Survey
* Your assessment is very important for improving the workof artificial intelligence, which forms the content of this project
* Your assessment is very important for improving the workof artificial intelligence, which forms the content of this project
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: !"##$%& !' 34,%* B*!*" B*(*'@,* J)%H0K)%H L%D)%$@,* 24,(,++,%$@ 2*#*H"*' ?H'+MA#*,%$ B)(D*.* M#"H"*' R"@@,* U)N,%,!*%0R$+ C#,0I*%A* J)%D"#*@ Y"(H*#,* C().*A,* 2)(*%D V4*,(*%D C)"-40E/#,!* 2*A,@-*% Z$%$Q"$(* 3)@-*0R,!* [*+*% C,%H*+)#$ \"*-$N*(* E#H$%-,%* \$)#H,* V*,P*% ()!*( +#,!$ '"*% 5678 +*!*-* 5575 #,%HH,878 5< D)((*# #"+,* 5>G66 +$@) 98 H"*#*%, ;666 +)"%D ;78 4#'.%* 978 ($" <: +$@) ><7: #"F($ >9 +$@) G6 #"+$$ 5;6 ($N+,#* :87;8 ($. <7;; ()#"%* 89 Q()-' G78 F*4G6 #*%D 5:7;8 #"+$$ 5:6 F)(,.*# 8=65 !)()% 55:6 '$% <86 D)((*# :7G ]"$-Q*( 5=7<8 +$@) = (*#, >758 D)((*# =8 *!-"*( .*("$ )/01 222 #*-$ )/01 976: :7:; =7;; :789 :7G: 57== =7=8 :79= ;:<8 >=6;7G9 8<7G <=7>< 8868 <;6:7<: 87== :76G 8768 <7=> 5:7< =7>< <:7; 5:7G8 <=75 587>9 :<7G 5;7:8 56: G57<; 597; 557G6 578> 67;G <;78 597=5 :75 <756 <97> 5;7:8 G7G >786 G675 >57;> <G:6 59:;76: 856 :G>78< 55< 967G8 578; 575G =78; 878G :76G <7<G 579 57:> :<75 <>75; #$*( #*-$ )/01 <7:=5 <7<:5 <76>G <766< 57;96 57;59 579;G 5799: 579>< 57==; 57=8< 57=86 57G9> 57G95 57G:6 578;= 578== 57>=9 57>G= 57>G= 57>:: 57>:6 57:;; 57:9; 57:G; 57:G> 57:88 57:>8 57:<= *!-"*( .*("$ ,%01 675<8 675<8 67<=8 675<; 67666 6765; 67666 675=: 675;9 676=G 676>< 676:= 676:5 67656 6768: 67G>; 676:> 67:<: 676:8 6758< 6765= 67666 6766< 6766; 67G<; 675:< 67:<= 6788G 676:5 222 #*-$ ,%01 #$*( #*-$ ,%01 67<;8 67<=; 678G> 67<89 67666 676:G 67666 67:<G 67:G8 675:8 676=: 676G8 6768< 6765G 6769G 576:= 6768: 67>== 6768< 67<<< 676<> 67665 6766: 6765< 679G5 67596 67>>: 67=>= 676>5 67><< 67>>9 67>9; 67>;; 67868 678<5 678<= 678:5 678>: 678G< 678=5 678=5 678;> 678;8 67G5> 67G<G 67G:> 67G=G 67G9< 67G9< 67G;9 67G;; 67=58 67=<6 67=:6 67=:: 67=:9 67=>> 67=8> ?@-)%,* C*"D,0E#*F,* I,-4"*%,* E"@-#*(,* ME? I*-.,* B$O,!) 3)()NF,* 3#)*-,* C)"-40K)#$* 3Q$!40R$+ S,T" J"%H*#' V"#A$' W$P0X$*(*%D C().$%,* E#"F* Y#*Q,( B)#)!!) 2$#" 34,($ M%,-$D0@-*-$@ 3*%*D* Y#,-*,% ?"#)(*%D CP$D$% U$%N*#A CP,-Q$#(*%D L!$(*%D W)#P*' !"##$%& !' ()!*( +#,!$ A#))% #,'*( (,-*@ D)((*# D,#4*N (*-@ +$@) +$@) A"%* P)% A)#"%* D)((*# /)#,%(,#$ D)((*# -)(*# /()#,% #$*( D,#4*N %$P0@)( +$@) D)((*# D)((*# +)"%D $"#) A#)%* A#)%$ /#*%! A#)%"# A#)%$# <;78 ; G78 :7<8 ; 57:8 <; G866 58 <866 8;768 >7G8 8G6 >7< >7>8 8<6 >7;8 G7> <>78 ;78 58G6 :75 :78< 57;> <7;> :: <=7=8 G7: >8; >: *!-"*( .*("$ )/01 222 #*-$ )/01 5<7: ;78< :7=8 <7;6 <7G; <756 57:: 5768 :7G= <7;6 6788 67>> 557: ;7:8 <86> <6;G7== 87=< >79> ;8< 96G7>8 <<75 5;768 57=: 5786 <6G 5967G8 578> 57:8 57G< 57>> 59; 5G=7=> 57=; 57G6 <7: <76G 97=5 =7;6 :7<G :76G 8:6 86:7<: 5 5766 575< 575> 678:< 67G: 67=95 67;8 =7<9 567G8 879< 97;8 57<5 <76: =< 5>976G G75 5:79= #$*( #*-$ )/01 57<;: 57<;< 57<9: 57<G; 57<G> 57<G: 57<69 575;> 5759< 57596 575G6 5758: 575>6 575:= 575<; 575<= 575<5 5755> 5756< 576G> 5768: 57666 67;9G 67986 679<> 67G9> 67G86 678;8 67>9G 67>>6 *!-"*( .*("$ ,%01 67695 67<G= 67:=< 67=8< 67<=< 57959 67699 67666 675=8 67665 676>8 678=9 67668 67G>; 67G5= 67668 6788; 67>:8 67558 67:6= 6766< 57666 679;: 57996 57<96 675:= 675=< 679<G 6765> 675G> 222 #*-$ ,%01 #$*( #*-$ ,%01 67568 67:>> 67>== 67;8> 67:>> <7<;G 6756= 67666 67<6= 67665 6768< 67GG= 6766G 67=:9 67G;= 6766G 67G<G 67>9> 675<= 67:<G 6766< 57666 67995 578;9 5768> 676;> 6755< 67>;< 6766= 676=< 67==> 67==> 67==; 67=99 67=;5 67=;< 679<9 679:= 679>G 679>= 679G< 679G= 679== 67996 6799G 67999 679;< 679;9 67;6= 67;>6 67;>; 57666 5765> 575=G 57<5> 57>G< 578:9 57G96 <768G <7<=> 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 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? 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?