
CHAPTER 4: THE INTEREST RATE PARITY ................................................................................................................ 14
4.1. UNCOVERED INTEREST RATE PARITY (UIRP) .......................................................................................................... 14
4.2. COVERED INTEREST RATE PARITY (CIRP) .............................................................................................................. 15
4.3. CARRY TRADING (IRP IN PRACTICE) ..................................................................................................................... 16
CHAPTER 5: PURCHASING POWER PARITY (PPP) AND REAL EXCHANGE RATE ........................................................ 17
5.1. TERMINOLOGY ................................................................................................................................................ 17
5.2. LAW OF ONE PRICE (LOP) ................................................................................................................................. 17
5.3. ABSOLUTE PURCHASING POWER PARITY (APPP) .................................................................................................... 18
5.3.1. DEVIATIONS FROM PPP.......................................................................................................................................... 19
1
,5.3.2. PROBLEMS WITH APPP .......................................................................................................................................... 19
5.4. RELATIVE PURCHASING POWER PARITY (RPPP) ..................................................................................................... 20
5.5. PARITY CONDITIONS AND EXCHANGE RATE FORECAST ............................................................................................... 21
5.5.1. THE FISHER HYPOTHESIS ......................................................................................................................................... 21
CHAPTER 6: EXCHANGE RATE DETERMINATION AND FORECASTING ...................................................................... 22
5.1. FUNDAMENTAL EXCHANGE RATE DETERMINATION .................................................................................................. 22
5.1.1. THE MONETARY MODEL .......................................................................................................................................... 23
5.1.2. THE MUNDELL-FLEMING MODEL ............................................................................................................................. 25
5.1.3. THE OVERSHOOTING MODEL .................................................................................................................................. 29
5.1.4. PPP-BASED FORECASTS .......................................................................................................................................... 31
5.2. TECHNICAL ANALYSIS ........................................................................................................................................ 31
5.2.1. CHARTISM............................................................................................................................................................ 31
5.2.2. FILTER RULES ........................................................................................................................................................ 32
CHAPTER 7: THE FINANCING DECISION IN INTERNATIONAL FIXED-INCOME MARKETS ........................................... 33
7.1. THE GLOBAL SOURCES OF FUNDS FOR INTERNATIONAL FIRMS ..................................................................................... 33
7.2. THE CHARACTERISTICS OF DEBT INSTRUMENTS ........................................................................................................ 33
7.2.1. CURRENCY DENOMINATION..................................................................................................................................... 33
7.2.2. MATURITY ........................................................................................................................................................... 34
7.2.3. INTEREST RATE PAYMENTS: FIXED VS. FLOATING .......................................................................................................... 34
7.2.4. TRADABILITY OF DEBT ............................................................................................................................................. 35
7.2.5. INTERNATIONAL CHARACTER OF DEBT........................................................................................................................ 35
7.3. A TOUR OF THE WORLD’S BOND MARKETS ............................................................................................................. 35
7.3.1. DOMESTIC BONDS VS. INTERNATIONAL BONS........................................................... FOUT! BLADWIJZER NIET GEDEFINIEERD.
7.4. INTERNATIONAL BANKING .................................................................................................................................. 36
7.5. INTERNATIONAL BANK LOANS ............................................................................................................................. 36
7.6. COMPARING COST OF DEBT ............................................................................................................................... 36
7.6.1. THE ALL-IN-COST PRINCIPLE .................................................................................................................................... 37
CHAPTER 8: INTERNATIONAL EQUITY FINANCING.................................................................................................. 38
8.1. A TOUR OF INTERNATIONAL STOCK MARKETS.......................................................................................................... 38
8.1.1. CASE STUDY: CHINESE STOCK MARKETS .................................................................. FOUT! BLADWIJZER NIET GEDEFINIEERD.
8.2. INTERNATIONAL CROSS-LISTING AND DEPOSITARY RECEIPTS ....................................................................................... 39
8.3. THE ADVANTAGES AND DISADVANTAGES OF CROSS-LISTING ....................................................................................... 40
CHAPTER 9: FOREIGN EXCHANGE PRODUCTS ........................................................................................................ 41
9.1. FORWARD CONTRACTS...................................................................................................................................... 41
9.1.1. FORWARD RATES ................................................................................................................................................... 41
9.1.2. FORWARD PREMIUM AND DISCOUNT ........................................................................................................................ 41
9.1.3. MARKET VALUE OF A FORWARD CONTRACT ................................................................................................................ 41
9.2. CURRENCY OPTIONS ......................................................................................................................................... 41
9.2.1. CURRENCY OPTIONS QUOTATION AND PRICES ............................................................................................................. 41
9.2.2. USING FOREIGN CURRENCY OPTIONS ......................................................................................................................... 41
9.2.3. OPTION PRICING AND VALUATION ............................................................................................................................ 41
9.3. CURRENCY SWAPS ........................................................................................................................................... 41
9.3.1. MODERN CURRENCY SWAPS .................................................................................................................................... 41
9.3.2. CURRENCY SWAP VALUATION .................................................................................................................................. 41
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