Download The Currency Market and its Satellites

Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Overview
Part II
The Currency Market
and its Satellites
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Overview
Chapter 3
Spot Markets
for Foreign Exchange
Overview
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Overview
Exchange Rates
The HC/FC Convention (—ours)
The FC/HC Convention
Bid and Ask
Primary and Cross Rates
Inverting bid and asks
Major Markets for Foreign Exchange
How Exchange Markets Work
Markets by Location and by Currency
Markets by Delivery Date
The Law Of One Price in Spot Mkts
Price Differences Across Market Makers
Triangular Arbitrage and the LOP
PPP Exchange Rates and Real Rates
PPP Exchange Rates
The Real Rate or Deviation from APPP
Is the RER constant? Devs from RPPP
What have we learned in this chapter?
Overview
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Overview
Exchange Rates
The HC/FC Convention (—ours)
The FC/HC Convention
Bid and Ask
Primary and Cross Rates
Inverting bid and asks
Major Markets for Foreign Exchange
How Exchange Markets Work
Markets by Location and by Currency
Markets by Delivery Date
The Law Of One Price in Spot Mkts
Price Differences Across Market Makers
Triangular Arbitrage and the LOP
PPP Exchange Rates and Real Rates
PPP Exchange Rates
The Real Rate or Deviation from APPP
Is the RER constant? Devs from RPPP
What have we learned in this chapter?
Overview
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Overview
Exchange Rates
The HC/FC Convention (—ours)
The FC/HC Convention
Bid and Ask
Primary and Cross Rates
Inverting bid and asks
Major Markets for Foreign Exchange
How Exchange Markets Work
Markets by Location and by Currency
Markets by Delivery Date
The Law Of One Price in Spot Mkts
Price Differences Across Market Makers
Triangular Arbitrage and the LOP
PPP Exchange Rates and Real Rates
PPP Exchange Rates
The Real Rate or Deviation from APPP
Is the RER constant? Devs from RPPP
What have we learned in this chapter?
Overview
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Overview
Exchange Rates
The HC/FC Convention (—ours)
The FC/HC Convention
Bid and Ask
Primary and Cross Rates
Inverting bid and asks
Major Markets for Foreign Exchange
How Exchange Markets Work
Markets by Location and by Currency
Markets by Delivery Date
The Law Of One Price in Spot Mkts
Price Differences Across Market Makers
Triangular Arbitrage and the LOP
PPP Exchange Rates and Real Rates
PPP Exchange Rates
The Real Rate or Deviation from APPP
Is the RER constant? Devs from RPPP
What have we learned in this chapter?
Overview
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Overview
Exchange Rates
The HC/FC Convention (—ours)
The FC/HC Convention
Bid and Ask
Primary and Cross Rates
Inverting bid and asks
Major Markets for Foreign Exchange
How Exchange Markets Work
Markets by Location and by Currency
Markets by Delivery Date
The Law Of One Price in Spot Mkts
Price Differences Across Market Makers
Triangular Arbitrage and the LOP
PPP Exchange Rates and Real Rates
PPP Exchange Rates
The Real Rate or Deviation from APPP
Is the RER constant? Devs from RPPP
What have we learned in this chapter?
Outline
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Exchange Rates
The
HC / FC
Convention
The
FC / HC
Convention
Bid and Ask
Primary and Cross Rates
Inverting bid and asks
Major Markets
The LOP in Spot
Mkts
PPP Rates and Real
Rates
What have we
learned?
Exchange Rates
The HC/FC Convention (—ours)
The FC/HC Convention
Bid and Ask
Primary and Cross Rates
Inverting bid and asks
Major Markets for Foreign Exchange
How Exchange Markets Work
Markets by Location and by Currency
Markets by Delivery Date
The Law Of One Price in Spot Mkts
Price Differences Across Market Makers
Triangular Arbitrage and the LOP
PPP Exchange Rates and Real Rates
PPP Exchange Rates
The Real Rate or Deviation from APPP
Is the RER constant? Devs from RPPP
What have we learned in this chapter?
Our Convention: HC units per unit of FC
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Our quoting convention: the price, in units of home
currency (HC), per unit of foreign currency (FC)—or
HC / FC —like we do for bread or umbrellas.
Exchange Rates
Example
The
HC / FC
Convention
The
FC / HC
Convention
Bid and Ask
Primary and Cross Rates
Inverting bid and asks
Major Markets
The LOP in Spot
Mkts
PPP Rates and Real
Rates
What have we
learned?
B “USD/EUR 1.25” is an American’s natural quote for the EUR. Under our
convention, Eurolanders would quote EUR/USD 0.80.
B “USD/CAD 0.8333” is an American’s natural quote for the CAD, since the
CAD is the currency in the denominator, the one the price is expressed
in.
Semantics
B called “right”, “direct” quote;
US :
“US terms”
B denoted in the text as e.g. St = CAD/USD 1.25 where CAD/USD
is the dimension
B pro’s use the inverse of the dimension as the symbol:
“USDCAD or USD/CAD = 1.20” (dimension: CAD/USD)
|
{z
}
“value of USD in CAD”
Our Convention: HC units per unit of FC
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Our quoting convention: the price, in units of home
currency (HC), per unit of foreign currency (FC)—or
HC / FC —like we do for bread or umbrellas.
Exchange Rates
Example
The
HC / FC
Convention
The
FC / HC
Convention
Bid and Ask
Primary and Cross Rates
Inverting bid and asks
Major Markets
The LOP in Spot
Mkts
PPP Rates and Real
Rates
What have we
learned?
B “USD/EUR 1.25” is an American’s natural quote for the EUR. Under our
convention, Eurolanders would quote EUR/USD 0.80.
B “USD/CAD 0.8333” is an American’s natural quote for the CAD, since the
CAD is the currency in the denominator, the one the price is expressed
in.
Semantics
B called “right”, “direct” quote;
US :
“US terms”
B denoted in the text as e.g. St = CAD/USD 1.25 where CAD/USD
is the dimension
B pro’s use the inverse of the dimension as the symbol:
“USDCAD or USD/CAD = 1.20” (dimension: CAD/USD)
|
{z
}
“value of USD in CAD”
Our Convention: HC units per unit of FC
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Our quoting convention: the price, in units of home
currency (HC), per unit of foreign currency (FC)—or
HC / FC —like we do for bread or umbrellas.
Exchange Rates
Example
The
HC / FC
Convention
The
FC / HC
Convention
Bid and Ask
Primary and Cross Rates
Inverting bid and asks
Major Markets
The LOP in Spot
Mkts
PPP Rates and Real
Rates
What have we
learned?
B “USD/EUR 1.25” is an American’s natural quote for the EUR. Under our
convention, Eurolanders would quote EUR/USD 0.80.
B “USD/CAD 0.8333” is an American’s natural quote for the CAD, since the
CAD is the currency in the denominator, the one the price is expressed
in.
Semantics
B called “right”, “direct” quote;
US :
“US terms”
B denoted in the text as e.g. St = CAD/USD 1.25 where CAD/USD
is the dimension
B pro’s use the inverse of the dimension as the symbol:
“USDCAD or USD/CAD = 1.20” (dimension: CAD/USD)
|
{z
}
“value of USD in CAD”
3.1. EXCHANGE RATES
Symbols v dimensions: examples
Spot Markets
P. Sercu, Figure
International
Finance: Theory into
Practice
Exchange Rates
The
HC / FC
Convention
The
FC / HC
Convention
Bid and Ask
Primary and Cross Rates
Inverting bid and asks
Major Markets
The LOP in Spot
Mkts
PPP Rates and Real
Rates
What have we
learned?
3.1: Key exchange rates: pros’ notation, dimensions, and nicknam
Symbol
USDJPY
USDCHF
USDCAD
USDZAR
GBPUSD
GBPCHF*
GBPJPY*
AUDUSD
NZDUSD
EURUSD
EURGBP*
EURJPY*
EURCHF*
CHFJPY*
GLDUSD
SLVUSD
Currency Pair
US Dollar, in Japanese Yen
US Dollar, in Swiss Franc
US Dollar, in Canadian Dollar
US Dollar, in South African Rand
British Pound, in US Dollar
British Pound, in Swiss Franc
British Pound, in Japanese Yen
Australian Dollar, in US Dollar
New Zealand Dollar, in US Dollar
Euro, in US Dollar
Euro, in British Pound
Euro, in Japanese Yen
Euro, in Swiss Franc
Swiss Franc, in Japanese Yen
Gold, in US Dollar per troy ounce
Silver, in US Dollar per troy ounce
dimension
Trading Terminology
JPY/USD
CHF/USD
CAD/USD
ZAR/USD
USD/GBP
CHF/GBP
JPY/GBP
USD/AUD
USD/NZD
USD/EUR
GBP/EUR
JPY/EUR
CHF/EUR
JPY/CHF
USD/ozXAU
USD/ozXAG
Dollar Yen
Dollar Swiss, or Swissy
Dollar Canada
Dollar Zar or South African Rand
Cable
Sterling Swiss
Sterling Yen
Aussie Dollar
New Zealand Dollar or Kiwi
Euro
Euro Sterling
Euro Yen
Euro Swiss
Swiss Yen
Gold
Silver
Key ∗ : cross rate, from the us perspective. Most names should be obvious, except perhaps
(Confederatio Helvetica, Latin for Switzerland—the way a four-language country solves a polit
conundrum). The zar, South-African Rand, is not to be confused with SAR, Saudi Riyal. GLD
SLV are onorthodox: the official codes as used by e.g. Swift are XAU and XAG, with X signal
Who uses the weird (FC/HC) Convention?
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
“with one Rupee you can buy 1/15th of a bread”?
(against USD:) NY traders
B traders need a unique language
Exchange Rates
The
HC / FC
Convention
The
FC / HC
Convention
Bid and Ask
B European governments had officially fixed the rate as e.g.
DEM / USD 4, their own natural quote
Primary and Cross Rates
Inverting bid and asks
Major Markets
The LOP in Spot
Mkts
PPP Rates and Real
Rates
What have we
learned?
(against GBP:) all pro’s & all Brits (and similarly for
ZAR , AUD , NZD , IEP )
B the pound used to be intractably nondecimal (until 1967)
B the pound used to play the key role taken by USD after WW2
Also US traders still do this; so they use unnatural one for e.g.
CHF but natural quote for GBP etc
(against EUR:) everybody
B the
EUR
used to be “foreign” even for Eurolanders;
B ? Europe thought the indirect quote was posher?
Who uses the weird (FC/HC) Convention?
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
“with one Rupee you can buy 1/15th of a bread”?
(against USD:) NY traders
B traders need a unique language
Exchange Rates
The
HC / FC
Convention
The
FC / HC
Convention
Bid and Ask
B European governments had officially fixed the rate as e.g.
DEM / USD 4, their own natural quote
Primary and Cross Rates
Inverting bid and asks
Major Markets
The LOP in Spot
Mkts
PPP Rates and Real
Rates
What have we
learned?
(against GBP:) all pro’s & all Brits (and similarly for
ZAR , AUD , NZD , IEP )
B the pound used to be intractably nondecimal (until 1967)
B the pound used to play the key role taken by USD after WW2
Also US traders still do this; so they use unnatural one for e.g.
CHF but natural quote for GBP etc
(against EUR:) everybody
B the
EUR
used to be “foreign” even for Eurolanders;
B ? Europe thought the indirect quote was posher?
Who uses the weird (FC/HC) Convention?
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
“with one Rupee you can buy 1/15th of a bread”?
(against USD:) NY traders
B traders need a unique language
Exchange Rates
The
HC / FC
Convention
The
FC / HC
Convention
Bid and Ask
B European governments had officially fixed the rate as e.g.
DEM / USD 4, their own natural quote
Primary and Cross Rates
Inverting bid and asks
Major Markets
The LOP in Spot
Mkts
PPP Rates and Real
Rates
What have we
learned?
(against GBP:) all pro’s & all Brits (and similarly for
ZAR , AUD , NZD , IEP )
B the pound used to be intractably nondecimal (until 1967)
B the pound used to play the key role taken by USD after WW2
Also US traders still do this; so they use unnatural one for e.g.
CHF but natural quote for GBP etc
(against EUR:) everybody
B the
EUR
used to be “foreign” even for Eurolanders;
B ? Europe thought the indirect quote was posher?
Who uses the weird (FC/HC) Convention?
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
“with one Rupee you can buy 1/15th of a bread”?
(against USD:) NY traders
B traders need a unique language
Exchange Rates
The
HC / FC
Convention
The
FC / HC
Convention
Bid and Ask
B European governments had officially fixed the rate as e.g.
DEM / USD 4, their own natural quote
Primary and Cross Rates
Inverting bid and asks
Major Markets
The LOP in Spot
Mkts
PPP Rates and Real
Rates
What have we
learned?
(against GBP:) all pro’s & all Brits (and similarly for
ZAR , AUD , NZD , IEP )
B the pound used to be intractably nondecimal (until 1967)
B the pound used to play the key role taken by USD after WW2
Also US traders still do this; so they use unnatural one for e.g.
CHF but natural quote for GBP etc
(against EUR:) everybody
B the
EUR
used to be “foreign” even for Eurolanders;
B ? Europe thought the indirect quote was posher?
3.1. EXCHANGE RATES
What Dimensions are Standard, in Practice?
Spot Markets
P. Sercu, Figure
International
Finance: Theory into
Practice
Exchange Rates
The
HC / FC
Convention
The
FC / HC
Convention
Bid and Ask
Primary and Cross Rates
Inverting bid and asks
Major Markets
The LOP in Spot
Mkts
PPP Rates and Real
Rates
What have we
learned?
3.1: Key exchange rates: pros’ notation, dimensions, and nicknam
Symbol
USDJPY
USDCHF
USDCAD
USDZAR
GBPUSD
GBPCHF*
GBPJPY*
AUDUSD
NZDUSD
EURUSD
EURGBP*
EURJPY*
EURCHF*
CHFJPY*
GLDUSD
SLVUSD
Currency Pair
US Dollar, in Japanese Yen
US Dollar, in Swiss Franc
US Dollar, in Canadian Dollar
US Dollar, in South African Rand
British Pound, in US Dollar
British Pound, in Swiss Franc
British Pound, in Japanese Yen
Australian Dollar, in US Dollar
New Zealand Dollar, in US Dollar
Euro, in US Dollar
Euro, in British Pound
Euro, in Japanese Yen
Euro, in Swiss Franc
Swiss Franc, in Japanese Yen
Gold, in US Dollar per troy ounce
Silver, in US Dollar per troy ounce
dimension
Trading Terminology
JPY/USD
CHF/USD
CAD/USD
ZAR/USD
USD/GBP
CHF/GBP
JPY/GBP
USD/AUD
USD/NZD
USD/EUR
GBP/EUR
JPY/EUR
CHF/EUR
JPY/CHF
USD/ozXAU
USD/ozXAG
Dollar Yen
Dollar Swiss, or Swissy
Dollar Canada
Dollar Zar or South African Rand
Cable
Sterling Swiss
Sterling Yen
Aussie Dollar
New Zealand Dollar or Kiwi
Euro
Euro Sterling
Euro Yen
Euro Swiss
Swiss Yen
Gold
Silver
Key ∗ : cross rate, from the us perspective. Most names should be obvious, except perhaps
(Confederatio Helvetica, Latin for Switzerland—the way a four-language country solves a polit
conundrum). The zar, South-African Rand, is not to be confused with SAR, Saudi Riyal. GLD
SLV are onorthodox: the official codes as used by e.g. Swift are XAU and XAG, with X signal
Bid and Ask Rates
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Exchange Rates
The
HC / FC
Convention
The
FC / HC
Convention
Bid and Ask
Primary and Cross Rates
Bid and Ask
B You buy at (bank’s) Ask, you sell at (bank’s) Bid
B Bid-Ask Spread := Ask – Bid ≥ 0 (why ≥ 0?)
Equivalent commission = 1/2 spread:
Example
EUR USD
=
USD / EUR 1.2345
- 1.2347
Inverting bid and asks
Major Markets
B Buying (at 47) is like paying midpoint (46) + cost 1
The LOP in Spot
Mkts
B Selling (at 45) is like getting midpoint (46) – cost 1
PPP Rates and Real
Rates
What have we
learned?
Determinants of bid-ask spread
B Retail: spread falls with order size
B Wholesale: spread falls when risk of posting a quote is lower:
– high liquidity
– low volatility
– a normal quantity—not too large
Bid and Ask Rates
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Exchange Rates
The
HC / FC
Convention
The
FC / HC
Convention
Bid and Ask
Primary and Cross Rates
Bid and Ask
B You buy at (bank’s) Ask, you sell at (bank’s) Bid
B Bid-Ask Spread := Ask – Bid ≥ 0 (why ≥ 0?)
Equivalent commission = 1/2 spread:
Example
EUR USD
=
USD / EUR 1.2345
- 1.2347
Inverting bid and asks
Major Markets
B Buying (at 47) is like paying midpoint (46) + cost 1
The LOP in Spot
Mkts
B Selling (at 45) is like getting midpoint (46) – cost 1
PPP Rates and Real
Rates
What have we
learned?
Determinants of bid-ask spread
B Retail: spread falls with order size
B Wholesale: spread falls when risk of posting a quote is lower:
– high liquidity
– low volatility
– a normal quantity—not too large
Bid and Ask Rates
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Exchange Rates
The
HC / FC
Convention
The
FC / HC
Convention
Bid and Ask
Primary and Cross Rates
Bid and Ask
B You buy at (bank’s) Ask, you sell at (bank’s) Bid
B Bid-Ask Spread := Ask – Bid ≥ 0 (why ≥ 0?)
Equivalent commission = 1/2 spread:
Example
EUR USD
=
USD / EUR 1.2345
- 1.2347
Inverting bid and asks
Major Markets
B Buying (at 47) is like paying midpoint (46) + cost 1
The LOP in Spot
Mkts
B Selling (at 45) is like getting midpoint (46) – cost 1
PPP Rates and Real
Rates
What have we
learned?
Determinants of bid-ask spread
B Retail: spread falls with order size
B Wholesale: spread falls when risk of posting a quote is lower:
– high liquidity
– low volatility
– a normal quantity—not too large
Figure 3.6: Order
limits
and spreads for various
rates,internet
semi-professional
Spreads
and
Acceptable
Orders
broker, 2007
Ticker
EURUSD
GBPUSD
EURCHF
EURJPY
USDJPY
GBPCHF
EURGBP
GBPJPY
USDCHF
USDCAD
AUDUSD
CHFJPY
EURCAD
NZDUSD
USDSGD
EURAUD
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Exchange Rates
The
HC / FC
Convention
The
FC / HC
Convention
Bid and Ask
Primary and Cross Rates
Inverting bid and asks
Major Markets
The LOP in Spot
Mkts
PPP Rates and Real
Rates
What have we
learned?
Size of 1.0 lot
EUR 100,000
GBP 100,000
EUR 100,000
EUR 100,000
USD 100,000
GBP 100,000
EUR 100,000
GBP 100,000
USD 100,000
USD 100,000
AUD 100,000
CHF 100,000
EUR 100,000
NZD 100,000
USD 100,000
EUR 100,000
Instant
Execution
up to 10M
up to 10M
up to 5M
up to 10M
up to 10M
up to 5M
up to 5M
up to 5M
up to 10M
up to 5M
up to 5M
up to 5M
up to 3M
up to 2M
up to 1M
up to 5M
Spread
2 pips
3 pips
3 pips
3 pips
3 pips
7 pips
2 pips
7 pips
4 pips
4 pips
3 pips
4 pips
8 pips
5 pips
8 pips
10 pips
Limit & Stop March 9, 2007 spread,
levels*
rate (in pips)
%^2
2 pips
13,115
1.5
3 pips
19,319
1.6
3 pips
16,163
1.9
3 pips
15,489
1.9
3 pips
11,810
2.5
7 pips
23,810
2.9
2 pips
6,788
2.9
7 pips
22,817
3.1
4 pips
12,325
3.2
4 pips
11,735
3.4
3 pips
7,802
3.8
4 pips
9,583
4.2
8 pips
15,389
5.2
5 pips
9,583
5.2
8 pips
15,267
5.2
10 pips
16,810
5.9
spread (bp)
Key The
table shows conditions for various currencies from a particular broker. The min and max
7
quantities are not interbank, but still professional rather than hardcore retail. The spread and the
6
tick size for limit and stop levels are likewise wider than interbank. Do note how the spread vary
5
depending
on liquidity and the level of the rate, and how the max order size (imperfectly) relates to
4 Souce: http://www.alpari.co.uk/en/cspec/ for columns 1-5; WSJ Europe March 12, 2007
spread.
for column
6; spread in bp has been added. Data have been re-arranged by increasing relative
3
spread.
2
1
0
EUR/USD,
meaning
“please
provide
a quote
for the
eur,
in usd”.
Player
A 20
can also
0
2
4
6
8
10
12
14
16
18
mention the quantity, in millions. The millions are max
omitted;
is, 5USD)
means five
orderthat
size (m
million; and the quantity bears on the currency in the denominator, traditionally
Primary and Cross Rates
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Exchange Rates
The
HC / FC
Convention
The
FC / HC
Convention
Bid and Ask
Primary and Cross Rates
Inverting bid and asks
Major Markets
The LOP in Spot
Mkts
PPP Rates and Real
Rates
What have we
learned?
Primary rate against reference or base currency (as
of WW2: USD)
Cross rate between two non-base currencies
B Until mid 1980s only calculated from primary rates, never
quoted independently:
– the officially defended rates were primary, not cross
– the cross-markets did not have enough volume to be competitive
against two USD transactions
– in pre-computer days, keeping track of a 50×50 matrix was
impossible
B now also quoted directly for important pairs
Primary and Cross Rates
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Exchange Rates
The
HC / FC
Convention
The
FC / HC
Convention
Bid and Ask
Primary and Cross Rates
Inverting bid and asks
Major Markets
The LOP in Spot
Mkts
PPP Rates and Real
Rates
What have we
learned?
Primary rate against reference or base currency (as
of WW2: USD)
Cross rate between two non-base currencies
B Until mid 1980s only calculated from primary rates, never
quoted independently:
– the officially defended rates were primary, not cross
– the cross-markets did not have enough volume to be competitive
against two USD transactions
– in pre-computer days, keeping track of a 50×50 matrix was
impossible
B now also quoted directly for important pairs
Primary and Cross Rates
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Exchange Rates
The
HC / FC
Convention
The
FC / HC
Convention
Bid and Ask
Primary and Cross Rates
Inverting bid and asks
Major Markets
The LOP in Spot
Mkts
PPP Rates and Real
Rates
What have we
learned?
Primary rate against reference or base currency (as
of WW2: USD)
Cross rate between two non-base currencies
B Until mid 1980s only calculated from primary rates, never
quoted independently:
– the officially defended rates were primary, not cross
– the cross-markets did not have enough volume to be competitive
against two USD transactions
– in pre-computer days, keeping track of a 50×50 matrix was
impossible
B now also quoted directly for important pairs
Inverting bid and asks
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Exchange Rates
The
HC / FC
Convention
The
FC / HC
Convention
Bid and Ask
Rule: 1/ask = bid, 1/bid = ask
Why?
B mathematically, 1/bigger = smaller and vv
Example
Primary and Cross Rates
USD / GBP
Inverting bid and asks
Major Markets
The LOP in Spot
Mkts
PPP Rates and Real
Rates
What have we
learned?
bid =
ask =
1.9990
2.0010
inverse = GBP/USD
1/1.9990 = 0.50025
1/2.0010 = 0.49975
= ask
= bid
B semantically, when one switches home currency, buying
currency 1 becomes selling currency 2
Example:
Mr X gives 1000 yen to the bank and receives 10 dollar
− to a Japanese this looks like buying
USD
− to an American this looks like selling
JPY
10 at
JPY / USD
1000 at
100
USD / JPY
0.01
Inverting bid and asks
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Exchange Rates
The
HC / FC
Convention
The
FC / HC
Convention
Bid and Ask
Rule: 1/ask = bid, 1/bid = ask
Why?
B mathematically, 1/bigger = smaller and vv
Example
Primary and Cross Rates
USD / GBP
Inverting bid and asks
Major Markets
The LOP in Spot
Mkts
PPP Rates and Real
Rates
What have we
learned?
bid =
ask =
1.9990
2.0010
inverse = GBP/USD
1/1.9990 = 0.50025
1/2.0010 = 0.49975
= ask
= bid
B semantically, when one switches home currency, buying
currency 1 becomes selling currency 2
Example:
Mr X gives 1000 yen to the bank and receives 10 dollar
− to a Japanese this looks like buying
USD
− to an American this looks like selling
JPY
10 at
JPY / USD
1000 at
100
USD / JPY
0.01
Inverting bid and asks
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Exchange Rates
The
HC / FC
Convention
The
FC / HC
Convention
Bid and Ask
Rule: 1/ask = bid, 1/bid = ask
Why?
B mathematically, 1/bigger = smaller and vv
Example
Primary and Cross Rates
USD / GBP
Inverting bid and asks
Major Markets
The LOP in Spot
Mkts
PPP Rates and Real
Rates
What have we
learned?
bid =
ask =
1.9990
2.0010
inverse = GBP/USD
1/1.9990 = 0.50025
1/2.0010 = 0.49975
= ask
= bid
B semantically, when one switches home currency, buying
currency 1 becomes selling currency 2
Example:
Mr X gives 1000 yen to the bank and receives 10 dollar
− to a Japanese this looks like buying
USD
− to an American this looks like selling
JPY
10 at
JPY / USD
1000 at
100
USD / JPY
0.01
Inverting bid and asks
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Exchange Rates
The
HC / FC
Convention
The
FC / HC
Convention
Bid and Ask
Rule: 1/ask = bid, 1/bid = ask
Why?
B mathematically, 1/bigger = smaller and vv
Example
Primary and Cross Rates
USD / GBP
Inverting bid and asks
Major Markets
The LOP in Spot
Mkts
PPP Rates and Real
Rates
What have we
learned?
bid =
ask =
1.9990
2.0010
inverse = GBP/USD
1/1.9990 = 0.50025
1/2.0010 = 0.49975
= ask
= bid
B semantically, when one switches home currency, buying
currency 1 becomes selling currency 2
Example:
Mr X gives 1000 yen to the bank and receives 10 dollar
− to a Japanese this looks like buying
USD
− to an American this looks like selling
JPY
10 at
JPY / USD
1000 at
100
USD / JPY
0.01
Inverting bid and asks
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Exchange Rates
The
HC / FC
Convention
The
FC / HC
Convention
Bid and Ask
Rule: 1/ask = bid, 1/bid = ask
Why?
B mathematically, 1/bigger = smaller and vv
Example
Primary and Cross Rates
USD / GBP
Inverting bid and asks
Major Markets
The LOP in Spot
Mkts
PPP Rates and Real
Rates
What have we
learned?
bid =
ask =
1.9990
2.0010
inverse = GBP/USD
1/1.9990 = 0.50025
1/2.0010 = 0.49975
= ask
= bid
B semantically, when one switches home currency, buying
currency 1 becomes selling currency 2
Example:
Mr X gives 1000 yen to the bank and receives 10 dollar
− to a Japanese this looks like buying
USD
− to an American this looks like selling
JPY
10 at
JPY / USD
1000 at
100
USD / JPY
0.01
Inverting bid and asks
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Exchange Rates
The
HC / FC
Convention
The
FC / HC
Convention
Bid and Ask
Rule: 1/ask = bid, 1/bid = ask
Why?
B mathematically, 1/bigger = smaller and vv
Example
Primary and Cross Rates
USD / GBP
Inverting bid and asks
Major Markets
The LOP in Spot
Mkts
PPP Rates and Real
Rates
What have we
learned?
bid =
ask =
1.9990
2.0010
inverse = GBP/USD
1/1.9990 = 0.50025
1/2.0010 = 0.49975
= ask
= bid
B semantically, when one switches home currency, buying
currency 1 becomes selling currency 2
Example:
Mr X gives 1000 yen to the bank and receives 10 dollar
− to a Japanese this looks like buying
USD
− to an American this looks like selling
JPY
10 at
JPY / USD
1000 at
100
USD / JPY
0.01
Outline
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Exchange Rates
Exchange Rates
The HC/FC Convention (—ours)
The FC/HC Convention
Bid and Ask
Primary and Cross Rates
Inverting bid and asks
Major Markets
How Xmkts work
Markets by Location and by
Currency
Markets by Delivery Date
The LOP in Spot
Mkts
PPP Rates and Real
Rates
What have we
learned?
Major Markets for Foreign Exchange
How Exchange Markets Work
Markets by Location and by Currency
Markets by Delivery Date
The Law Of One Price in Spot Mkts
Price Differences Across Market Makers
Triangular Arbitrage and the LOP
PPP Exchange Rates and Real Rates
PPP Exchange Rates
The Real Rate or Deviation from APPP
Is the RER constant? Devs from RPPP
What have we learned in this chapter?
How Exchange Markets Work
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Not an organized market (unlike eg NYSE or LSE)
Two tiers: 24-h wholesale tier, (informal network of
banks and big corporations) and a retail tier
Exchange Rates
Major Markets
How Xmkts work
Markets by Location and by
Currency
Markets by Delivery Date
Wholesale: 2 kind of professionals
B market makers: give two-way quotes binding up to an agreed
limit (e.gUSD 10m or 20m). Purely bilateral.
The LOP in Spot
Mkts
– traditionally done by phone (taped, and confirmed by mail, telex or
fax).
PPP Rates and Real
Rates
– Since mid-90s, computer “conversation”s (Reuters 3000, EBS)
dominate: faster, safer (STP).
What have we
learned?
B brokers: these shop around to find takers for someone else’s
offer.
– Nowadays, Reuters and EBS run limit-order books for this purpose
[⇒ mkt becomes more centralized/multilateral] , and ...
– brokers just do the special deals (large, or “structured”)
How Exchange Markets Work
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Not an organized market (unlike eg NYSE or LSE)
Two tiers: 24-h wholesale tier, (informal network of
banks and big corporations) and a retail tier
Exchange Rates
Major Markets
How Xmkts work
Markets by Location and by
Currency
Markets by Delivery Date
Wholesale: 2 kind of professionals
B market makers: give two-way quotes binding up to an agreed
limit (e.gUSD 10m or 20m). Purely bilateral.
The LOP in Spot
Mkts
– traditionally done by phone (taped, and confirmed by mail, telex or
fax).
PPP Rates and Real
Rates
– Since mid-90s, computer “conversation”s (Reuters 3000, EBS)
dominate: faster, safer (STP).
What have we
learned?
B brokers: these shop around to find takers for someone else’s
offer.
– Nowadays, Reuters and EBS run limit-order books for this purpose
[⇒ mkt becomes more centralized/multilateral] , and ...
– brokers just do the special deals (large, or “structured”)
How Exchange Markets Work
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Not an organized market (unlike eg NYSE or LSE)
Two tiers: 24-h wholesale tier, (informal network of
banks and big corporations) and a retail tier
Exchange Rates
Major Markets
How Xmkts work
Markets by Location and by
Currency
Markets by Delivery Date
Wholesale: 2 kind of professionals
B market makers: give two-way quotes binding up to an agreed
limit (e.gUSD 10m or 20m). Purely bilateral.
The LOP in Spot
Mkts
– traditionally done by phone (taped, and confirmed by mail, telex or
fax).
PPP Rates and Real
Rates
– Since mid-90s, computer “conversation”s (Reuters 3000, EBS)
dominate: faster, safer (STP).
What have we
learned?
B brokers: these shop around to find takers for someone else’s
offer.
– Nowadays, Reuters and EBS run limit-order books for this purpose
[⇒ mkt becomes more centralized/multilateral] , and ...
– brokers just do the special deals (large, or “structured”)
How Exchange Markets Work
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Not an organized market (unlike eg NYSE or LSE)
Two tiers: 24-h wholesale tier, (informal network of
banks and big corporations) and a retail tier
Exchange Rates
Major Markets
How Xmkts work
Markets by Location and by
Currency
Markets by Delivery Date
Wholesale: 2 kind of professionals
B market makers: give two-way quotes binding up to an agreed
limit (e.gUSD 10m or 20m). Purely bilateral.
The LOP in Spot
Mkts
– traditionally done by phone (taped, and confirmed by mail, telex or
fax).
PPP Rates and Real
Rates
– Since mid-90s, computer “conversation”s (Reuters 3000, EBS)
dominate: faster, safer (STP).
What have we
learned?
B brokers: these shop around to find takers for someone else’s
offer.
– Nowadays, Reuters and EBS run limit-order books for this purpose
[⇒ mkt becomes more centralized/multilateral] , and ...
– brokers just do the special deals (large, or “structured”)
3.2. MAJOR MARKETS FOR FOREIGN EXCHANGE
How Exchange Markets Work—the movie
77
Figure 3.4: Trader activity over the day
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Exchange Rates
Major Markets
How Xmkts work
78
CHAPTER 3. SPOT MARKETS FOR FOREIGN CURRENCY
Markets by Location and by
Currency
Markets by Delivery Date
The LOP in Spot
Mkts
PPP Rates and Real
Rates
What have we
learned?
Figure 3.5: A Reuters conversation and an EBS broking screen
A Reuters conversation
An EBS broking screen
Key Graph courtesy of Luc Bauwens, Université Catholique de Louvain. The graph shows, per 5Sept 3 – 10:25
minute interval over 24 hours, the evolution of the average number of indicative quotes entered into
From: GENP
5 SEP
the Reuters FX/FX pages. Time is GMT in summer, GMT+1 in winter; that is, European time is
Hi:
EUR/USD
inNY
5 pse?
t+2
hrs,
London +1,
–4 hrs; Sydney and TokyoEUR/USD
time are ate t+10 and t+9 hrs, respectively.
Hi 25
27 + working days as 8:00-17:00, but many start1.28
Below
I describe
earlier and others stop later. At 0:00,
5 at
27inval
5/9 +has been op and running for about 2 hrs,
3 25and
- 27Tokyo
5
theMine
morning
shift
Sydney
for 1 hrs, Hong
Kong
be followed by Singapore in 1 hrUSD/JPY
and Bahrain in 3. Between 6:00 and 8:00 the
Tksstarts
$ toup,
CititoBibi
Far East bows out but Western Europe takes over over—first
105 the continent (6:00), then London
(7:00) ; activity soars. A minor dip follows around the European noon but activity recovers again
5 64 – 66 6
in the afternoon, peaking when New York takes over (12:00) and Europeans close their positions
(15:00 on the continent, 16:00 London). NY does less and less as time passes. By 22:00 Sydney is
Reutersup,
conversation:
is an abbreviated
name (Jenpi, Jean-Pierre); he asks for a quote for EUR in
starting
and TokyoGENP
is preparing
breakfast.
A Panel of Reuters Broking Windows
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
gbp/usd
1.73
Exchange Rates
Major Markets
How Xmkts work
Markets by Location and by
Currency
PPP Rates and Real
Rates
What have we
learned?
aud/usd
1.73
64 / 65
3
[3]
Markets by Delivery Date
The LOP in Spot
Mkts
64 / 65
( 3x5 )
1.7364G
5
0.73
605 / 655
[2]
[1]
( 1x1 )
0.68615G
( 2x2 )
0.7345P
2
28.7
1
0.64
66 / 68
[2]
[3]
( 3x5 )
0.6465P
28.7
( 3x2 )
28.725G
2
eur/nok
0.64
66 / 68
5
00 / 55
00 / 55
3
nzd/usd
0.68
605 / 655
1
eur/czk
0.73
44 / 45
2
eur/gbp
0.68
44 / 45
1
8.02
60 / 90
8.02
60 / 90
1
[3]
( 1x3 )
8.0295P
3
Markets by Location and by Currency
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Volume over time and by currency
3.5
EUR &
GBP
2%
EUR &
JPY
2%
ForeX
3
OTC derivatives
Exchange Rates
Major Markets
2.5
EUR &
other
4%
other
pairs
4%
USD &
EUR
27%
2
How Xmkts work
Markets by Location and by
Currency
Markets by Delivery Date
The LOP in Spot
Mkts
PPP Rates and Real
Rates
What have we
learned?
1.5
1
USD
other
36%
0.5
0
1989
1992
1995
1998
2001
2004
2007
USD &
JPY
13%
USD &
GBP
12%
Major centers:
B The big 3: London, New York, and Tokyo — with LN >
NY+TK, and growing faster
B Less important: Sydney, HK, Singapore, Zurich, and Frankfurt
B Ambitious upstart: Dubai
Markets by Location and by Currency
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Volume over time and by currency
3.5
EUR &
GBP
2%
EUR &
JPY
2%
ForeX
3
OTC derivatives
Exchange Rates
Major Markets
2.5
EUR &
other
4%
other
pairs
4%
USD &
EUR
27%
2
How Xmkts work
Markets by Location and by
Currency
Markets by Delivery Date
The LOP in Spot
Mkts
PPP Rates and Real
Rates
What have we
learned?
1.5
1
USD
other
36%
0.5
0
1989
1992
1995
1998
2001
2004
2007
USD &
JPY
13%
USD &
GBP
12%
Major centers:
B The big 3: London, New York, and Tokyo — with LN >
NY+TK, and growing faster
B Less important: Sydney, HK, Singapore, Zurich, and Frankfurt
B Ambitious upstart: Dubai
Markets by Delivery Date
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Spot (rate: St ) = “immediate” (t) payment/delivery
B “immediate” means 2nd working day (“t + 2”) (t + 1 for
US-Canada and -Mexico)
B Less than half of the market
Exchange Rates
Major Markets
How Xmkts work
Markets by Location and by
Currency
Markets by Delivery Date
The LOP in Spot
Mkts
PPP Rates and Real
Rates
What have we
learned?
Forward: (rate: Ft,T ) = payment/delivery at some
future date (T > t + 2)
B nowadays up to ten years, but the most active forward markets
remain “30”, “90” days (that is, t + 2 plus N/30 months);
Example
– Deal on Wedn April 19, 2000 ⇒ t + 2 means Frid April 21; “+ 180
days” means Oct 21, a Saturday, so delivery is Mond Oct 23.
– Actually 185 days.
B Quotes for any “broken” date on request.
B Volume: larger than the spot market.
Markets by Delivery Date
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Spot (rate: St ) = “immediate” (t) payment/delivery
B “immediate” means 2nd working day (“t + 2”) (t + 1 for
US-Canada and -Mexico)
B Less than half of the market
Exchange Rates
Major Markets
How Xmkts work
Markets by Location and by
Currency
Markets by Delivery Date
The LOP in Spot
Mkts
PPP Rates and Real
Rates
What have we
learned?
Forward: (rate: Ft,T ) = payment/delivery at some
future date (T > t + 2)
B nowadays up to ten years, but the most active forward markets
remain “30”, “90” days (that is, t + 2 plus N/30 months);
Example
– Deal on Wedn April 19, 2000 ⇒ t + 2 means Frid April 21; “+ 180
days” means Oct 21, a Saturday, so delivery is Mond Oct 23.
– Actually 185 days.
B Quotes for any “broken” date on request.
B Volume: larger than the spot market.
Markets by Delivery Date
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Spot (rate: St ) = “immediate” (t) payment/delivery
B “immediate” means 2nd working day (“t + 2”) (t + 1 for
US-Canada and -Mexico)
B Less than half of the market
Exchange Rates
Major Markets
How Xmkts work
Markets by Location and by
Currency
Markets by Delivery Date
The LOP in Spot
Mkts
PPP Rates and Real
Rates
What have we
learned?
Forward: (rate: Ft,T ) = payment/delivery at some
future date (T > t + 2)
B nowadays up to ten years, but the most active forward markets
remain “30”, “90” days (that is, t + 2 plus N/30 months);
Example
– Deal on Wedn April 19, 2000 ⇒ t + 2 means Frid April 21; “+ 180
days” means Oct 21, a Saturday, so delivery is Mond Oct 23.
– Actually 185 days.
B Quotes for any “broken” date on request.
B Volume: larger than the spot market.
Outline
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Exchange Rates
Exchange Rates
The HC/FC Convention (—ours)
The FC/HC Convention
Bid and Ask
Primary and Cross Rates
Inverting bid and asks
Major Markets
The LOP in Spot
Mkts
Across Mkt Makers
Triangular Arbitrage
PPP Rates and Real
Rates
What have we
learned?
Major Markets for Foreign Exchange
How Exchange Markets Work
Markets by Location and by Currency
Markets by Delivery Date
The Law Of One Price in Spot Mkts
Price Differences Across Market Makers
Triangular Arbitrage and the LOP
PPP Exchange Rates and Real Rates
PPP Exchange Rates
The Real Rate or Deviation from APPP
Is the RER constant? Devs from RPPP
What have we learned in this chapter?
What mechanisms help enforcing the LOP?
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Exchange Rates
Major Markets
The LOP in Spot
Mkts
Across Mkt Makers
Arbitrage (two-way)
B buy low, immediately re-sell high without risk
B arb opp: no net investment, no chance of loss, and possibly a
gain
B too nice to be true: selfdestructive
B two-way trade: sum of transaction costs matters
Triangular Arbitrage
PPP Rates and Real
Rates
What have we
learned?
Shopping around (one way)
B exogenous motivation to do a particular trade—just choose in
what mkt segment you’ll do the trade
B difference of costs matters
B opportunities happen all the time—are often intended by mkt
maker
What mechanisms help enforcing the LOP?
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Exchange Rates
Major Markets
The LOP in Spot
Mkts
Across Mkt Makers
Arbitrage (two-way)
B buy low, immediately re-sell high without risk
B arb opp: no net investment, no chance of loss, and possibly a
gain
B too nice to be true: selfdestructive
B two-way trade: sum of transaction costs matters
Triangular Arbitrage
PPP Rates and Real
Rates
What have we
learned?
Shopping around (one way)
B exogenous motivation to do a particular trade—just choose in
what mkt segment you’ll do the trade
B difference of costs matters
B opportunities happen all the time—are often intended by mkt
maker
Arbitrage Across Market Makers
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Example
What would you do when seeing ...
bank X: USD/EUR XXX56 - 58
bank Y: USD/EUR XXX52 - 54
Exchange Rates
88
Major Markets
B arb opp: sure gain without really needing cash
The LOP in Spot
Mkts
Across Mkt Makers
Triangular Arbitrage
PPP Rates and Real
Rates
What have we
learned?
CHAPTER 3. SPOT MARKETS FOR FOREIGN CURRENCY
B triggers massive flows
Figure 3.11: Arbitrage and Shopping-around opportunities across market
B ⇒ No-arb condition: Bidi ≤ Askj ∀i, j—no empty space
makers
()50"
X
()58
!
()55"
()70"
X’
()63
!
()60"
()64"
Y
Z’
Z
()75
!
()72
!
()68
!
B Is there
an arb opp
...
3.3.2
Shopping
Around
across Competing Market Makers
– between Y and X? – between Y and Z? – between X and Z?
B If there is an arb
opp, implies
do we know
who differences
is wrong? like those between the pair
Shopping-around
activity
that small
Arbitrage Across Market Makers
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Example
What would you do when seeing ...
bank X: USD/EUR XXX56 - 58
bank Y: USD/EUR XXX52 - 54
Exchange Rates
88
Major Markets
B arb opp: sure gain without really needing cash
The LOP in Spot
Mkts
Across Mkt Makers
Triangular Arbitrage
PPP Rates and Real
Rates
What have we
learned?
CHAPTER 3. SPOT MARKETS FOR FOREIGN CURRENCY
B triggers massive flows
Figure 3.11: Arbitrage and Shopping-around opportunities across market
B ⇒ No-arb condition: Bidi ≤ Askj ∀i, j—no empty space
makers
()50"
X
()58
!
()55"
()70"
X’
()63
!
()60"
()64"
Y
Z’
Z
()75
!
()72
!
()68
!
B Is there
an arb opp
...
3.3.2
Shopping
Around
across Competing Market Makers
– between Y and X? – between Y and Z? – between X and Z?
B If there is an arb
opp, implies
do we know
who differences
is wrong? like those between the pair
Shopping-around
activity
that small
Arbitrage Across Market Makers
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Example
What would you do when seeing ...
bank X: USD/EUR XXX56 - 58
bank Y: USD/EUR XXX52 - 54
Exchange Rates
88
Major Markets
B arb opp: sure gain without really needing cash
The LOP in Spot
Mkts
Across Mkt Makers
Triangular Arbitrage
PPP Rates and Real
Rates
What have we
learned?
CHAPTER 3. SPOT MARKETS FOR FOREIGN CURRENCY
B triggers massive flows
Figure 3.11: Arbitrage and Shopping-around opportunities across market
B ⇒ No-arb condition: Bidi ≤ Askj ∀i, j—no empty space
makers
()50"
X
()58
!
()55"
()70"
X’
()63
!
()60"
()64"
Y
Z’
Z
()75
!
()72
!
()68
!
B Is there
an arb opp
...
3.3.2
Shopping
Around
across Competing Market Makers
– between Y and X? – between Y and Z? – between X and Z?
B If there is an arb
opp, implies
do we know
who differences
is wrong? like those between the pair
Shopping-around
activity
that small
Arbitrage Across Market Makers
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Example
What would you do when seeing ...
bank X: USD/EUR XXX56 - 58
bank Y: USD/EUR XXX52 - 54
Exchange Rates
88
Major Markets
B arb opp: sure gain without really needing cash
The LOP in Spot
Mkts
Across Mkt Makers
Triangular Arbitrage
PPP Rates and Real
Rates
What have we
learned?
CHAPTER 3. SPOT MARKETS FOR FOREIGN CURRENCY
B triggers massive flows
Figure 3.11: Arbitrage and Shopping-around opportunities across market
B ⇒ No-arb condition: Bidi ≤ Askj ∀i, j—no empty space
makers
()50"
X
()58
!
()55"
()70"
X’
()63
!
()60"
()64"
Y
Z’
Z
()75
!
()72
!
()68
!
B Is there
an arb opp
...
3.3.2
Shopping
Around
across Competing Market Makers
– between Y and X? – between Y and Z? – between X and Z?
B If there is an arb
opp, implies
do we know
who differences
is wrong? like those between the pair
Shopping-around
activity
that small
Arbitrage Across Market Makers
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Example
What would you do when seeing ...
bank X: USD/EUR XXX56 - 58
bank Y: USD/EUR XXX52 - 54
Exchange Rates
88
Major Markets
B arb opp: sure gain without really needing cash
The LOP in Spot
Mkts
Across Mkt Makers
Triangular Arbitrage
PPP Rates and Real
Rates
What have we
learned?
CHAPTER 3. SPOT MARKETS FOR FOREIGN CURRENCY
B triggers massive flows
Figure 3.11: Arbitrage and Shopping-around opportunities across market
B ⇒ No-arb condition: Bidi ≤ Askj ∀i, j—no empty space
makers
()50"
X
()58
!
()55"
()70"
X’
()63
!
()60"
()64"
Y
Z’
Z
()75
!
()72
!
()68
!
B Is there
an arb opp
...
3.3.2
Shopping
Around
across Competing Market Makers
– between Y and X? – between Y and Z? – between X and Z?
B If there is an arb
opp, implies
do we know
who differences
is wrong? like those between the pair
Shopping-around
activity
that small
Arbitrage Across Market Makers
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Example
What would you do when seeing ...
bank X: USD/EUR XXX56 - 58
bank Y: USD/EUR XXX52 - 54
Exchange Rates
88
Major Markets
B arb opp: sure gain without really needing cash
The LOP in Spot
Mkts
Across Mkt Makers
Triangular Arbitrage
PPP Rates and Real
Rates
What have we
learned?
CHAPTER 3. SPOT MARKETS FOR FOREIGN CURRENCY
B triggers massive flows
Figure 3.11: Arbitrage and Shopping-around opportunities across market
B ⇒ No-arb condition: Bidi ≤ Askj ∀i, j—no empty space
makers
()50"
X
()58
!
()55"
()70"
X’
()63
!
()60"
()64"
Y
Z’
Z
()75
!
()72
!
()68
!
B Is there
an arb opp
...
3.3.2
Shopping
Around
across Competing Market Makers
– between Y and X? – between Y and Z? – between X and Z?
B If there is an arb
opp, implies
do we know
who differences
is wrong? like those between the pair
Shopping-around
activity
that small
Arbitrage Across Market Makers
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Example
What would you do when seeing ...
bank X: USD/EUR XXX56 - 58
bank Y: USD/EUR XXX52 - 54
Exchange Rates
88
Major Markets
B arb opp: sure gain without really needing cash
The LOP in Spot
Mkts
Across Mkt Makers
Triangular Arbitrage
PPP Rates and Real
Rates
What have we
learned?
CHAPTER 3. SPOT MARKETS FOR FOREIGN CURRENCY
B triggers massive flows
Figure 3.11: Arbitrage and Shopping-around opportunities across market
B ⇒ No-arb condition: Bidi ≤ Askj ∀i, j—no empty space
makers
()50"
X
()58
!
()55"
()70"
X’
()63
!
()60"
()64"
Y
Z’
Z
()75
!
()72
!
()68
!
B Is there
an arb opp
...
3.3.2
Shopping
Around
across Competing Market Makers
– between Y and X? – between Y and Z? – between X and Z?
B If there is an arb
opp, implies
do we know
who differences
is wrong? like those between the pair
Shopping-around
activity
that small
Shopping Around Across Market Makers
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Exchange Rates
Major Markets
The LOP in Spot
Mkts
Across Mkt Makers
Triangular Arbitrage
PPP Rates and Real
Rates
Example
What would you do when seeing ...
bank X: USD/EUR XXX56 - 58
bank Y: USD/EUR XXX57 - 59
3.2. Shopping around across market makers
3. Law
B all buyers go to ... and all sellers to ...
Example:
of One Price
bank Y: BEF/DEM 52 - 54
B This may bebank
(temporarily)
bank X has a (delete one:)
Z : BEF/DEMthe
53 -idea—if
56
shortage/excess
, and Y but
a shortage/excess.
There is no scope for arbitrage,
buyers buy from Y, at 54, while all sellers sell to Z, at 53
B But •inallthe
medium run X and Y’s positions must vary all the time.
• This may be (temporarily) the idea—if bank Z has a shortage, and Y an excess.
A
What have we
learned?
B
C
D
E
Exercise: Skewing the spreads
• Who, among these traders, is
• keen on buying?
• keen on selling?
• just twiddling thumbs?
• Why do wannabuys move both quotes, not just the bid?
F
2 3 4 5 6 7 8 9
• Why do wannasells move both quotes, not just the ask?
Shopping Around Across Market Makers
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Exchange Rates
Major Markets
The LOP in Spot
Mkts
Across Mkt Makers
Triangular Arbitrage
PPP Rates and Real
Rates
Example
What would you do when seeing ...
bank X: USD/EUR XXX56 - 58
bank Y: USD/EUR XXX57 - 59
3.2. Shopping around across market makers
3. Law
B all buyers go to ... and all sellers to ...
Example:
of One Price
bank Y: BEF/DEM 52 - 54
B This may bebank
(temporarily)
bank X has a (delete one:)
Z : BEF/DEMthe
53 -idea—if
56
shortage/excess
, and Y but
a shortage/excess.
There is no scope for arbitrage,
buyers buy from Y, at 54, while all sellers sell to Z, at 53
B But •inallthe
medium run X and Y’s positions must vary all the time.
• This may be (temporarily) the idea—if bank Z has a shortage, and Y an excess.
A
What have we
learned?
B
C
D
E
Exercise: Skewing the spreads
• Who, among these traders, is
• keen on buying?
• keen on selling?
• just twiddling thumbs?
• Why do wannabuys move both quotes, not just the bid?
F
2 3 4 5 6 7 8 9
• Why do wannasells move both quotes, not just the ask?
Shopping Around Across Market Makers
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Exchange Rates
Major Markets
The LOP in Spot
Mkts
Across Mkt Makers
Triangular Arbitrage
PPP Rates and Real
Rates
Example
What would you do when seeing ...
bank X: USD/EUR XXX56 - 58
bank Y: USD/EUR XXX57 - 59
3.2. Shopping around across market makers
3. Law
B all buyers go to ... and all sellers to ...
Example:
of One Price
bank Y: BEF/DEM 52 - 54
B This may bebank
(temporarily)
bank X has a (delete one:)
Z : BEF/DEMthe
53 -idea—if
56
shortage/excess
, and Y but
a shortage/excess.
There is no scope for arbitrage,
buyers buy from Y, at 54, while all sellers sell to Z, at 53
B But •inallthe
medium run X and Y’s positions must vary all the time.
• This may be (temporarily) the idea—if bank Z has a shortage, and Y an excess.
A
What have we
learned?
B
C
D
E
Exercise: Skewing the spreads
• Who, among these traders, is
• keen on buying?
• keen on selling?
• just twiddling thumbs?
• Why do wannabuys move both quotes, not just the bid?
F
2 3 4 5 6 7 8 9
• Why do wannasells move both quotes, not just the ask?
Shopping Around Across Market Makers
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Exchange Rates
Major Markets
The LOP in Spot
Mkts
Across Mkt Makers
Triangular Arbitrage
PPP Rates and Real
Rates
Example
What would you do when seeing ...
bank X: USD/EUR XXX56 - 58
bank Y: USD/EUR XXX57 - 59
3.2. Shopping around across market makers
3. Law
B all buyers go to ... and all sellers to ...
Example:
of One Price
bank Y: BEF/DEM 52 - 54
B This may bebank
(temporarily)
bank X has a (delete one:)
Z : BEF/DEMthe
53 -idea—if
56
shortage/excess
, and Y but
a shortage/excess.
There is no scope for arbitrage,
buyers buy from Y, at 54, while all sellers sell to Z, at 53
B But •inallthe
medium run X and Y’s positions must vary all the time.
• This may be (temporarily) the idea—if bank Z has a shortage, and Y an excess.
A
What have we
learned?
B
C
D
E
Exercise: Skewing the spreads
• Who, among these traders, is
• keen on buying?
• keen on selling?
• just twiddling thumbs?
• Why do wannabuys move both quotes, not just the bid?
F
2 3 4 5 6 7 8 9
• Why do wannasells move both quotes, not just the ask?
Triangular Arbitrage and the LOP
3.3. THE LAW OF ONE PRICE FOR SPOT EXCHANGE QUOTES
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Exchange Rates
Major Markets
The LOP in Spot
Mkts
Across Mkt Makers
3.3 Triangular
therates
LOP quoted in
Triangular?
RelationsArbitrage
betweenand
spot
3. Law of One Price
various currencies—e.g.
GBPin/ USD
, JPY
/USD, JPY/GBP/USD,
GBP .
• Relationships
between spot rates quoted
various
currencies—e.g.
EUR/USD, EUR/USD.
Figure 3.10: Triangular arbitrage and triangular shopping arou
Triangular arbitrage:
Do I make money doing this:?
USD
Triangular shopping-around:
which of the two gives me the best price?
USD
USD
Triangular Arbitrage
PPP Rates and Real
Rates
JPY
JPY
JPY
What have we
learned?
GBP
is out > in?
GBP
GBP
go direct or indirect?
For either application we need to know the “synthetic”
(indirect) rate JPY/GBP
.
P. Sercu and R. Uppal
The International Finance Workbook
page
3.3
1.14
The Law of One Price for Spot Exchange Quo
Triangular Arbitrage and the LOP
3.3. THE LAW OF ONE PRICE FOR SPOT EXCHANGE QUOTES
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Exchange Rates
Major Markets
The LOP in Spot
Mkts
Across Mkt Makers
3.3 Triangular
therates
LOP quoted in
Triangular?
RelationsArbitrage
betweenand
spot
3. Law of One Price
various currencies—e.g.
GBPin/ USD
, JPY
/USD, JPY/GBP/USD,
GBP .
• Relationships
between spot rates quoted
various
currencies—e.g.
EUR/USD, EUR/USD.
Figure 3.10: Triangular arbitrage and triangular shopping arou
Triangular arbitrage:
Do I make money doing this:?
USD
Triangular shopping-around:
which of the two gives me the best price?
USD
USD
Triangular Arbitrage
PPP Rates and Real
Rates
JPY
JPY
JPY
What have we
learned?
GBP
is out > in?
GBP
GBP
go direct or indirect?
For either application we need to know the “synthetic”
(indirect) rate JPY/GBP
.
P. Sercu and R. Uppal
The International Finance Workbook
page
3.3
1.14
The Law of One Price for Spot Exchange Quo
Computing Synthetic Cross-Rates (1)
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Exchange Rates
Major Markets
The LOP in Spot
Mkts
Concepts introduced in this section:
Replication
A synthetic version or replication of a contract is
– a combination of two or more other transactions
– that achieves the same purpose as the original contract
Across Mkt Makers
Triangular Arbitrage
PPP Rates and Real
Rates
What have we
learned?
Rip-off Rule
Law of the Worst Possible Combination or Rip-Off
Rule:
– At every single transaction we get the worse rate—hi for buy, lo for sell
– so, in a chain of transactions one always ends up with the worst
possible combination
Computing Synthetic Cross-Rates (1)
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Exchange Rates
Major Markets
The LOP in Spot
Mkts
Concepts introduced in this section:
Replication
A synthetic version or replication of a contract is
– a combination of two or more other transactions
– that achieves the same purpose as the original contract
Across Mkt Makers
Triangular Arbitrage
PPP Rates and Real
Rates
What have we
learned?
Rip-off Rule
Law of the Worst Possible Combination or Rip-Off
Rule:
– At every single transaction we get the worse rate—hi for buy, lo for sell
– so, in a chain of transactions one always ends up with the worst
possible combination
Computing Synthetic Cross-Rates (1)
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Exchange Rates
Major Markets
The LOP in Spot
Mkts
Concepts introduced in this section:
Replication
A synthetic version or replication of a contract is
– a combination of two or more other transactions
– that achieves the same purpose as the original contract
Across Mkt Makers
Triangular Arbitrage
PPP Rates and Real
Rates
What have we
learned?
Rip-off Rule
Law of the Worst Possible Combination or Rip-Off
Rule:
– At every single transaction we get the worse rate—hi for buy, lo for sell
– so, in a chain of transactions one always ends up with the worst
possible combination
Example of synthetic rates (1)
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Exchange Rates
Major Markets
The LOP in Spot
Mkts
Across Mkt Makers
Example
Find the cost of synthetically buying GBP against JPY if
JPY / USD 101.07 – 101.20 ,
USD / GBP 1.3840 – 1.3850
B Divide or multiply? Look at the dimensions:
Triangular Arbitrage
PPP Rates and Real
Rates
What have we
learned?
[JPY/GBP] = [JPY/USD ] × [USD/GBP]
B Bid or ask? Use the Law of the Worst Possible Combination:
– Synth bid = lowest product = lo × lo
= 101.07 × 1.3840 = 139.88088
– Synth ask = highest product = hi × hi
= 101.20 × 1.3850 = 140.16200
Example of synthetic rates (1)
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Exchange Rates
Major Markets
The LOP in Spot
Mkts
Across Mkt Makers
Example
Find the cost of synthetically buying GBP against JPY if
JPY / USD 101.07 – 101.20 ,
USD / GBP 1.3840 – 1.3850
B Divide or multiply? Look at the dimensions:
Triangular Arbitrage
PPP Rates and Real
Rates
What have we
learned?
[JPY/GBP] = [JPY/USD ] × [USD/GBP]
B Bid or ask? Use the Law of the Worst Possible Combination:
– Synth bid = lowest product = lo × lo
= 101.07 × 1.3840 = 139.88088
– Synth ask = highest product = hi × hi
= 101.20 × 1.3850 = 140.16200
Example of synthetic rates (1)
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Exchange Rates
Major Markets
The LOP in Spot
Mkts
Across Mkt Makers
Example
Find the cost of synthetically buying GBP against JPY if
JPY / USD 101.07 – 101.20 ,
USD / GBP 1.3840 – 1.3850
B Divide or multiply? Look at the dimensions:
Triangular Arbitrage
PPP Rates and Real
Rates
What have we
learned?
[JPY/GBP] = [JPY/USD ] × [USD/GBP]
B Bid or ask? Use the Law of the Worst Possible Combination:
– Synth bid = lowest product = lo × lo
= 101.07 × 1.3840 = 139.88088
– Synth ask = highest product = hi × hi
= 101.20 × 1.3850 = 140.16200
Example of synthetic rates (2)
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Exchange Rates
Example — imagine Brits quote the logical way?!
Find the cost of synthetically buying GBP against JPY if
JPY / USD 101.07 – 101.20 ,
GBP / USD .72202 – .72254
Major Markets
The LOP in Spot
Mkts
Across Mkt Makers
Triangular Arbitrage
PPP Rates and Real
Rates
What have we
learned?
B Divide or multiply? Look at the dimensions:
[JPY/GBP] =
B Bid or ask? Use the Law of the Worst Possible Combination:
– Synth bid = lowest quotient =
=
– Synth ask = highest quotient =
=
Example of synthetic rates (2)
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Exchange Rates
Example — imagine Brits quote the logical way?!
Find the cost of synthetically buying GBP against JPY if
JPY / USD 101.07 – 101.20 ,
GBP / USD .72202 – .72254
Major Markets
The LOP in Spot
Mkts
Across Mkt Makers
Triangular Arbitrage
PPP Rates and Real
Rates
What have we
learned?
B Divide or multiply? Look at the dimensions:
[JPY/GBP] =
B Bid or ask? Use the Law of the Worst Possible Combination:
– Synth bid = lowest quotient =
=
– Synth ask = highest quotient =
=
Example of synthetic rates (2)
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Exchange Rates
Example — imagine Brits quote the logical way?!
Find the cost of synthetically buying GBP against JPY if
JPY / USD 101.07 – 101.20 ,
GBP / USD .72202 – .72254
Major Markets
The LOP in Spot
Mkts
Across Mkt Makers
Triangular Arbitrage
PPP Rates and Real
Rates
What have we
learned?
B Divide or multiply? Look at the dimensions:
[JPY/GBP] =
B Bid or ask? Use the Law of the Worst Possible Combination:
– Synth bid = lowest quotient =
=
– Synth ask = highest quotient =
=
92
CHAPTER 3. SPOT MARKETS FOR FOREIGN CURRENCY
Triangular Arb: Bounds on Cross-rates
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Exchange Rates
Figure 3.12: Triangular Arbitrage and Shopping-around
139.48
"
X
139.78
!
139.68
"
140.20
"
X’
Across Mkt Makers
140.50
!
139.98
!
140.00
"
Major Markets
The LOP in Spot
Mkts
Z
139.88
"
Z’
140.30
!
140.16
!
Synth
Triangular Arbitrage
PPP Rates and Real
Rates
What have we
learned?
Let us look at another example. The data are the same except that the British
quotes
now are direct not indirect.
Implication:
if the synthetic rates are 139.88088 – 140.16200, then ...
DoItYourself
3.1 exist only if ...
– the directproblem
mkt can fully
The jpy/gbp synthetic bid and ask rates, if the quotes are
– if so, the no-arb condition
... and
jpy/usdensures
101.07 that
- 101.20
gbp/usd
0.72202
.72254,
– and the shopping-around effect implies that ...
are
jpy/usd
jpy/usd
St,bid
St,ask
jpy/gbp
jpy/gbp
Synth St,bid
= gbp/usd = 139.88 , Synth St,ask
= gbp/usd = 140.16.
St,ask
St,bid
92
CHAPTER 3. SPOT MARKETS FOR FOREIGN CURRENCY
Triangular Arb: Bounds on Cross-rates
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Exchange Rates
Figure 3.12: Triangular Arbitrage and Shopping-around
139.48
"
X
139.78
!
139.68
"
140.20
"
X’
Across Mkt Makers
140.50
!
139.98
!
140.00
"
Major Markets
The LOP in Spot
Mkts
Z
139.88
"
Z’
140.30
!
140.16
!
Synth
Triangular Arbitrage
PPP Rates and Real
Rates
What have we
learned?
Let us look at another example. The data are the same except that the British
quotes
now are direct not indirect.
Implication:
if the synthetic rates are 139.88088 – 140.16200, then ...
DoItYourself
3.1 exist only if ...
– the directproblem
mkt can fully
The jpy/gbp synthetic bid and ask rates, if the quotes are
– if so, the no-arb condition
... and
jpy/usdensures
101.07 that
- 101.20
gbp/usd
0.72202
.72254,
– and the shopping-around effect implies that ...
are
jpy/usd
jpy/usd
St,bid
St,ask
jpy/gbp
jpy/gbp
Synth St,bid
= gbp/usd = 139.88 , Synth St,ask
= gbp/usd = 140.16.
St,ask
St,bid
92
CHAPTER 3. SPOT MARKETS FOR FOREIGN CURRENCY
Triangular Arb: Bounds on Cross-rates
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Exchange Rates
Figure 3.12: Triangular Arbitrage and Shopping-around
139.48
"
X
139.78
!
139.68
"
140.20
"
X’
Across Mkt Makers
140.50
!
139.98
!
140.00
"
Major Markets
The LOP in Spot
Mkts
Z
139.88
"
Z’
140.30
!
140.16
!
Synth
Triangular Arbitrage
PPP Rates and Real
Rates
What have we
learned?
Let us look at another example. The data are the same except that the British
quotes
now are direct not indirect.
Implication:
if the synthetic rates are 139.88088 – 140.16200, then ...
DoItYourself
3.1 exist only if ...
– the directproblem
mkt can fully
The jpy/gbp synthetic bid and ask rates, if the quotes are
– if so, the no-arb condition
... and
jpy/usdensures
101.07 that
- 101.20
gbp/usd
0.72202
.72254,
– and the shopping-around effect implies that ...
are
jpy/usd
jpy/usd
St,bid
St,ask
jpy/gbp
jpy/gbp
Synth St,bid
= gbp/usd = 139.88 , Synth St,ask
= gbp/usd = 140.16.
St,ask
St,bid
A trader’s shopping-around spreadsheet
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Exchange Rates
Major Markets
The LOP in Spot
Mkts
Across Mkt Makers
Triangular Arbitrage
PPP Rates and Real
Rates
What have we
learned?
Outline
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Exchange Rates
Exchange Rates
The HC/FC Convention (—ours)
The FC/HC Convention
Bid and Ask
Primary and Cross Rates
Inverting bid and asks
Major Markets
The LOP in Spot
Mkts
PPP Rates and Real
Rates
Major Markets for Foreign Exchange
How Exchange Markets Work
Markets by Location and by Currency
Markets by Delivery Date
PPP Exchange Rates
The Real Rate (dev from
APPP)
Deviations from RPPP
What have we
learned?
The Law Of One Price in Spot Mkts
Price Differences Across Market Makers
Triangular Arbitrage and the LOP
PPP Exchange Rates and Real Rates
PPP Exchange Rates
The Real Rate or Deviation from APPP
Is the RER constant? Devs from RPPP
What have we learned in this chapter?
Issues related to interpretation of S or Y ∗
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Major Markets
Two (related) issues: If price levels are very different,
home v abroad, how can we measure ...
The LOP in Spot
Mkts
– the true meaning of a
PPP Rates and Real
Rates
– the average price difference? (Real Rate, deviation from Abs
PPP)
Exchange Rates
PPP Exchange Rates
The Real Rate (dev from
APPP)
Deviations from RPPP
What have we
learned?
FC
amount to a local? (PPP rate)
– the change in the price difference (deviations from Rel. PPP)
PPP Exchange Rates
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Exchange Rates
Major Markets
The LOP in Spot
Mkts
PPP Rates and Real
Rates
PPP Exchange Rates
The Real Rate (dev from
APPP)
Deviations from RPPP
What have we
learned?
Example
Your friend makes FDK 2000, which seems little, against
your USD 50! Data:
B “Nominal” spot rate is
USD/ FDK
B A Big Meal costs
5 here,
USD
0.010.
FDK
250 there.
Calculations:
B at the spot rate her income is 2000 × 0.01 =
USD
20 50.
B but she spends it locally, where prices are possibly different
– over there, she can buy 2000/250 = 8 BigMeals
– 8 Bigmeals would cost 8×5 = USD 40 to you here
– so FDK 2000 means as much to her, over there, as USD 40 to you, here
– the implied rate (“PPP rate”) is 2000/40 = 0.02 USD/FDK:
General:
PPP
rate = Π/Π∗
PPP Exchange Rates
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Exchange Rates
Major Markets
The LOP in Spot
Mkts
PPP Rates and Real
Rates
PPP Exchange Rates
The Real Rate (dev from
APPP)
Deviations from RPPP
What have we
learned?
Example
Your friend makes FDK 2000, which seems little, against
your USD 50! Data:
B “Nominal” spot rate is
USD/ FDK
B A Big Meal costs
5 here,
USD
0.010.
FDK
250 there.
Calculations:
B at the spot rate her income is 2000 × 0.01 =
USD
20 50.
B but she spends it locally, where prices are possibly different
– over there, she can buy 2000/250 = 8 BigMeals
– 8 Bigmeals would cost 8×5 = USD 40 to you here
– so FDK 2000 means as much to her, over there, as USD 40 to you, here
– the implied rate (“PPP rate”) is 2000/40 = 0.02 USD/FDK:
General:
PPP
rate = Π/Π∗
Are PPP rates far from Nominal Rates?
Spot Markets
Exchange Rates
Major Markets
The LOP in Spot
Mkts
PPP Rates and Real
Rates
PPP Exchange Rates
The Real Rate (dev from
APPP)
Deviations from RPPP
What have we
learned?
The Economist’s Big Mac Standard:
!"##$%&
!'
34,%*
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Table 3.1: PPP rates based in Big-Mac prices from The Economist
Formatted 09:58 on 13 June 2007c
!: P. Sercu, K.U.Leuven SB&E. Free distribution stops in 2008
P. Sercu,
International
Finance: Theory into
Practice
Are PPP rates far from Nominal Rates?
96
CHAPTER 3. SPOT MARKETS FOR FOREIGN CURRENCY
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
If we plot log against log, the link seems close:
Figure 3.13: Log PPP v log actual rates, HC/USD
10
Exchange Rates
8
Major Markets
The LOP in Spot
Mkts
PPP Exchange Rates
The Real Rate (dev from
APPP)
log actual rate
PPP Rates and Real
Rates
6
4
Deviations from RPPP
2
What have we
learned?
0
-2
0
2
4
-2
log PPP rate
Source Based on data from The Economist, May 26, 2006
6
8
10
Are PPP rates far from Nominal Rates?
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
3.4. TRANSLATING FC FIGURES: NOMINAL RATES, PPP RATES, AND DEVIATIONS
FROM PPP
99
If we plot untransformed figures, we see big deviations:
Figure 3.14: PPP v actual rates, HC/USD
Exchange Rates
Major Markets
The LOP in Spot
Mkts
PPP Rates and Real
Rates
PPP Exchange Rates
The Real Rate (dev from
APPP)
Deviations from RPPP
What have we
learned?
Rates are in FC/USD, so a dot below the 45-degree line
Source Based on data from The Economist, May 26, 2006
means the dollar is below PPP.
3.4.3
The Real Exchange Rate and (Deviations from) Absolute PPP
The real exchange rate (RER) is a measure of how far the nominal rate differs from
The Real Rate or Deviation from APPP
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
B RER measures the difference between S and ŜPPP :
Real XRate :=
Exchange Rates
S
ŜPPP
Major Markets
The LOP in Spot
Mkts
B RER is also the ratio between the translated price levels:
PPP Rates and Real
Rates
Real XRate :=
PPP Exchange Rates
The Real Rate (dev from
APPP)
Deviations from RPPP
What have we
learned?
SΠ∗
translated Π∗
S
=
=
∗
Π/Π
Π
home Π
So RER tells us what country is more expensive, and by how
much.
B Absolute
PPP
is said to hold if
PPP
APPP: RERt = 1 ⇔ St = Ŝt
⇔ St × Π∗t = Πt
The Real Rate or Deviation from APPP
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
B RER measures the difference between S and ŜPPP :
Real XRate :=
Exchange Rates
S
ŜPPP
Major Markets
The LOP in Spot
Mkts
B RER is also the ratio between the translated price levels:
PPP Rates and Real
Rates
Real XRate :=
PPP Exchange Rates
The Real Rate (dev from
APPP)
Deviations from RPPP
What have we
learned?
SΠ∗
translated Π∗
S
=
=
∗
Π/Π
Π
home Π
So RER tells us what country is more expensive, and by how
much.
B Absolute
PPP
is said to hold if
PPP
APPP: RERt = 1 ⇔ St = Ŝt
⇔ St × Π∗t = Πt
The Real Rate or Deviation from APPP
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
B RER measures the difference between S and ŜPPP :
Real XRate :=
Exchange Rates
S
ŜPPP
Major Markets
The LOP in Spot
Mkts
B RER is also the ratio between the translated price levels:
PPP Rates and Real
Rates
Real XRate :=
PPP Exchange Rates
The Real Rate (dev from
APPP)
Deviations from RPPP
What have we
learned?
SΠ∗
translated Π∗
S
=
=
∗
Π/Π
Π
home Π
So RER tells us what country is more expensive, and by how
much.
B Absolute
PPP
is said to hold if
PPP
APPP: RERt = 1 ⇔ St = Ŝt
⇔ St × Π∗t = Πt
100
3. SPOT MARKETS FOR FOREIGN CURRENCY
Deviations
fromCHAPTER
BigMacParity
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Figure 3.15: Real rates based on Big-Mac prices from The Economist
2.500
translated price level (US=1)
2.000
Exchange Rates
Major Markets
1.500
The LOP in Spot
Mkts
PPP Rates and Real
Rates
1.000
PPP Exchange Rates
The Real Rate (dev from
APPP)
0.500
Deviations from RPPP
What have we
learned?
0.000
Norway
Iceland
Switzerland
Denmark
Sweden
Euroland
Britain
Canada
United states
Chile
Peru
Morocco
Brazil
Aruba
Slovenia
New Zealand
Turkey
Hungary
Fiju
Czech
South Korea
Croatia
Colombia
Mexico
Latvia
UAE
Australia
Lithuania
Saudi Arabia
Estonia
Taiwan
Georgia
Argentina
Guatemala
Singapore
Japan
Costa Rica
Venezuela
Pakistan
South Africa
Thailand
Poland
Slovakia
Bulgaria
Honduras
Sri Lanka
Dominican Rep
Russia
Uruguay
Moldava
Ukraine
Egypt
Paraguay
Philippines
Indonesia
Hong Kong
Malaysia
Macau
China
Source Based on data from The Economist, May 26, 2006
rate tells you how much cheaper (if
RER
< 1) or more expensive (if
RER
> 1) the
Deviations from BigMacParity
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Example
Exchange Rates
is 100 Crowns per dollar; complete Freedonia’s PPP rates in the table:
BigMac costs 3.10 in the
Major Markets
The LOP in Spot
Mkts
currency
Freedonia
korona
US
local
price
155
and 155 in Freedonia, and the spot rate
actual
value
of $
PPP
rate
of $
real
rate
of $
actual
value
in $
PPP
rate
in $
100
PPP Rates and Real
Rates
PPP Exchange Rates
The Real Rate (dev from
APPP)
Deviations from RPPP
Example: 2006 GDPs translated into
What have we
learned?
Russia
China
at S
741 b
2 225 b
at ŜPPP
1 589 b
8 883 b
USD
ratio b/a
2.15
3.99
(http://www.cia.gov/cia/publications/factbook/geos/rs.html)
real
rate
in $
Deviations from BigMacParity
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Example
Exchange Rates
is 100 Crowns per dollar; complete Freedonia’s PPP rates in the table:
BigMac costs 3.10 in the
Major Markets
The LOP in Spot
Mkts
currency
Freedonia
korona
US
local
price
155
and 155 in Freedonia, and the spot rate
actual
value
of $
PPP
rate
of $
real
rate
of $
actual
value
in $
PPP
rate
in $
100
PPP Rates and Real
Rates
PPP Exchange Rates
The Real Rate (dev from
APPP)
Deviations from RPPP
Example: 2006 GDPs translated into
What have we
learned?
Russia
China
at S
741 b
2 225 b
at ŜPPP
1 589 b
8 883 b
USD
ratio b/a
2.15
3.99
(http://www.cia.gov/cia/publications/factbook/geos/rs.html)
real
rate
in $
Deviations from Relative PPP
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Exchange Rates
Major Markets
The LOP in Spot
Mkts
PPP Rates and Real
Rates
Issue?
B If Absolute price data are missing, we cannot compute the
RER
B But we can still know whether RER is up or down, relative to a
base period:
RERt
RERt0
=
PPP Exchange Rates
The Real Rate (dev from
APPP)
=
Deviations from RPPP
What have we
learned?
≈
Π∗t /Π∗t0
Πt /Πt0
1 + infl∗t0 ,t
(1 + st0 ,t )
−1
1 + inflt0 ,t
[St /St0 ]
st0 ,t + [infl∗t0 ,t − inflt0 ,t ]
where infl and infl∗ can be proxied by local CPI inflation rates if
Absolute price levels are missing.
B If the RER has not changed, Relative PPP is said to hold.
Deviations from Relative PPP
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Exchange Rates
Major Markets
The LOP in Spot
Mkts
PPP Rates and Real
Rates
Issue?
B If Absolute price data are missing, we cannot compute the
RER
B But we can still know whether RER is up or down, relative to a
base period:
RERt
RERt0
=
PPP Exchange Rates
The Real Rate (dev from
APPP)
=
Deviations from RPPP
What have we
learned?
≈
Π∗t /Π∗t0
Πt /Πt0
1 + infl∗t0 ,t
(1 + st0 ,t )
−1
1 + inflt0 ,t
[St /St0 ]
st0 ,t + [infl∗t0 ,t − inflt0 ,t ]
where infl and infl∗ can be proxied by local CPI inflation rates if
Absolute price levels are missing.
B If the RER has not changed, Relative PPP is said to hold.
Deviations from Relative PPP
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Exchange Rates
Major Markets
The LOP in Spot
Mkts
PPP Rates and Real
Rates
Issue?
B If Absolute price data are missing, we cannot compute the
RER
B But we can still know whether RER is up or down, relative to a
base period:
RERt
RERt0
=
PPP Exchange Rates
The Real Rate (dev from
APPP)
=
Deviations from RPPP
What have we
learned?
≈
Π∗t /Π∗t0
Πt /Πt0
1 + infl∗t0 ,t
(1 + st0 ,t )
−1
1 + inflt0 ,t
[St /St0 ]
st0 ,t + [infl∗t0 ,t − inflt0 ,t ]
where infl and infl∗ can be proxied by local CPI inflation rates if
Absolute price levels are missing.
B If the RER has not changed, Relative PPP is said to hold.
Is the RER constant? (RPPP deviations?)
Spot Markets
Exchange Rates
Real value of 4 currencies, from US perspective, relative
to 1965
4
Major Markets
The LOP in Spot
Mkts
Cumulative RPPP, Jan1965=1.00
CPI* x S/CPI_us
P. Sercu,
International
Finance: Theory into
Practice
3
DEM-EUR
JPY
GBP
SAR
THB
PPP Rates and Real
Rates
PPP Exchange Rates
2
The Real Rate (dev from
APPP)
Deviations from RPPP
1
Jan-06
Jan-05
Jan-04
Jan-03
Jan-02
Jan-01
Jan-00
Jan-99
Jan-98
Jan-97
Jan-96
Jan-95
Jan-94
Jan-93
Jan-92
Jan-91
Jan-90
Jan-89
Jan-88
Jan-87
Jan-86
Jan-85
Jan-84
Jan-83
Jan-82
Jan-81
Jan-80
Jan-79
Jan-78
Jan-77
Jan-76
Jan-75
Jan-74
Jan-73
Jan-72
Jan-71
Jan-70
Jan-69
Jan-68
Jan-67
Jan-66
0
Jan-65
What have we
learned?
Is the RER constant? (RPPP deviations?)
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Nominal and RPPP value of GBP against USD, relative to
1965
GBP RPPP v actual
Exchange Rates
RPPP
actual
1.2
Major Markets
The LOP in Spot
Mkts
PPP Rates and Real
Rates
PPP Exchange Rates
The Real Rate (dev from
APPP)
1
0.8
0.6
Deviations from RPPP
0.4
What have we
learned?
0.2
Jan-06
Jan-05
Jan-04
Jan-03
Jan-02
Jan-01
Jan-00
Jan-99
Jan-98
Jan-97
Jan-96
Jan-95
Jan-94
Jan-93
Jan-92
Jan-91
Jan-90
Jan-89
Jan-88
Jan-87
Jan-86
Jan-85
Jan-84
Jan-83
Jan-82
Jan-81
Jan-80
Jan-79
Jan-78
Jan-77
Jan-76
Jan-75
Jan-74
Jan-73
Jan-72
Jan-71
Jan-70
Jan-69
Jan-68
Jan-67
Jan-66
Jan-65
0
Is the RER constant? (RPPP deviations?)
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Nominal and RPPP value of JPY against USD, relative to
1965
JPY RPPP v actual
Exchange Rates
Major Markets
The LOP in Spot
Mkts
RPPP
actual
5
4.5
4
3.5
PPP Rates and Real
Rates
3
PPP Exchange Rates
2
1.5
1
0.5
Jan-06
Jan-05
Jan-04
Jan-03
Jan-02
Jan-01
Jan-00
Jan-99
Jan-98
Jan-97
Jan-96
Jan-95
Jan-94
Jan-93
Jan-92
Jan-91
Jan-90
Jan-89
Jan-88
Jan-87
Jan-86
Jan-85
Jan-84
Jan-83
Jan-82
Jan-81
Jan-80
Jan-79
Jan-78
Jan-77
Jan-76
Jan-75
Jan-74
Jan-73
Jan-72
Jan-71
Jan-70
Jan-69
Jan-68
Jan-67
0
Jan-66
Deviations from RPPP
What have we
learned?
2.5
Jan-65
The Real Rate (dev from
APPP)
Is the RER constant? (RPPP deviations?)
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Nominal and RPPP value of ZAR against USD, relative to
1965
SAR RPPP v actual
Exchange Rates
RPPP
actual
1.2
Major Markets
1
The LOP in Spot
Mkts
PPP Rates and Real
Rates
PPP Exchange Rates
0.8
0.6
The Real Rate (dev from
APPP)
Deviations from RPPP
0.4
What have we
learned?
0.2
Jan-06
Jan-05
Jan-04
Jan-03
Jan-02
Jan-01
Jan-00
Jan-99
Jan-98
Jan-97
Jan-96
Jan-95
Jan-94
Jan-93
Jan-92
Jan-91
Jan-90
Jan-89
Jan-88
Jan-87
Jan-86
Jan-85
Jan-84
Jan-83
Jan-82
Jan-81
Jan-80
Jan-79
Jan-78
Jan-77
Jan-76
Jan-75
Jan-74
Jan-73
Jan-72
Jan-71
Jan-70
Jan-69
Jan-68
Jan-67
Jan-66
Jan-65
0
Is the RER constant? (RPPP deviations?)
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Nominal and RPPP value of THB against USD, relative to
1965
THB RPPP v actual
Exchange Rates
RPPP
actual
1.2
Major Markets
The LOP in Spot
Mkts
PPP Rates and Real
Rates
1
0.8
PPP Exchange Rates
The Real Rate (dev from
APPP)
0.6
Deviations from RPPP
0.4
0.2
Jan-06
Jan-05
Jan-04
Jan-03
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Jan-65
What have we
learned?
Things on RERs to be Remembered Forever
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Exchange Rates
RER Behavior
Major Markets
The LOP in Spot
Mkts
PPP Rates and Real
Rates
PPP Exchange Rates
The Real Rate (dev from
APPP)
Deviations from RPPP
What have we
learned?
B huge swings: halving/doubling in a matter of years
B high inertia (autocorrelation) in short run: halflife is like 5 yrs
B most of the variability comes from nominal rate, not PPP rate
– this is good: nominal rate can be hedged
B S is hard to predict — claim to be substantiated later
More Things to be Remembered Forever
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Exchange Rates
Major Markets
The LOP in Spot
Mkts
PPP Rates and Real
Rates
PPP Exchange Rates
The Real Rate (dev from
APPP)
Deviations from RPPP
What have we
learned?
Financial Policy Implications
B RER movements can force a company to radically change its
strategy
– 1970s: VW abandoned export strategy, became multinational
producer
– 1980s: John Deere, International Harvestor lost their export
markets
B Even nominal movements can kill a company
– 1990s: Slite (FI) went belly up because the FIM had devalued
B If rates would move predictably, we could prepare
operationally, eg move production, change sourcing & prices
B Since rates move unpredictably, financial hedging seems
useful.
– first we need to show whether/when such hedging adds value
– then we need to know our exposure, which determines the size of
the damage and the size of the hedge
– we need to select the hedge instrument: forwards, futures, options,
swaps?
More Things to be Remembered Forever
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Exchange Rates
Major Markets
The LOP in Spot
Mkts
PPP Rates and Real
Rates
PPP Exchange Rates
The Real Rate (dev from
APPP)
Deviations from RPPP
What have we
learned?
Financial Policy Implications
B RER movements can force a company to radically change its
strategy
– 1970s: VW abandoned export strategy, became multinational
producer
– 1980s: John Deere, International Harvestor lost their export
markets
B Even nominal movements can kill a company
– 1990s: Slite (FI) went belly up because the FIM had devalued
B If rates would move predictably, we could prepare
operationally, eg move production, change sourcing & prices
B Since rates move unpredictably, financial hedging seems
useful.
– first we need to show whether/when such hedging adds value
– then we need to know our exposure, which determines the size of
the damage and the size of the hedge
– we need to select the hedge instrument: forwards, futures, options,
swaps?
More Things to be Remembered Forever
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Exchange Rates
Major Markets
The LOP in Spot
Mkts
PPP Rates and Real
Rates
PPP Exchange Rates
The Real Rate (dev from
APPP)
Deviations from RPPP
What have we
learned?
Financial Policy Implications
B RER movements can force a company to radically change its
strategy
– 1970s: VW abandoned export strategy, became multinational
producer
– 1980s: John Deere, International Harvestor lost their export
markets
B Even nominal movements can kill a company
– 1990s: Slite (FI) went belly up because the FIM had devalued
B If rates would move predictably, we could prepare
operationally, eg move production, change sourcing & prices
B Since rates move unpredictably, financial hedging seems
useful.
– first we need to show whether/when such hedging adds value
– then we need to know our exposure, which determines the size of
the damage and the size of the hedge
– we need to select the hedge instrument: forwards, futures, options,
swaps?
More Things to be Remembered Forever
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Exchange Rates
Major Markets
The LOP in Spot
Mkts
PPP Rates and Real
Rates
PPP Exchange Rates
The Real Rate (dev from
APPP)
Deviations from RPPP
What have we
learned?
Financial Policy Implications
B RER movements can force a company to radically change its
strategy
– 1970s: VW abandoned export strategy, became multinational
producer
– 1980s: John Deere, International Harvestor lost their export
markets
B Even nominal movements can kill a company
– 1990s: Slite (FI) went belly up because the FIM had devalued
B If rates would move predictably, we could prepare
operationally, eg move production, change sourcing & prices
B Since rates move unpredictably, financial hedging seems
useful.
– first we need to show whether/when such hedging adds value
– then we need to know our exposure, which determines the size of
the damage and the size of the hedge
– we need to select the hedge instrument: forwards, futures, options,
swaps?
Outline
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Exchange Rates
Exchange Rates
The HC/FC Convention (—ours)
The FC/HC Convention
Bid and Ask
Primary and Cross Rates
Inverting bid and asks
Major Markets
The LOP in Spot
Mkts
PPP Rates and Real
Rates
What have we
learned?
Major Markets for Foreign Exchange
How Exchange Markets Work
Markets by Location and by Currency
Markets by Delivery Date
The Law Of One Price in Spot Mkts
Price Differences Across Market Makers
Triangular Arbitrage and the LOP
PPP Exchange Rates and Real Rates
PPP Exchange Rates
The Real Rate or Deviation from APPP
Is the RER constant? Devs from RPPP
What have we learned in this chapter?
What have we learned in this chapter?
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Exchange Rates
Major Markets
The LOP in Spot
Mkts
PPP Rates and Real
Rates
What have we
learned?
Exchange rates, in this text, are always shown as
HC / FC . Market makers quote them as bid-ask, with the
spread determined by risk considerations (which?).
The market is traditionally a bilateral OTC market
(“conversations”), but is now becoming more
multilateral (Reuters 3000 & EBS auctions).
There are spot and forward segments.
Even in purely bilateral markets, prices are
(imperfectly) unified across market makers by
arbitrage and by shopping-around. True, traders often
skew their bids—but just until their desired trade has
been achieved.
What have we learned in this chapter?
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Exchange Rates
Major Markets
The LOP in Spot
Mkts
PPP Rates and Real
Rates
What have we
learned?
Exchange rates, in this text, are always shown as
HC / FC . Market makers quote them as bid-ask, with the
spread determined by risk considerations (which?).
The market is traditionally a bilateral OTC market
(“conversations”), but is now becoming more
multilateral (Reuters 3000 & EBS auctions).
There are spot and forward segments.
Even in purely bilateral markets, prices are
(imperfectly) unified across market makers by
arbitrage and by shopping-around. True, traders often
skew their bids—but just until their desired trade has
been achieved.
What have we learned in this chapter?
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Exchange Rates
Major Markets
The LOP in Spot
Mkts
PPP Rates and Real
Rates
What have we
learned?
Exchange rates, in this text, are always shown as
HC / FC . Market makers quote them as bid-ask, with the
spread determined by risk considerations (which?).
The market is traditionally a bilateral OTC market
(“conversations”), but is now becoming more
multilateral (Reuters 3000 & EBS auctions).
There are spot and forward segments.
Even in purely bilateral markets, prices are
(imperfectly) unified across market makers by
arbitrage and by shopping-around. True, traders often
skew their bids—but just until their desired trade has
been achieved.
What have we learned in this chapter?
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Exchange Rates
Major Markets
The LOP in Spot
Mkts
PPP Rates and Real
Rates
What have we
learned?
Exchange rates, in this text, are always shown as
HC / FC . Market makers quote them as bid-ask, with the
spread determined by risk considerations (which?).
The market is traditionally a bilateral OTC market
(“conversations”), but is now becoming more
multilateral (Reuters 3000 & EBS auctions).
There are spot and forward segments.
Even in purely bilateral markets, prices are
(imperfectly) unified across market makers by
arbitrage and by shopping-around. True, traders often
skew their bids—but just until their desired trade has
been achieved.
What more have we learned in this chapter?
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Exchange Rates
Major Markets
The LOP in Spot
Mkts
PPP Rates and Real
Rates
What have we
learned?
In triangular arbitrage, we came across our first
example of replication or synthetic versions of
contracts, and discovered the Law of the Worst
Possible Combination.
Two complementary notions help us interpret S:
– Translation at the PPP rate, ŜPPP := Π/Π∗ , tells us what a FC amount
really means over there, expressed in terms you understand: how
much should I make here to be able to spend as much as that amount
buys there.
– The real rate, RER := S/ŜPPP = [SΠ∗ ]/Π, tells me how much more
expensive the foreign country is.
There are two related PPP notions:
– If RER=1, Absolute PPP is said to hold.
– If the RER is constant, Relative PPP is said to hold.
If absolute price data are missing, we can still approximate the % change
in the RER by the % changes in the spot rate and the two CPIs:
(1 + s)(1 + inf∗ )/(1 + inf) − 1.
What more have we learned in this chapter?
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Exchange Rates
Major Markets
The LOP in Spot
Mkts
PPP Rates and Real
Rates
What have we
learned?
In triangular arbitrage, we came across our first
example of replication or synthetic versions of
contracts, and discovered the Law of the Worst
Possible Combination.
Two complementary notions help us interpret S:
– Translation at the PPP rate, ŜPPP := Π/Π∗ , tells us what a FC amount
really means over there, expressed in terms you understand: how
much should I make here to be able to spend as much as that amount
buys there.
– The real rate, RER := S/ŜPPP = [SΠ∗ ]/Π, tells me how much more
expensive the foreign country is.
There are two related PPP notions:
– If RER=1, Absolute PPP is said to hold.
– If the RER is constant, Relative PPP is said to hold.
If absolute price data are missing, we can still approximate the % change
in the RER by the % changes in the spot rate and the two CPIs:
(1 + s)(1 + inf∗ )/(1 + inf) − 1.
What more have we learned in this chapter?
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
Exchange Rates
Major Markets
The LOP in Spot
Mkts
PPP Rates and Real
Rates
What have we
learned?
In triangular arbitrage, we came across our first
example of replication or synthetic versions of
contracts, and discovered the Law of the Worst
Possible Combination.
Two complementary notions help us interpret S:
– Translation at the PPP rate, ŜPPP := Π/Π∗ , tells us what a FC amount
really means over there, expressed in terms you understand: how
much should I make here to be able to spend as much as that amount
buys there.
– The real rate, RER := S/ŜPPP = [SΠ∗ ]/Π, tells me how much more
expensive the foreign country is.
There are two related PPP notions:
– If RER=1, Absolute PPP is said to hold.
– If the RER is constant, Relative PPP is said to hold.
If absolute price data are missing, we can still approximate the % change
in the RER by the % changes in the spot rate and the two CPIs:
(1 + s)(1 + inf∗ )/(1 + inf) − 1.
What more have we learned in this chapter?
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
In practice, real rates are not equal to unity and vary a
lot over time:
Exchange Rates
– Long swings with slow mean-reversion
Major Markets
– Swings are big—the rate can double or even triple in a few years
The LOP in Spot
Mkts
– For mainstream countries, most of the variation of the RER comes
from the nominal rate, and these are hard to predict.
PPP Rates and Real
Rates
What have we
learned?
Implications for the CFO:
– Variations in RER can have a big impact and may force you to change
strategy
– Variations in S may also hurt you via capital losses
– We still need to determine whether hedging adds value, though
– If answer is positive, we need to understand/chose a hedge: forwards,
futures, swaps, options?
What more have we learned in this chapter?
Spot Markets
P. Sercu,
International
Finance: Theory into
Practice
In practice, real rates are not equal to unity and vary a
lot over time:
Exchange Rates
– Long swings with slow mean-reversion
Major Markets
– Swings are big—the rate can double or even triple in a few years
The LOP in Spot
Mkts
– For mainstream countries, most of the variation of the RER comes
from the nominal rate, and these are hard to predict.
PPP Rates and Real
Rates
What have we
learned?
Implications for the CFO:
– Variations in RER can have a big impact and may force you to change
strategy
– Variations in S may also hurt you via capital losses
– We still need to determine whether hedging adds value, though
– If answer is positive, we need to understand/chose a hedge: forwards,
futures, swaps, options?