International corporate finance:
Part 1: Architecture of International Markets
Class 1: Spot markets for foreign currency
1.1 How do exchange markets work?
The exchange market is not an organized market like the stock market
This means it doesn’t start and end at a certain time, and doesn’t have platform
Currency is a commodity, if you keep printing it, the value will drop.
We see that the volume of transactions of time has risen and keeps on rising.
Transactions used to be on paper, now almost only online via computer
2 tiers:
Wholesale tier with an information network of banks and big corporations
o 2 kind of professionals active
Market makers: Give 2-way quotes binding up to an agreed limit. It is
purely bilateral. Ex: You want to sell 1milj EUR for pounds than a
market maker will give you a price you can take or leave.
Brokers: These shop around to find takers for someone else’s offer. He
looks for the special deals where he can be cheap and sell high.
We call this arbitrage, hence why special deals
Retail tier: People go on holiday and need foreign currency. They go to a shop, …
Ask and Bid price Ask price > bid price. The Ask price is what the bank asks, the bid price is
what you can sell it for. Ask price > bid price because of risk, transaction costs, …
We always look at the ratio of HC/FC with HC (Home Currency) and FC (Foreign currency)
Ex. 1.25USD/EUR If you want to buy 1EUR, you need 1.25 USD. THIS IS THE RATE FOR EUR
IN TERMS OF USD
3 Major markets: London, Tokyo and New York London > Tokyo + New York
Less important: Sidney, Hong Kong, Singapore, …
Ambitious startup: Dubai
1.2 Spot transaction
Spot (rate: St): A spot transaction in the interbank market is the purchase of foreign
exchange, with the delivery and payment to take place, normally, on the second following
business day so t+2.
So it requires the delivery/payment to take place at a future value date of a specified
amount of one currency for a specified amount of another currency.
This is called a Forward (rate: F, T)= Payment/delivery at some future date (T> t+2)
Forward rate used to minimalize risk in hedge funds
Futures: This is the same as a forward but standardized. Forward is more of a unique
contract between the 2 parties, futures is more standard contract
1
,Option: This is a derivative with values on the stock markets Used to hedge or reduce the
risk.
Call option: The right to buy FX in the future
Put option: The right to sell FX in the future
1.3 Exchange rates:
Our quoting convention: The price, in unites of Home Currency (HC), per unit of foreign
currency (FC). So HC/FC
Ex: 1.25USD/EUR You buy EUR because it is FC. You need 1.25USD for 1EUR
1/(1.25USD/EUR) = 0.8EUR/USD You buy USD because it is FC. You need 0.8EUR for 1USD.
Some countries still use weird FC/HC convention:
USD: NY traders
o Traders need a unique language
o European governments had officially fixed the rate
GDP: Brits
o The pound used to be intractably nondecimal
o The pound used to play the key role taken by the USD after WWII
EUR: Everybody
o The EUR used to be “foreign’ even for Eurolanders, because very young
1.4 Bid and Ask rates
You buy at a bank’s ASK price
You sell to a bank’s BID price
Bid-Ask spread = Ask – Bid >= 0
o Ask > Bid
Bank has the power, transaction costs, commission for risk
o Determinants of bid-ask spread
Retail: Spread falls with the order size Bigger order size, less spread
Wholesale: Spread falls when risk of posting a quote is lower
Ex: USD/EUR: 1.2345-1.2347 ASK:1.2347 and BID:1.2345
Buying at 47 is like paying midpoint (46) + cost
Selling at 45 is like paying midpoint (46) – cost
Ex. RUB/USD: 35-36
When you arrive in Russia you get 35RUB for 1 USD
When you leave in Russia you pay 36RUB for 1USD
1.5 Bid price higher than Ask price?
Possible
Call this arbitrage opportunity
Bid price above ask rate; Huge risk-free profits
You buy at the ask and resell immediately at the higher bid price
So this is profit with no risk
2
,Primary and cross rate:
Primary rate is against a reference or base currency: USD
Cross rate between 2 non-base currencies: not involving USD
o Bv GBP/EUR
GBP/USD x USD/EUR
o Higher costs because more transactions
Example: EUR/GBP is what we want
so we need to EUR/USD x USD/GBP
USD/EUR 1/(USD/EUR) = EUR/USD
EUR/USD: 1.0152 (ask) – 1.0134 (bid)
USD/GBP: 1.7019 (bid) – 1.7936 (ask)
EUR/GDP (bid) = EUR/USD (bid) x USD/GDP (bid) = 1.0134 x 1.7019 = 1.7250 (bid)
EUR/GDP (ask) = EUR/USD (ask) x USD/GDP (ask) = 1.0152 x 1.7936 = 1.7295 (ask)
Measuring a change in exchange rate for the HC:
If s > 0 the Foreign currency has appreciated
If s < 0 The foreign currency has depreciated
Example HC/FC
o In June: EUR/USD = 0.875
o In December: EUR/USD = 0.9504
0.9503−0.875
Percentage change in exchange rate: =0.086
0.875
This means the dollar appreciated with 8.6% against the euro over a period of
six months
1.6 What mechanisms help enforcing the LOP
LOP or Law of One Price
In frictionless markets, 2 securities with the same Cashflow must have the same price
Arbitrage (2 currencies)
o Buy low and sell immediately higher without risk
o Opportunity because no net investment, no chance of loss, and only possibly
a gain
o Too nice to be true: Self-destructive
Shopping around (3 currencies)
Ex.
You buy at Citibank for 1.65 and sell at Morgan Chase for 1.6501
You buy at X for 58 and sell with Y for 60
3
, NY: USD/AUD = 0.5295 – 0.5293
=> So you buy AUD in Sydney for 0.5280 and sell it in NY for 0.5293 Risk free profit of
0.0013
For 20milj AUD you make 20 000 000 x 0.0013 = 26 000 profit
Buy 20milj AUD in Sydney, you need 10,56milj USD (20milj AUD x 0,5280). This 20milj AUD
you sell in NY (20milj AUD x 0.5293) and receive 10,586milj USD. So 26 000USD profit
=> If we now want to buy USD, than USD is de Foreign Currency
NY AUD/USD: 1.8885-1.8890
SY 1/(USD/AUD): 1.89-1.896
So we buy 20milj USD in NY (because lowest ask price between NY and SY) You need
20milj USD x 1.8890 AUD/USD = 37.78Milj AUD necessary
This 20milj USD you are going to sell in SY against higher bid price (1.8930)
20MIL USD X 1.8930 AUD/USD = 37.87MILJ AUD.
So you receive 37.78milj AUD and payed 37.78milj AUD
Make a profit of 0.08Milj AUD
Exc 12:
So we calculated JPY/AUD based on 2 currencies
JPY/USD x USD/AUD
Need to AUD/USD turn around
0.6053-0.6050
Om JPY/AUDbid = JPY/USDbid x USD/AUDbid
= 110.25 x 0.6050 = 66.7
Om JPY/AUDask = JPY/USDask x USD/AUDask
= 111.10 x 0.6053 =67v cvc
So arbitrage because we can buy at 67.25 JPY/AUD and sell at 68.30 in Sydney
Profit is 1.05 or (68.30-67.25)/67.25 = 1.56% (N-O)/O
1.7 Triangular Arbitrage and the LOP:
Triangular (3 currencies): Relations between spot rates quoted in various currencies.
Solve? Take 2 rate together and compare it with the other one
Ex; GBP/USD, JPY/USD, JPY/GBP
JPY/USD x (1/(GBP/USD)) This rate we compare with JPY/GBP given
This creation of non existing rate is called “SYNTHETIC SPREAD”
4
Part 1: Architecture of International Markets
Class 1: Spot markets for foreign currency
1.1 How do exchange markets work?
The exchange market is not an organized market like the stock market
This means it doesn’t start and end at a certain time, and doesn’t have platform
Currency is a commodity, if you keep printing it, the value will drop.
We see that the volume of transactions of time has risen and keeps on rising.
Transactions used to be on paper, now almost only online via computer
2 tiers:
Wholesale tier with an information network of banks and big corporations
o 2 kind of professionals active
Market makers: Give 2-way quotes binding up to an agreed limit. It is
purely bilateral. Ex: You want to sell 1milj EUR for pounds than a
market maker will give you a price you can take or leave.
Brokers: These shop around to find takers for someone else’s offer. He
looks for the special deals where he can be cheap and sell high.
We call this arbitrage, hence why special deals
Retail tier: People go on holiday and need foreign currency. They go to a shop, …
Ask and Bid price Ask price > bid price. The Ask price is what the bank asks, the bid price is
what you can sell it for. Ask price > bid price because of risk, transaction costs, …
We always look at the ratio of HC/FC with HC (Home Currency) and FC (Foreign currency)
Ex. 1.25USD/EUR If you want to buy 1EUR, you need 1.25 USD. THIS IS THE RATE FOR EUR
IN TERMS OF USD
3 Major markets: London, Tokyo and New York London > Tokyo + New York
Less important: Sidney, Hong Kong, Singapore, …
Ambitious startup: Dubai
1.2 Spot transaction
Spot (rate: St): A spot transaction in the interbank market is the purchase of foreign
exchange, with the delivery and payment to take place, normally, on the second following
business day so t+2.
So it requires the delivery/payment to take place at a future value date of a specified
amount of one currency for a specified amount of another currency.
This is called a Forward (rate: F, T)= Payment/delivery at some future date (T> t+2)
Forward rate used to minimalize risk in hedge funds
Futures: This is the same as a forward but standardized. Forward is more of a unique
contract between the 2 parties, futures is more standard contract
1
,Option: This is a derivative with values on the stock markets Used to hedge or reduce the
risk.
Call option: The right to buy FX in the future
Put option: The right to sell FX in the future
1.3 Exchange rates:
Our quoting convention: The price, in unites of Home Currency (HC), per unit of foreign
currency (FC). So HC/FC
Ex: 1.25USD/EUR You buy EUR because it is FC. You need 1.25USD for 1EUR
1/(1.25USD/EUR) = 0.8EUR/USD You buy USD because it is FC. You need 0.8EUR for 1USD.
Some countries still use weird FC/HC convention:
USD: NY traders
o Traders need a unique language
o European governments had officially fixed the rate
GDP: Brits
o The pound used to be intractably nondecimal
o The pound used to play the key role taken by the USD after WWII
EUR: Everybody
o The EUR used to be “foreign’ even for Eurolanders, because very young
1.4 Bid and Ask rates
You buy at a bank’s ASK price
You sell to a bank’s BID price
Bid-Ask spread = Ask – Bid >= 0
o Ask > Bid
Bank has the power, transaction costs, commission for risk
o Determinants of bid-ask spread
Retail: Spread falls with the order size Bigger order size, less spread
Wholesale: Spread falls when risk of posting a quote is lower
Ex: USD/EUR: 1.2345-1.2347 ASK:1.2347 and BID:1.2345
Buying at 47 is like paying midpoint (46) + cost
Selling at 45 is like paying midpoint (46) – cost
Ex. RUB/USD: 35-36
When you arrive in Russia you get 35RUB for 1 USD
When you leave in Russia you pay 36RUB for 1USD
1.5 Bid price higher than Ask price?
Possible
Call this arbitrage opportunity
Bid price above ask rate; Huge risk-free profits
You buy at the ask and resell immediately at the higher bid price
So this is profit with no risk
2
,Primary and cross rate:
Primary rate is against a reference or base currency: USD
Cross rate between 2 non-base currencies: not involving USD
o Bv GBP/EUR
GBP/USD x USD/EUR
o Higher costs because more transactions
Example: EUR/GBP is what we want
so we need to EUR/USD x USD/GBP
USD/EUR 1/(USD/EUR) = EUR/USD
EUR/USD: 1.0152 (ask) – 1.0134 (bid)
USD/GBP: 1.7019 (bid) – 1.7936 (ask)
EUR/GDP (bid) = EUR/USD (bid) x USD/GDP (bid) = 1.0134 x 1.7019 = 1.7250 (bid)
EUR/GDP (ask) = EUR/USD (ask) x USD/GDP (ask) = 1.0152 x 1.7936 = 1.7295 (ask)
Measuring a change in exchange rate for the HC:
If s > 0 the Foreign currency has appreciated
If s < 0 The foreign currency has depreciated
Example HC/FC
o In June: EUR/USD = 0.875
o In December: EUR/USD = 0.9504
0.9503−0.875
Percentage change in exchange rate: =0.086
0.875
This means the dollar appreciated with 8.6% against the euro over a period of
six months
1.6 What mechanisms help enforcing the LOP
LOP or Law of One Price
In frictionless markets, 2 securities with the same Cashflow must have the same price
Arbitrage (2 currencies)
o Buy low and sell immediately higher without risk
o Opportunity because no net investment, no chance of loss, and only possibly
a gain
o Too nice to be true: Self-destructive
Shopping around (3 currencies)
Ex.
You buy at Citibank for 1.65 and sell at Morgan Chase for 1.6501
You buy at X for 58 and sell with Y for 60
3
, NY: USD/AUD = 0.5295 – 0.5293
=> So you buy AUD in Sydney for 0.5280 and sell it in NY for 0.5293 Risk free profit of
0.0013
For 20milj AUD you make 20 000 000 x 0.0013 = 26 000 profit
Buy 20milj AUD in Sydney, you need 10,56milj USD (20milj AUD x 0,5280). This 20milj AUD
you sell in NY (20milj AUD x 0.5293) and receive 10,586milj USD. So 26 000USD profit
=> If we now want to buy USD, than USD is de Foreign Currency
NY AUD/USD: 1.8885-1.8890
SY 1/(USD/AUD): 1.89-1.896
So we buy 20milj USD in NY (because lowest ask price between NY and SY) You need
20milj USD x 1.8890 AUD/USD = 37.78Milj AUD necessary
This 20milj USD you are going to sell in SY against higher bid price (1.8930)
20MIL USD X 1.8930 AUD/USD = 37.87MILJ AUD.
So you receive 37.78milj AUD and payed 37.78milj AUD
Make a profit of 0.08Milj AUD
Exc 12:
So we calculated JPY/AUD based on 2 currencies
JPY/USD x USD/AUD
Need to AUD/USD turn around
0.6053-0.6050
Om JPY/AUDbid = JPY/USDbid x USD/AUDbid
= 110.25 x 0.6050 = 66.7
Om JPY/AUDask = JPY/USDask x USD/AUDask
= 111.10 x 0.6053 =67v cvc
So arbitrage because we can buy at 67.25 JPY/AUD and sell at 68.30 in Sydney
Profit is 1.05 or (68.30-67.25)/67.25 = 1.56% (N-O)/O
1.7 Triangular Arbitrage and the LOP:
Triangular (3 currencies): Relations between spot rates quoted in various currencies.
Solve? Take 2 rate together and compare it with the other one
Ex; GBP/USD, JPY/USD, JPY/GBP
JPY/USD x (1/(GBP/USD)) This rate we compare with JPY/GBP given
This creation of non existing rate is called “SYNTHETIC SPREAD”
4
