FIN 40500:

International Finance

Introduction to Currency Markets

 “Sherman, set the way-back machine for
1850!”

Prior to the late 1800s, international

transactions were made with gold and silver
coins…no exchange rate was necessary!!

The most prominent coins were US Coins were modeled after

Spanish Spanish coins

One Peseta = .8465 One US Dollar

ounces of Silver = .8465 ounces of
Silver

One Doubloon = .88 ounces of One US Dollar = 0.056

Gold (one Doubloon = 16 ounces of Gold
Pesetas)
 1 Dollar = .86 oz. silver
1 Dollar = 0.056 oz. gold

1 Pound = 3.98 oz. silver

1 Sovereign = .2354 oz.
Note that if, for example, the US was running a gold
trade deficit with Britain, Gold and Silver would
flow out of the US and into Britain (price-specie
flow mechanism)….when this happens, what
happens to prices?
As countries moved to paper currency in the late 1860s, governments
would regulate the value of that currency by fixing the price of gold

VS

$20.67 Per Ounce 4.40 Per Ounce

$1 = .0483 oz gold 1 Pound = .227 oz gold

These two prices imply an exchange rate between

the US Dollar and the British Pound

$20.67 Per Ounce

= $4.70 Per
4.40 Per Ounce
 Suppose that the exchange rate were $4.00 per
(The British Pound is Undervalued)

$20.67 Per Ounce

1 Start with $1, convert it to Pounds ( = .25 )

4.40 Per Ounce
2 Buy Gold in England ( .0658 oz )

3 Ship the gold back to the US and sell it ( = $1.17 )

The gold standard era saw very stable exchange rates!

 The Gold Standard maintained the
price-specie flow mechanism

$20.67 Per Ounce

$4.70 Per

4.40 Per Ounce

Note that if, for example, the US was running a trade deficit
with Britain, Excess demand for British pound notes would
cause the Pound to appreciate – arbitrage would cause gold
to flow out of the US and into England
In July 1944, delegates from 44 nations gathered at the Mount
Washington hotel in Bretton Woods New Hampshire. The result was the
Bretton Woods Agreement

$1 = 360 JPY

$1 = .2481 GBP

$1 = 3.33 DEM
1 oz = $35

$1 = 119 FRF

$1 = 575 ITL
 Johnson’s Great The British
Society programs Pound is
and the Vietnam attacked – The
war create large US Bank of
deficits England
devalues by
14%

1966 1968 1971

1965 1967 1970 1972

Bretton Woods
August 15, 1971:
collapses and
Nixon is forced to
the currency
suspend
boom begins!
convertibility of
dollars to gold
 From 1971 until 1987 the US followed a policy of managed floating (market
based exchange rate with periodic “re-alignments”).

USD/JPY The Plaza Accord

400.00 (1985) purposely
350.00 devalued the dollar
against the Yen and
300.00
Deutschmark by
250.00 51%
200.00
The Louvre Accord
150.00
(1987) ended the
100.00 dollar devaluation
50.00
policy of the plaza
accord
0.00
Jan-71 Jan-75 Jan-79 Jan-83 Jan-87

The Smithsonian Agreement (1971-1973) attempted to return to

the Bretton Woods system but without dollar/gold convertibility
In the meantime, the Europeans were developing an exchange rate system
of their own. Called the ERM (European exchange rate mechanism), this
system involved member countries to peg to an artificial currency called a
European Currency Unit

Currency Weight (%)

Belgian Franc 8.183
German Mark 31.915
Danish Krone 2.653
Spanish Peseta 4.138
French Franc 20.306
British Pound 12.452
Greek Drachma .437
Irish Punt 1.086 The ECU was the original
Italian Lira 7.84 recipe for the Euro
Luxembourg Franc .322
Dutch Guilder 9.87
Portuguese Escudo .695
 In 1992, George Soros (Quantum Fund) believed the British pound was
overvalued and began selling. On September 19, 1992 the British
government was forced to withdraw from the ERM and devalue the pound.

2.05

1.95

1.85

1.75
GBP/USD

1.65

1.55 George
1.45
Soros made
a profit of
1.35 $1B!!!
1.25
8/1/90 8/1/91 8/1/92 8/1/93 8/1/94 8/1/95
 Political turmoil and economic weaknesses led to a
collapse of the Mexican Peso in 1994.

This currency problem

eventually spread through Latin
America through what has
become knows as the “Tequila
Effect” (Not to be confused with the
other “Tequila Effect”)
 1998 2000 2002

1997 1999 2001 2003

Currency markets have had a turbulent decade!!!

 In January, 2002, the Euro officially
entered circulation in Europe. Since the
emergence of the Euro in 1999, the
dollar has had a bumpy ride!

1.40
USD/EUR
1.30

1.20 Will the Euro

survive as a
1.10 major
currency?
1.00

0.90

0.80
Jan-99 Jan-01 Jan-03 Jan-05
The foreign exchange market is unique not just because of its geographic
dispersion, but also because of its extreme liquidity and tremendous
volume – around $1.9T PER DAY!!
Name % of Volume
$600B in Spot market Deutsche Bank 17
Transactions
UBS 12.5
$1.3T in Derivative Market
Citigroup 7.5
Transactions
HSBC 6.4
 $200B in Forwards
Barclays 5.9
 $1T in Swaps Merrill Lynch 5.7
 $100B in Options JP Morgan Chase 5.3
Goldman Sachs 4.4
ABN Amro 4.2
Morgan Stanley 3.9

The ten most active traders account for 73% of the volume
 With trading centers in New York City, London, Tokyo and Sydney, currency
markets operate 24 hours a day, 5 days a week.

Eastern Standard Time

12 3 8 12 5 9 11
AM AM AM PM PM PM PM

Australia: 5PM - 2AM

8PM - 5AM Tokyo

London: 3AM -11AM

30000

New York City: 8AM -5PM

25000
Transactions/ Hour

20000

15000

10000

5000

0
12:00AM 4:00AM 8:00AM 12:00AM 4:00PM 8:00PM
Unlike other asset markets, England dominates foreign
exchange trading

Germany France Singapore Canada

Switzerland 5% 3% 6% 3%
4%
Australia
3%
Japan
9%

Other
19%
US
16%

UK Why is
32% this?
 The “Majors”
USD/CAD USD/AUD
USD/CHF 4% 4%
5%
USD/GBP
11%
USD/Other
17%

EUR/All
USD/JPY 8%
20%
USD/EUR
31%

The six “Majors” are: The US Dollar (USD), Japanese Yen (JPY), Euro (EUR),
British Pound (GBP), Swiss Franc (CHF), Australian Dollar (AUD), and the
Canadian Dollar (CAD)
 Spot transactions are executed immediately (delivery usually takes place
two days after the transaction date). A spot exchange rate is simply the
price of one currency in terms of another currency.

VS

400.00
USD/JPY = 110.49 (1 USD = 110.49 JPY)
350.00

300.00 The dollar appreciated against

the Yen in the early eighties
250.00
(USD/JPY increased )
USD/JPY

200.00

150.00

100.00

50.00
Overall, the trend is a dollar
0.00
Jan-71 Jan-76 Jan-81 Jan-86 Jan-91 Jan-96 Jan-01 Jan-06 depreciation (A decrease in
USD/JPY)
 In currency markets you need to PAY ATTENTION TO THE UNITS!!!!

VS

EUR/USD = 1.2885 (1 EUR = 1.2885 USD)

1.4000 The dollar has been depreciating
against the Euro since 2001 (an
1.3000
increase in EUR/USD)
1.2000

1.1000

1.0000

0.9000 The dollar appreciated sharply

against the Euro after its 1999
0.8000 release (a decrease in EUR/USD)
Jan-99 Jan-01 Jan-03 Jan-05
 Calculating Profits/Losses

Suppose that you took a long position in

dollars @ 110.00 and then reversed it @
110.10
Long: $10,000,000 USD/JPY 110.00
Short: $10,000,000 USD/JPY 110.10

These prices are in terms of

Yen per dollar!!

Profit = .10 ( $10,000,000) = Y 1,000,000

Y 1,000,000
= $9,082.65
110.10

Again…pay attention to the units!!!

 As a currency dealer, you need to decide where to buy,
where to sell and at what prices

USD/CHF = 1.2050 – 1.2055 Spread = 5 “Pips”

Bid Price for Dollars

(the price in which Offer Price for
the market maker is Dollars (the price the
willing to buy dollars) market maker is
willing to sell dollars)

.0005 CHF
Profits (Per dollar traded) = $1 (.0005) = 1.2050 = $0.0000415

What influences the spread?

Liquidity Why can’t we increase
News/Announcements the spread to increase
profits?
Trade Size
 Unlike other assets, there is no centralized exchange that determines
currency prices. The “market” is a network of dealers.

As an individual dealer, you “skew” your price relative

to the market

USD/AUS
You: 1.2882 – 1.2888 ?

Market = 1.2884 – 1.2890 You: 1.2884 – 1.2890 ?

You: 1.2886 – 1.2892 ?

What affects your price?

Economic Fundamentals
Technical Analysis
Order Flow We will talk about both of these
methods this semester
Your Position
Market: EUR/USD = 1.2882 – 89
Current Order: Buy 10 Million Euro

What price will you quote?

Scenario #1: Your current position is long 25M Euro

Scenario #2: Your current position is short 25M Euro

Scenario #3: Your current position is square; order to sell 20M Euro if
1.2881 deals stop loss
Scenario #4: Your current position is long 25M Euro; order to sell 20M
Euro if 1.2881 deals stop loss
Scenario #5: You’re short 20M Euros. NEWS: FED SEEN BUYING EUROS
IN THE MARKET
Market: EUR/USD = 1.2882 – 89
Current Order: 10 Million Euro

What price will you quote?

Scenario #1: German unemployment soars to 8.9%, much higher than

expected
Scenario #2: Fed raises Fed Funds 50 Basis Points

Scenario #3: S&P downgrades Japanese debt to A from Aa

Scenario #4: Rice’s trip to the Middle East ends with no resolution.
Violence continues

Scenario #5: US department of labor announces 350,000 new jobs created

in July. Much higher than the expected number of 100,000
 Suppose that a dealer were offering Euro at $1.22 in New York City
while a dealer in London was offering Euro at $1.24

Use the proceeds to buy

1 Sell Euro short in London 2
Euro in New York
Use your newly acquired
3 Euro to pay off your short
position

Arbitrage insures that currency prices will be the same at different

locations around the world. (Arbitrage will raise the price in NYC and
lower the price in London)
 Suppose that a dealer in New York City was offering the following
prices:
Euro/USD = $1.25
USD/JPY = Y115
Euro/JPY = Y135

2 Use the
dollars to
buy Yen at
Y115
3 Use the Yen
1 Sell Euro to buy Euro
short at $1.25 at Y135
Repay your short position

The USD/JPY, and Euro/JPY rates imply a Euro/USD rate (Cross Rates)

USD/JPY = Y115 Y135

Euro/USD = = $1.17
Euro/JPY = Y135 Y115
 Voice Brokers Direct Market

Offer
Bid/Offer

Bid/Offer
Bid
Bid/Offer
Banks contact brokers through
dedicated phone lines. The broker Traders contact market makers via phone
quotes a bid or offer or computer. Each trader is given a bid
and offer and can accept either (or both)
Electronic Exchange

Bid Offer

Traders submit orders to a

Offer computer network which
automatically match up buys
and sells
Since the early nineties, trading in currency markets have shifted towards
electronic trading platforms. Any trade less than $10M will almost definitely
be handled by computer
Prices have become more transparent
Spreads collapsing
Volume, Volume, Volume!!!
Voice
Brokers
5% Voice
Direct
Brokers
Market
5%
10%

Electronic Voice
30% Brokers
40%

Electronic Electronic
Direct
85% 95%
Market
60%

1994 2000 2002

 Forward contracts involve transactions to be made at a later date.
CAD/USD .9063
1 month forward .9065
3 months forward .9075
6 months forward .9090
0.91

0.909

0.908

0.907

0.906

0.905

0.904
0 8 14 20 26 30 36 42

Long position in CAD

Contract signed Transaction Made earns .0012 CAD profit
per CAD of contract size
(Spot Rate = .9087)
Derivative markets offer a variety of ways to hedge
currency risk
 Futures are standardized forward contracts, many futures are traded
in centralized markets (Chicago Mercantile Exchange)
 JPY: 12,500,000 Yen

 GBP: 62,500 Pounds

 Euro: 125,000 Euro

 CAD: 100,000 Canadian Dollars

 Options give the buyer the right to buy/sell currency, but not the
requirement
 Call: The right to buy at a specific “strike price”

 Put: The right to sell at a specific “strike price”

 Currency Swaps represent agreements to exchange one

currency for another at multiple pre-specified prices/dates.
 How do Multinational
Corporations deal with
exchange rate risk?

What causes exchange rates to

change? How can we detect
overvalued/undervalued
currencies?

What causes currency

Questions to be crashes? What
underlying conditions
Answered make them more likely?