ECW3121 International Trade and Finance Lecture 11

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ECW3121International Trade and FinanceLecture
11

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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
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Reading
International Finance
Interest Arbitrage

• Salvatore - Chapter 14

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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.

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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.

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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.

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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.

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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.
  

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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.

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Hedging
International Finance
Interest Arbitrage
Speculation and Hedging

• The avoidance of foreign exchange risk.
• (Covering of an open position).

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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.

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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.

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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.

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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.
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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.

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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

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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.

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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.