A summary of the course International Finance by professor Alessandro Diego Scopelliti from KU Leuven campus Brussels.
The summary follows the structure of the 9 lectures, and has added parts from the book in place.
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International Finance: Summary
Part 1: Introduction to Foreign Exchange Markets and Risks
Chapter 2: The Foreign Exchange Market
Introduction
Brexit and the value of the GBP
2.1 The organization of the foreign exchange market
2.4 Inside the interbank market II: communications and fund transfers
Exchange rate quotations
Chapter 4: The Balance of Payments
4.1 The balance of payments: concepts and terminology
4.2 Surpluses and deficits in the balance of payments accounts
4.4 Savings, investment, income, and the BOP
Chapter 5: Exchange Rate Systems
5.1 Alternative exchange rate arrangements and currency risk
5.2 Central banks
5.3 Flexible exchange rate systems
5.4 Fixed exchange rate systems
Part 2: International Parity Conditions and Exchange Rate Determination
Chapter 7: Speculation and Risk in the Foreign Exchange Market
7.2 Uncovered interest rate parity and the unbiasedness hypothesis
Chapter 6: Interest Rate Parity
6.1 The theory of covered interest rate parity
6.2 Covered interest rate parity in practice
Chapter 8: Purchasing Power Parity and Real Exchange Rates
8.3 The Law of One Price
8.7 Comparing incomes across countries
8.2 Absolute purchasing power parity
8.9 The real exchange rate
8.8 Relative PPP
Chapter 10: Exchange Rate Determination and Forecasting
10.1 Parity conditions and exchange rate forecasts
10.2 Currency forecasting techniques
10.3 Fundamental exchange rate forecasting
10.4 Technical analysis
Part 3: International Capital Markets
Chapter 11: International debt financing
International Finance: Summary 1
, 11.1 The global sources of funds for international firms
11.2 The characteristics of debt instruments
11.3 A tour of the world’s bond markets
11.4 International banking
11.5 International bank loans
11.6 Comparing the costs of debt
Chapter 12: International Equity Financing
12.1 A tour of international stock markets
Case study: Chinese stock markets
12.2 International cross-listing and depositary receipts
12.3 The advantages and disadvantages of cross-listing
Foreign Exchange Products: Forward Contracts
3.4 The forward foreign exchange market
3.5 Forward premiums and discounts
Foreign Exchange Products: Currency Options
20.3 Basics of foreign currency option contracts
Foreign Exchange Products: Currency Swaps
21.1 Introduction to swaps
Part 1: Introduction to Foreign Exchange
Markets and Risks
Chapter 2: The Foreign Exchange Market
Introduction
We will try to follow the structure of the slides, but use the titles/segments from the
book as a reference.
Foreign exchange rate risk - why it matters to companies:
Contractual exposure due to nominal exchange rate risk: uncertainty about
the value of an asset or liability that expires at some future point in time and is
denominated in foreign currency.
Example: company imports raw material from India. Cost of goods depends on the
value of the Indian rupee relative to the home currency.
❗ Hedging: use of financial instruments like forwards, futures, options, and
swaps.
International Finance: Summary 2
, Brexit and the value of the GBP
2.1 The organization of the foreign exchange market
How foreign exchange markets work
Book: 47 - 57
Interbank market
50% of transactions
Corporations: 7.5%
Other financial institutions: 92.5%
Most trades are >$1M
Retail market
Individual speculators
Tourists, travelers
Mainly through online brokers
Small amounts
Notice the core of the graphic: the interbank market.
International Finance: Summary 3
, Geography
In theory, there exists a ‘24h market’.
Benefits:
React to opportunities whenever
they arise
Trade when it’s most convenient
Take advantage of periods of higher
volatility when markets overlap
Size of the market
Due to electronification & diversity in
market participants. On a global scale,
London is the market for forex trading
(41% of market share)
E.g.: Deutsche Bank, UBS, Citigroup, etc.
They give two-way quotes binding up to an agreed limit (e.g. $10M USD or $20M).
Purely bilateral. They profit from buying foreign exchange at a bid price and reselling
it at a slightly higher offer or ask price. The difference between the bid and ask is
called the spread.
Interbank forex brokers (difference from dealers) are intermediaries between
interbank market makers. They match buyers and sellers but do not put their own
money at risk. They can be contacted usually by phone and a call box. The brokers
shop around to find takers of someone else’s offers. This is now, at the current day,
usually done by Electronic Broking Services (=EBS) and Thomson Reuters
Dealing Service.
E.g.: a German manufacturer needs to buy GBP to pay a UK-based supplier. →
Bid: €1.107/GPB and ask: €1.1010/GBP = Spread is €0.0003/GBP
You buy at the ask price, and sell at the bid price, which both are offered (usually) via
a bank. The spread should always be greater than or equal to 0. Why? Because
it serves as a ‘commission’ for the financial institution to provide the trade.
To get an idea of transaction costs in forex trading, big-ask spreads are expressed in
percentage points: Spread = (ask − bid)/midpoint. Where the midpoint is the
regular average of the bid and ask prices. Intuitively, the difference between the ask
price and the bid price actually represents two transaction costs. E.g. you buy from a
bank at its ask price, turn around and sell the same asset to another bank at its bid
price.
Rule: 1/ask = bid (indirect) and 1/bid = ask (indirect). Semantically, when one
switches the home currency (as a perspective), buying currency 1 becomes selling
currency 2.
E.g.: Someone gives 1000 yen to the bank and receives 10 USD. To a Japanese
this looks like buying 10 USD at 100JPY/USD. To an American this looks like
selling 1000 JPY at 0.01USD/JPY.
Bid-ask spreads are not constant over time. Determinants of the bid-ask spread:
Retail: spreads fall with order size
Wholesale: spreads fall when risk of posting a quote is lower
High liquidity
Low volatility
International Finance: Summary 5
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