ECW3121 International Trade and Finance Lecture 11 - PowerPoint PPT Presentation

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ECW3121 International Trade and Finance Lecture 11

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International Finance. Interest Arbitrage. Spot and Forward Exchange Rates ... International Finance. Interest Arbitrage. Covered and Uncovered Arbitrage ... – PowerPoint PPT presentation

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Title: ECW3121 International Trade and Finance Lecture 11


1
ECW3121International Trade and FinanceLecture
11

2
Heckscher-Ohlin
Stolper-Samuelson
Factor Price Equalisation
Comparative Advantage
Trade Theory Study Guide 1
Rybzcynski
Absolute Advantage
Immiserising Growth
Mercantilism
International Trade and Finance
Balance Of Payments
Foreign Exchange Markets
Non Tariff Barriers
Interest Arbitrage
Tariffs
TradeBlocs
Finance Study Guide 3
Trade Policy Study Guide 2
International Resource Movements
Exchange rate theorems
Tools of the Trade Policy Analysis
3
Reading
International Finance
Interest Arbitrage
  • Salvatore - Chapter 14

4
International Finance
Interest Arbitrage
  • Assume that behaviour of individuals and firms is
    consistent with profit maximisation.
  • Differences in interest rates between nations
    will give an opportunity to make a profit.
  • Capital will move around the world seeking the
    highest return.
  • This can be in the form of covered or uncovered
    interest arbitrage.

5
Spot exchange rate
International Finance
Interest Arbitrage
Spot and Forward Exchange Rates
  • The exchange rate in foreign exchange
    transactions that calls for the payment and
    receipt of foreign exchange within two business
    days from the date when the transaction has
    agreed upon.
  • Is driven by market forces as was discussed in
    the previous lecture.

6
Forward exchange rate
International Finance
Interest Arbitrage
Spot and Forward Exchange Rates
  • The exchange rate in foreign exchange
    transactions involving delivery of the foreign
    exchange one, three or six months after the
    contract is agreed upon.
  • Is driven by market forces as forecasted by the
    buyers and sellers of foreign exchange of the
    period of contract maturity.

7
Forward discount and forward premium
International Finance
Interest Arbitrage
Spot and Forward Exchange Rates
  • Forward Discount - the difference between a
    higher spot and a lower forward rate
  • Forward Premium - the difference between a lower
    spot and a higher forward rate.

8
Foreign Exchange Risk (Open Position)
International Finance
Interest Arbitrage
Speculation and Hedging
  • The risk, resulting from changes in exchange
    rates over time
  • Faced by anyone who expects to make or to receive
    a payment in a foreign currency at a future date.

9
Speculation
International Finance
Interest Arbitrage
Speculation and Hedging
  • The acceptance of foreign exchange risk (open
    position) in the hope of making a profit.
  • Short-term mechanism of equilibrating exchange
    rates.

10
Hedging
International Finance
Interest Arbitrage
Speculation and Hedging
  • The avoidance of foreign exchange risk.
  • (Covering of an open position).

11
Interest Arbitrage
International Finance
Interest Arbitrage
Covered and Uncovered Arbitrage
  • The transfer of short-term liquid funds abroad to
    earn a higher return.
  • Based on interest disparities.

12
Covered Interest Arbitrage
International Finance
Interest Arbitrage
Covered and Uncovered Arbitrage
  • Foreign Exchange dealings (for trade or profit)
    involve foreign exchange risk.
  • Hedging can be undertaken to minimise or
    eliminate this risk. The risk is then regarded
    as covered
  • One form of hedging is the forward contract.
  • A forward contract is an agreement to exchange
    currency at some future date at a fixed (forward)
    exchange rate.
  • The forward rate is determined by the market for
    forward contracts and embodies expectations about
    the future spot rate.

13
Covered Interest Arbitrage
International Finance
Interest Arbitrage
Covered and Uncovered Arbitrage
Covered Interest Arbitrage
  • The covering of foreign exchange risk means that
    a risk free profit can be made.
  • This profit will be less than what could be made
    by speculators who are prepared to accept the
    risk.
  • The existence of risk free profit will give
    incentive for profit maximisers to enter the
    market and take advantage.

14
Covered Arbitrage
International Finance
Interest Arbitrage
Covered and Uncovered Arbitrage
  • The transfer of short-term liquid funds abroad to
    earn a higher return -
  • with the foreign exchange risk covered by
  • spot purchase of the foreign currency
  • and a simultaneous offsetting forward sale.
  • Question does it always necessary to be covered
    by a forward rate to be higher than a spot rate?

Profit can be made because the gain on interest
rates more than offset the loss on the exchange
rate.
15
Uncovered Arbitrage
International Finance
Interest Arbitrage
Covered and Uncovered Arbitrage
  • The transfer of short-term liquid funds abroad to
    earn a higher return with the foreign exchange
    risk not covered by a simultaneous offsetting
    forward sale.
  • May be chosen, for example, when
  • a forward rate is considerably lower than a spot
    one, and
  • the speculator hopes that the spot rate at the
    time of the maturity of his contract will be
    higher than the current forward one.

16
International Finance
Interest Arbitrage
Covered and Uncovered Arbitrage
  • Spot Rate 0.7386
  • Discount 0.0386
  • Forward Rate 0.7000
  • Australian i/r p.a. 6.3
  • U.S. i/r p.a. 7.0
  • Term of borrowing 360 days
  • Borrowing Limit 1M AUD
  • DAY 1
  • Borrow 1M AUD _at_ 6.3 1000000 AUD
  • Exchange for USD at spot 738600 USD
  • Lend in US _at_ 7
  • DAY 360
  • Receive from investment 790302 USD
  • Exchange for AUD at forward 1129003 AUD
  • Repay Loan (1M _at_6.3) 1063000 AUD
  • RISK FREE PROFIT 66003 AUD

17
Interest Parity
International Finance
Interest Arbitrage
Covered and Uncovered Arbitrage
  • With Risk Free profit to be made, capital will
    flow from Australia to U.S.
  • This activity will have four effects on the
    financial sector
  • spot rate will fall due to strong demand for USD
    (capital outflow)
  • forward rate will rise due to increased demand
    for forward contracts in AUD .
  • demand for loanable funds will increase in
    Australia, causing the interest rate to rise.
  • supply of loanable funds will increase in USA,
    causing a fall in U.S. interest rates.

18
International Finance
Interest Arbitrage
Covered and Uncovered Arbitrage
Interest Parity
  • This process will continue until
  • s/f (1 i) / (1i)
  • No profit to be made
  • The gains/losses from the interest will be
    exactly offset by losses/gains from the exchange
    rate.
  • Ability to make profit depends on ability to
    recognise an open position and act on it
    accordingly.
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