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Summary International Financial Management (ECB3IFMIB)

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Weekly summary and lecture notes of international financial management ECB3IFMIB Utrecht University

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  • April 28, 2021
  • 23
  • 2020/2021
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Lecture Week 1 – 08/02/2021

Spot Exchange Rate – price at which you exchange two currencies now.

Exchange rates are expressed as fractions: S0 = 0.9 $/€ à pay $1 for €0.9 or vice-versa

2 typical sources of confusion:

1. Are you buying or selling?
2. Real world uses different notation à not a fraction.

𝑞𝑢𝑜𝑡𝑒 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦
𝑏𝑎𝑠𝑒 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦

- Quote currency said to have direct quote
- Base currency said to have indirect quote

USD/EUR à not a fraction

- Means USD is base and EUR is quote
- In our case this means €/$
- We will not use the USD/EUR notation in this course as to avoid confusion

American and European Quotes:

- American terms à USD is quote currency
- European terms à USD is base currency

Cross-currency rate: synthetic exchange rate obtained by combining 2 quoted exchange rates.

X = $/€ x Y/$ = Y/€

Arbitrage: arbitrage activity keeps synthetic and quoted rates close.

Bid-Ask Spread: market makers revenue comes from the bid-ask spread.

- If you were to keep buying and selling the same currency you would make a loss à
market makers profit.

Bid: €1 buys me $1.213 Ask: Need to sell $1.214 for €1

Anti-confusion tips:

1. Dealer needs to make a profit à correct exchange rate to use is always the one least
convenient for you.
2. Bid quote is the smaller one.

,Bid-Ask spread and Cross-Currency rates:

- Ask yourself 2 things:
- 1. How many GBP can I buy using EUR (bid-rate)
- 2. How many EUR can I buy using GBP (ask-rate)

Forward Rate: set exchange rate at t1 for a txn occurring at t2

Ft1, t2 à t1 is when F is decided, t2 is when transaction takes place.

- Most actions occur at short maturities.

Long or short a forward:

- Long EUR forward à buy € at forward rate.
- Short EUR forward à sell € at forward rate.

Eurocurrencies: has nothing to do with €
- An example: sizable amount of USD accumulated outside of the US.

Eurocurrency market: money market for borrowing and lending currencies that are held in the
form of deposits in banks located outside the country where the currency is issued as legal
tender.

, Lecture Week 2 – 15/02/2021

International Parity Conditions

The law of one price: if 2 financial instruments pay the same cash flows:
1. In the same moments in time
2. In the same states of nature

à they must have the same price; otherwise there is arbitrage opportunity.

- We can use the no arbitrage opportunity condition to price financial instruments
and/or form expectations about price movements.

Stochastic arbitrage: (speculation) à still exposed to risk. No speculation condition may hold
only on average.

Covered interest rate parity: used to be the closest thing in finance to a law of nature.

𝐹 €/$ 1 + 𝑖€
=
𝑆 €/$ 1 + 𝑖$

- Can be used to compute the fair forward price à no arbitrage opportunity

€ 1 + 𝑖€
𝐹 7$ = . 𝑆 €/$
1 + 𝑖$

- At this forward price, you don’t pay for entering long or short.

- Covered interest rate parity should always hold as a result of arbitrage activity.

Example of arbitrage strategy:

- Invest €1 in Europe à 1 x (1 + 0.015) = €1.015
- Convert €1 to $ à 1 x (1/0.9) x (1 + 0.035) x 0.92 = €1.058
- à clearly the CIRP is not holding as the two approaches differ.

FX hedging synthetic rate = the 5.8% interest rate that we “created” à the resulting demand
of this interest rate results in the elimination of the arbitrage opportunity.

Some definitions:

# €%$ & '! €%$
- Forward premium: 𝐹𝑃 =
'! €%$


o FP > 0 = euro trades at forward premium over the dollar

o FP < 0 = euro trades at a forward discount over the dollar

- Covered interest rate parity is approximated as: i€ - i$

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