微信客服：xiaoxionga100
微信客服：ITCS521
FINS3616-无代写
时间：2023-10-12
UNSW Sydney
FINS3616
International Business Finance
T3,2023
Lecture 2
Mohamad Mourad – Lecturer in Charge
(m.mourad@unsw.edu.au)
Lecture 2 –
Schedule
• The Foreign Exchange (FX)
Market.
• The Real Exchange Rate.
• The theory of Purchasing Power
Parity (PPP) and the International
Parity Conditions.
• Law of One Price (LOOP).
• Absolute Purchasing Power Parity
(APPP).
• Relative Purchasing Power Parity
(RPPP).
• Week 2 BONUS Exercise.
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616
International Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any
way, shape or form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity
or individual, however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distributio d r -us of thes n tes outsid the cop f t e course, in any way, shape or form
is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual, however
defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
The Foreign Exchange (FX) Market
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
The Foreign Exchange Market
- The foreign exchange market is the de-centralised space where all currencies are
traded.
- The FX market facilitates the purchasing power denominated in one currency to be
obtained. For example, an individual sells USD for Chinese Renminbi, that individual
is selling USD-denominated purchasing power and buying Renminbi-denominated
purchasing power.
- Approximately 95% of currency transactions are channeled through the interbank
market. The interbank market is normally referred to as the FX market. Approximately
20 banks dominate the interbank market.
- Trading is done via the Society for Worldwide Interbank Financial Telecommunications
(SWIFT). Swift links 11,000 banks and institutions in more than 200 countries.
- The wholesale market is where the major banks trade – Operates from major financial
cities: e.g. London, New York, Tokyo, 24 hours/day.
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
The Size of the Foreign Exchange Market
Source: BIS, Savills, Sifma and others. Please email me if you’d like the exact source links.
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Contracts Traded on the Foreign Exchange Market
Contracts traded on the FX market are:
- Spot contracts: Currencies traded for immediate delivery. Immediate delivery
officially means the currencies are traded literally within two business days following
the concluding of the transaction.
- Forward contracts and futures: Buying or selling currencies for future delivery.
- Swap contracts: a combination of a spot contract and forward contract.
- Derivatives: contracts that derive value from changes in the underlying asset’s value.
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Foreign Exchange Rate Quotations
- When the trading of currencies involves the USD, quotations can be on:
- There are two ways in which foreign currency exchange rates are quoted:
American Terms
Number of USD per unit
of foreign currency.
For example: the AUD
rate in American terms:
USD 0.75/AUD.
European Terms
Number of foreign
currency units per USD.
For example:
AUD1.333/USD.
Direct Quote
Direct AUD quote in
Australia is the number of
AUD per USD
Indirect Quote
Indirect AUD quote in
Australia is the number of
USD per AUD.
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Participants in the FX Market
- Foreign exchange dealers
oMajor commercial and investment banks
oMarket makers: actively dealing in foreign exchange for their own accounts.
- Foreign exchange brokers:
o Intermediaries: match supplier and demander banks
oReceive commission on trades.
- Other participants:
oMultinational corporations
oCentral banks
oPrivate individuals
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Bid Exchange Rate and Ask Exchange Rate
- In practice there is no such thing as “the exchange rate”.
- When market participants buy and sell one currency for another, they will see a bid
exchange rate and an ask exchange rate. For example:
- The bid rate is the ______ that the market maker is willing to pay for the ______
currency.
- The ask rate is the ________ that the market maker is willing to pay for the ______
currency.
- The reciprocal of the AUD bid rate is _____________________.
- The reciprocal of the AUD ask rate is _____________________.
Bid Ask
Spot Rate USD0.768/AUD USD0.774/AUD
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Bid Rate and Ask Rate
- The magnitude of the bid-ask spread depends on:
o currency’s market size,
o volatility of currency values, and
omarket uncertainty
- What is the implication of market uncertainty? Forward spreads > Spot spreads.
Why do we have bid exchange rates and ask exchange rates for currencies?
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Bid-Ask Exchange Rate Spread – Example 1
- Suppose we have the following spot exchange rates between the GBP and the USD:
USD1.2022−31/GBP
- The bid spot rate will be: USD1.2022/GBP.
- The ask spot rate will be: USD1.2031/GBP.
- The percentage spread is expressed (in the course textbook) as:
=
−
× 100
- In the example above, the bid-ask spread will be:
=
1.2031/GBP − 1.2022/GBP
1.2031/GBP
× 100 = 0.075%
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Cross Exchange Rate – Example 1
- The cross exchange rate is also known as the ‘cross currency triangulation’. The cross
exchange rate arises from the fact that most currencies are not traded against one
another in the interbank market. In other words, it relates to foreign currency
exchanges not involving the USD.
- Another way of seeing this is the exchange rate between two currencies is based on
the exchange rate between each of these two currencies and a third currency, usually
the USD.
- For example: USD1.53/EUR and USD0.96/CHF. What is the CHF/EUR exchange
rate?
=
1
0.96
×
1.53
1.04167
×
1.53
=
1.59375
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Cross Exchange Rate – Example 2
- You are at the foreign exchange market in New York, where the spot rates for the
Renminbi (RMB) and AUD are quoted at RMB8.522/USD and AUD1.371/USD,
respectively. What is the RMB/AUD spot rate?
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Triangular Arbitrage
- Triangular currency arbitrage profiting from exchange rate inconsistencies or
mispricing across money markets involving three currencies.
- In equilibrium, we must have:
/ = / × /
/ × / × / = 1
- If the product of the 3 exchange rate quotations is ≠ 1, then the law of one price
(LOOP) is not satisfied and profit can be made through arbitrage.
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Triangular Arbitrage – Example 1
- Suppose you observe the exchange rates for AUD, USD, and CNY:
1.282/
4.03/
0.21/
- Can we make a riskless profit from these quotations? We need to first establish
whether the law of one price (LOOP) holds.
1.282/ × 4.03/ × 0.21/ = 1.085 > 1
Strategy to exploit the disparity:
1. Sell 1 USD for 1.282 AUD
2. Then sell 1.282 AUD for 5.16646 CNY ( = 1.282 x 4.03)
3. sell 5.16646 CNY for 1.085 USD ( = 5.16646 x 0.21)
You have earned 1.085 USD – 1 USD = 0.085USD.
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Triangular Arbitrage – Example 2 (For You)
- Suppose you observe the exchange rates for JPY, EUR, and THB:
138.06/
0.26/
38.84/
- Can we make a riskless profit from these quotations? We need to first establish
whether the law of one price (LOOP) holds.
What do you obtain if
you take the
reciprocal of the
product of the three
prices?
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Triangular Arbitrage – Stylised Visual
Shapiro textbook page 270. 10th Edition
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Triangular Arbitrage with Bid-Ask Rates – Example 1
- What is the arbitrage opportunity?
Direction 1 around the “triangle”:
- Sell GBP and buy USD at
- Sell USD and buy MYR at
- Sell MYR and buy GBP at
Bid Rate Ask Rate
USD1.60/GBP USD1.61/GBP
USD0.200/MYR USD0.201/MYR
MYR8.10/GBP MYR8.20/GBP
- Thus, the return obtained is:
GBP
USDMYR
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Triangular Arbitrage with Bid-Ask Rates – Example 1
- What is the arbitrage opportunity?
Direction 2 around the “triangle”:
- Sell GBP and buy MYR at
- Sell MYR and buy USD at
- Sell USD and buy GBP at
Bid Rate Ask Rate
USD1.60/GBP USD1.61/GBP
USD0.200/MYR USD0.201/MYR
MYR8.10/GBP MYR8.20/GBP
- Thus, the return obtained is:
GBP
USDMYR
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Triangular Arbitrage with Bid-Ask Rates – Example 1
- What does the comparison of the implied bid and ask rates to the quoted bid and ask
rates (for a selected currency pair) reveal?
Bid Rate Ask Rate
USD1.60/GBP USD1.61/GBP
USD0.200/MYR USD0.201/MYR
MYR8.10/GBP MYR8.20/GBP
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Triangular Arbitrage with Bid-Ask Rates – Example 2
- The following table contains the spot rates for selected currencies. Determine whether
a riskless arbitrage opportunity exists. If one does exist, then what is the profit made?
- You are to show calculations for both ways around the triangle and also the implied
spread approach.
Bid Rate Ask Rate
EUR1.38705/USD EUR1.38710/USD
GBP1.59440/USD GBP1.59455/USD
EUR0.86975/GBP EUR0.86990/GBP
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Triangular Arbitrage with Bid-Ask Rates – Example 2
- Working out space
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Forward Rates and Forward Points
- Consider the following spot exchange rates along with the 30-day, 90-day and 180-
day forward quotes:
- If the -day forward bid rate < -day forward ask rate, then the currency being
expressed (i.e. the base currency) is at a forward premium. Thus, we ADD the points
to spot rate.
- If the -day forward bid rate > -day forward ask rate, then the currency being
expressed (i.e. the base currency) is at a forward discount. Thus, we SUBTRACT the
points from the spot rate.
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Forwards Rates and Spot Rates
- If AUD forward rate > AUD spot rate , then the AUD is at a forward premium.
- If AUD forward rate < AUD spot rate, then the AUD is at a forward discount.
=
−
×
360
- If the 180-day forward AUD is priced at USD0.796/AUD, and the spot rate is
USD0.790/AUD, what is the (annualized) forward premium?
=
0.796/ − 0.790/
0.790/
×
360
180
= 0.015 1.52%
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
The Real Exchange Rate
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
The Real Exchange Rate (RER)
Using the USD and the AUD as currencies, the real exchange rate is expressed as:
=
/ ×
= /
1 +
1 +
where:
= the price level in Australia.
= the price level in the US.
/= the nominal exchange rate
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Understanding the Real Exchange Rate
Suppose the price level in Australia is AUD120, the price level in the US is USD145 and
the nominal exchange rate is USD0.70/AUD. What is the real exchange rate?
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Purchasing Power Parity (PPP) and the International
Parity Conditions
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
The Parity Conditions in International Macroeconomics
- A set of theoretical relationships that, in equilibrium, explain product prices, interest
rates, spot rates and forward exchange rates.
- In a perfect world, arbitrage will ensure all relationships are in equilibrium.
- In the next two weeks, we will discuss the 6 theoretical economic relationships:
1. Absolute Purchasing Power Parity (APPP)
2. Relative Purchasing Power Parity (RPPP)
3. Fisher Effect (FE)
4. International Fisher Effect (IFE)
5. Interest Rate Parity (IRP)
6. Unbiased Forward Rate Hypothesis (UFR)
- However, everything starts from the Law of One Price (LOOP).
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
The Law of One Price (LOOP)
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
The Law of One Price (LOOP)
Consider the following footballs sold in period :
Since the two footballs are identical, that means that their respective currency
denominated prices are identical. Thus, on a per unit basis we can derive the exchange
rate between the British pound and the Australian dollar:
GBP50
90.75
= GBP0.551/AUD or
90.75
GBP50
= AUD1.815/GBP
UK price: GBP50 Price in Australia = AUD90.75
Sold in the UK Sold in Australia
=
= ==
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
International Parity Condition 1:
Absolute Purchasing Power Parity (APPP)
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Absolute Purchasing Power Parity (APPP)
- The fundamental basis of all exchange rates.
- PPP theory stipulates that an identical basket of goods should sell for the same price
regardless of where that basket is sold. However, strictly speaking, the price of the
representative basket is actually the price level.
- Purchasing-power parity implies that exchange rates are determined by the value of
goods that currencies can buy. APPP is expressed as:
= /
- It is the natural extension of the law of one price (LOOP) which is expressed as:
= / ∀
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Absolute Purchasing Power Parity (APPP)
Consider the following basket of goods and services (representing the goods
consumed):
Since the two baskets are identical, that means that their respective currency
denominated prices must be identical. Thus, on a per unit basis we can derive the
exchange rate between the British pound and the Australian dollar:
GBP758
1,376
= GBP0.551/AUD or
1,376
GBP758
= 1.815/GBP
UK price: GBP758 Price in Australia = AUD1,376
Sold in the UK Sold in Australia
=
=
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Internal Purchasing Power & External Purchasing Power
- Under APPP:
internal purchasing power = external purchasing power
- Another way of saying this is: 1 of any currency must have the same purchasing
power worldwide.
- If external PP > internal PP → Overvalued currency – Buy goods abroad and sell
them at home – Overvalued currencies must weaken (depreciate).
- If internal PP > external PP → Undervalued currency – Buy goods at home and sell
them abroad – Undervalued currencies must strengthen (appreciate).
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Internal PP and External PP – Exercise (For You)
- Suppose that the aggregate price level in Greece is EUR1,618 per consumption
bundle, the price level in Argentina is ARS178,593 per consumption bundle, and the
spot exchange rate is ARS203.27/EUR. If you have EUR45,000 where would you
prefer to spend this money? Which currency is overvalued?
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Comparing the PPP-implied spot rate with the spot rate
- If the PPP-implied spot rate () > the actual spot rate on the FX market, then the
currency being expressed is undervalued. We expect that ____________________.
- If the PPP-implied spot rate () < the actual spot rate on the FX market, then the
currency being expressed is overvalued. We expect that ____________________.
- If the PPP-implied spot rate () = the actual spot rate on the FX market, then the
currency being expressed is fairly valued.
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Comparing the PPP Implied Rate & the Actual Rate
Source: The World Bank, Macrotrends.
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Comparing the PPP Implied Rate & the Actual Rate
Source: OECD, Macrotrends.
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Comparing the PPP Implied Rate & the Actual Rate
Source: The World Bank, Macrotrends.
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Reasons for Deviation from PPP
Firstly let’s consider what are the assumptions behind PPP:
- Perfectly competitive markets.
- Identical goods.
- No transaction costs by any party in exchange.
- No tariffs or quotas.
Other reasons include:
- The price indices used to measure PPP may use different weights or different goods
and services.
- Since some goods and services used in the indices are not traded, there could be
price discrepancies between countries.
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
International Parity Condition 2:
Relative Purchasing Power Parity (RPPP)
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Relative PPP (RPPP)
- Changes in exchange rates between two currencies reflect changes in the two
countries’ price levels (inflation/deflation). The one-period expression for RPPP is:
(1 + ℎ
)
1 +
ℎ/ = (ℎ/)
- If ℎ/ is the spot rate and (ℎ/,) is the expected spot rate at time , then relative
PPP implies:
1 + ℎ
1 +
ℎ/ = (ℎ/,)
- Currencies with high expected inflation rates should depreciate relative to currencies
with lower inflation rates.
- However, what assumption does this multi-period expression of RPPP make?
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Relative PPP (RPPP) – Example 1
- Suppose the USD/AUD exchange rate is USD0.79/AUD at time = 0, and expected
inflation rates in the US and Australia are 3% and 10%, respectively. What is the
forecast exchange rate for = 1?
1 +
1 +
/ = (/)
1 + 0.03 1
1 + 0.10 1
0.79/ = 0.7397/
- Notice, that since the expected rate of inflation in Australia is higher than that of the
US, the Australian dollar has depreciated against the USD.
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Relative PPP (RPPP) – Example 2
- Suppose the EUR/GBP exchange rate is EUR1.19/GBP at time = 0, and expected
inflation rates in the UK and Germany are 5% and 2%, respectively. What is the
forecast exchange rate for = 1?
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
RPPP Exchange Rate – Example 1
- Between 2005 and 2022, the NZD/USD exchange rate changed from NZD1.904/USD
to NZD1.788/USD. The price level in New Zealand increased from 105.77 to 118.83,
while the price level in the US increased from 88.93 to 111.25.
- What should the PPP NZD/USD exchange rate be in 2022?
118.83
105.77
111.25
88.93
1.904/ = 1.710/
- Thus, there is a ________% divergence between what materialized and what PPP
theory predicted should materialize.
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
RPPP Exchange Rate – Example 2
- Between 2015 and 2022, the DKK/CHF exchange rate changed from DKK7.4705/CHF
to DKK6.8429/CHF. The price level in Switzerland changed from 104.53 to 116.96,
while the price level in Denmark changed from 110.78 to 105.31.
- What should the PPP DKK/CHF exchange rate be in 2022?
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
The Generalised RPPP Equation
- There is no reason to assume that expectations of inflation rates are constant per
period. In practice, expectations change.
- Thus, the -period formulation of RPPP is:
ς=1
1 + ℎ,
ς=1
1 + ,
ℎ/ = ℎ/,
- This expression of RPPP is general and allows for both constant and non-constant
expectations of the rate of inflation in a country.
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Week 2 BONUS Exercise
You are a fund manager and see the following spot
rates:
€0.8171/USD
USD1.4650/£
€1.1910/£
Suppose you have $5,000,000. Can you make a
profit? If yes, what is your return?
FINS3616
International Business Finance
T3,2023
Lecture 2
Mohamad Mourad – Lecturer in Charge
(m.mourad@unsw.edu.au)
Lecture 2 –
Schedule
• The Foreign Exchange (FX)
Market.
• The Real Exchange Rate.
• The theory of Purchasing Power
Parity (PPP) and the International
Parity Conditions.
• Law of One Price (LOOP).
• Absolute Purchasing Power Parity
(APPP).
• Relative Purchasing Power Parity
(RPPP).
• Week 2 BONUS Exercise.
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616
International Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any
way, shape or form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity
or individual, however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distributio d r -us of thes n tes outsid the cop f t e course, in any way, shape or form
is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual, however
defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
The Foreign Exchange (FX) Market
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
The Foreign Exchange Market
- The foreign exchange market is the de-centralised space where all currencies are
traded.
- The FX market facilitates the purchasing power denominated in one currency to be
obtained. For example, an individual sells USD for Chinese Renminbi, that individual
is selling USD-denominated purchasing power and buying Renminbi-denominated
purchasing power.
- Approximately 95% of currency transactions are channeled through the interbank
market. The interbank market is normally referred to as the FX market. Approximately
20 banks dominate the interbank market.
- Trading is done via the Society for Worldwide Interbank Financial Telecommunications
(SWIFT). Swift links 11,000 banks and institutions in more than 200 countries.
- The wholesale market is where the major banks trade – Operates from major financial
cities: e.g. London, New York, Tokyo, 24 hours/day.
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
The Size of the Foreign Exchange Market
Source: BIS, Savills, Sifma and others. Please email me if you’d like the exact source links.
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Contracts Traded on the Foreign Exchange Market
Contracts traded on the FX market are:
- Spot contracts: Currencies traded for immediate delivery. Immediate delivery
officially means the currencies are traded literally within two business days following
the concluding of the transaction.
- Forward contracts and futures: Buying or selling currencies for future delivery.
- Swap contracts: a combination of a spot contract and forward contract.
- Derivatives: contracts that derive value from changes in the underlying asset’s value.
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Foreign Exchange Rate Quotations
- When the trading of currencies involves the USD, quotations can be on:
- There are two ways in which foreign currency exchange rates are quoted:
American Terms
Number of USD per unit
of foreign currency.
For example: the AUD
rate in American terms:
USD 0.75/AUD.
European Terms
Number of foreign
currency units per USD.
For example:
AUD1.333/USD.
Direct Quote
Direct AUD quote in
Australia is the number of
AUD per USD
Indirect Quote
Indirect AUD quote in
Australia is the number of
USD per AUD.
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Participants in the FX Market
- Foreign exchange dealers
oMajor commercial and investment banks
oMarket makers: actively dealing in foreign exchange for their own accounts.
- Foreign exchange brokers:
o Intermediaries: match supplier and demander banks
oReceive commission on trades.
- Other participants:
oMultinational corporations
oCentral banks
oPrivate individuals
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Bid Exchange Rate and Ask Exchange Rate
- In practice there is no such thing as “the exchange rate”.
- When market participants buy and sell one currency for another, they will see a bid
exchange rate and an ask exchange rate. For example:
- The bid rate is the ______ that the market maker is willing to pay for the ______
currency.
- The ask rate is the ________ that the market maker is willing to pay for the ______
currency.
- The reciprocal of the AUD bid rate is _____________________.
- The reciprocal of the AUD ask rate is _____________________.
Bid Ask
Spot Rate USD0.768/AUD USD0.774/AUD
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Bid Rate and Ask Rate
- The magnitude of the bid-ask spread depends on:
o currency’s market size,
o volatility of currency values, and
omarket uncertainty
- What is the implication of market uncertainty? Forward spreads > Spot spreads.
Why do we have bid exchange rates and ask exchange rates for currencies?
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Bid-Ask Exchange Rate Spread – Example 1
- Suppose we have the following spot exchange rates between the GBP and the USD:
USD1.2022−31/GBP
- The bid spot rate will be: USD1.2022/GBP.
- The ask spot rate will be: USD1.2031/GBP.
- The percentage spread is expressed (in the course textbook) as:
=
−
× 100
- In the example above, the bid-ask spread will be:
=
1.2031/GBP − 1.2022/GBP
1.2031/GBP
× 100 = 0.075%
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Cross Exchange Rate – Example 1
- The cross exchange rate is also known as the ‘cross currency triangulation’. The cross
exchange rate arises from the fact that most currencies are not traded against one
another in the interbank market. In other words, it relates to foreign currency
exchanges not involving the USD.
- Another way of seeing this is the exchange rate between two currencies is based on
the exchange rate between each of these two currencies and a third currency, usually
the USD.
- For example: USD1.53/EUR and USD0.96/CHF. What is the CHF/EUR exchange
rate?
=
1
0.96
×
1.53
1.04167
×
1.53
=
1.59375
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Cross Exchange Rate – Example 2
- You are at the foreign exchange market in New York, where the spot rates for the
Renminbi (RMB) and AUD are quoted at RMB8.522/USD and AUD1.371/USD,
respectively. What is the RMB/AUD spot rate?
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Triangular Arbitrage
- Triangular currency arbitrage profiting from exchange rate inconsistencies or
mispricing across money markets involving three currencies.
- In equilibrium, we must have:
/ = / × /
/ × / × / = 1
- If the product of the 3 exchange rate quotations is ≠ 1, then the law of one price
(LOOP) is not satisfied and profit can be made through arbitrage.
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Triangular Arbitrage – Example 1
- Suppose you observe the exchange rates for AUD, USD, and CNY:
1.282/
4.03/
0.21/
- Can we make a riskless profit from these quotations? We need to first establish
whether the law of one price (LOOP) holds.
1.282/ × 4.03/ × 0.21/ = 1.085 > 1
Strategy to exploit the disparity:
1. Sell 1 USD for 1.282 AUD
2. Then sell 1.282 AUD for 5.16646 CNY ( = 1.282 x 4.03)
3. sell 5.16646 CNY for 1.085 USD ( = 5.16646 x 0.21)
You have earned 1.085 USD – 1 USD = 0.085USD.
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Triangular Arbitrage – Example 2 (For You)
- Suppose you observe the exchange rates for JPY, EUR, and THB:
138.06/
0.26/
38.84/
- Can we make a riskless profit from these quotations? We need to first establish
whether the law of one price (LOOP) holds.
What do you obtain if
you take the
reciprocal of the
product of the three
prices?
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Triangular Arbitrage – Stylised Visual
Shapiro textbook page 270. 10th Edition
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Triangular Arbitrage with Bid-Ask Rates – Example 1
- What is the arbitrage opportunity?
Direction 1 around the “triangle”:
- Sell GBP and buy USD at
- Sell USD and buy MYR at
- Sell MYR and buy GBP at
Bid Rate Ask Rate
USD1.60/GBP USD1.61/GBP
USD0.200/MYR USD0.201/MYR
MYR8.10/GBP MYR8.20/GBP
- Thus, the return obtained is:
GBP
USDMYR
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Triangular Arbitrage with Bid-Ask Rates – Example 1
- What is the arbitrage opportunity?
Direction 2 around the “triangle”:
- Sell GBP and buy MYR at
- Sell MYR and buy USD at
- Sell USD and buy GBP at
Bid Rate Ask Rate
USD1.60/GBP USD1.61/GBP
USD0.200/MYR USD0.201/MYR
MYR8.10/GBP MYR8.20/GBP
- Thus, the return obtained is:
GBP
USDMYR
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Triangular Arbitrage with Bid-Ask Rates – Example 1
- What does the comparison of the implied bid and ask rates to the quoted bid and ask
rates (for a selected currency pair) reveal?
Bid Rate Ask Rate
USD1.60/GBP USD1.61/GBP
USD0.200/MYR USD0.201/MYR
MYR8.10/GBP MYR8.20/GBP
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Triangular Arbitrage with Bid-Ask Rates – Example 2
- The following table contains the spot rates for selected currencies. Determine whether
a riskless arbitrage opportunity exists. If one does exist, then what is the profit made?
- You are to show calculations for both ways around the triangle and also the implied
spread approach.
Bid Rate Ask Rate
EUR1.38705/USD EUR1.38710/USD
GBP1.59440/USD GBP1.59455/USD
EUR0.86975/GBP EUR0.86990/GBP
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Triangular Arbitrage with Bid-Ask Rates – Example 2
- Working out space
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Forward Rates and Forward Points
- Consider the following spot exchange rates along with the 30-day, 90-day and 180-
day forward quotes:
- If the -day forward bid rate < -day forward ask rate, then the currency being
expressed (i.e. the base currency) is at a forward premium. Thus, we ADD the points
to spot rate.
- If the -day forward bid rate > -day forward ask rate, then the currency being
expressed (i.e. the base currency) is at a forward discount. Thus, we SUBTRACT the
points from the spot rate.
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Forwards Rates and Spot Rates
- If AUD forward rate > AUD spot rate , then the AUD is at a forward premium.
- If AUD forward rate < AUD spot rate, then the AUD is at a forward discount.
=
−
×
360
- If the 180-day forward AUD is priced at USD0.796/AUD, and the spot rate is
USD0.790/AUD, what is the (annualized) forward premium?
=
0.796/ − 0.790/
0.790/
×
360
180
= 0.015 1.52%
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
The Real Exchange Rate
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
The Real Exchange Rate (RER)
Using the USD and the AUD as currencies, the real exchange rate is expressed as:
=
/ ×
= /
1 +
1 +
where:
= the price level in Australia.
= the price level in the US.
/= the nominal exchange rate
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Understanding the Real Exchange Rate
Suppose the price level in Australia is AUD120, the price level in the US is USD145 and
the nominal exchange rate is USD0.70/AUD. What is the real exchange rate?
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Purchasing Power Parity (PPP) and the International
Parity Conditions
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
The Parity Conditions in International Macroeconomics
- A set of theoretical relationships that, in equilibrium, explain product prices, interest
rates, spot rates and forward exchange rates.
- In a perfect world, arbitrage will ensure all relationships are in equilibrium.
- In the next two weeks, we will discuss the 6 theoretical economic relationships:
1. Absolute Purchasing Power Parity (APPP)
2. Relative Purchasing Power Parity (RPPP)
3. Fisher Effect (FE)
4. International Fisher Effect (IFE)
5. Interest Rate Parity (IRP)
6. Unbiased Forward Rate Hypothesis (UFR)
- However, everything starts from the Law of One Price (LOOP).
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
The Law of One Price (LOOP)
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
The Law of One Price (LOOP)
Consider the following footballs sold in period :
Since the two footballs are identical, that means that their respective currency
denominated prices are identical. Thus, on a per unit basis we can derive the exchange
rate between the British pound and the Australian dollar:
GBP50
90.75
= GBP0.551/AUD or
90.75
GBP50
= AUD1.815/GBP
UK price: GBP50 Price in Australia = AUD90.75
Sold in the UK Sold in Australia
=
= ==
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
International Parity Condition 1:
Absolute Purchasing Power Parity (APPP)
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Absolute Purchasing Power Parity (APPP)
- The fundamental basis of all exchange rates.
- PPP theory stipulates that an identical basket of goods should sell for the same price
regardless of where that basket is sold. However, strictly speaking, the price of the
representative basket is actually the price level.
- Purchasing-power parity implies that exchange rates are determined by the value of
goods that currencies can buy. APPP is expressed as:
= /
- It is the natural extension of the law of one price (LOOP) which is expressed as:
= / ∀
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Absolute Purchasing Power Parity (APPP)
Consider the following basket of goods and services (representing the goods
consumed):
Since the two baskets are identical, that means that their respective currency
denominated prices must be identical. Thus, on a per unit basis we can derive the
exchange rate between the British pound and the Australian dollar:
GBP758
1,376
= GBP0.551/AUD or
1,376
GBP758
= 1.815/GBP
UK price: GBP758 Price in Australia = AUD1,376
Sold in the UK Sold in Australia
=
=
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Internal Purchasing Power & External Purchasing Power
- Under APPP:
internal purchasing power = external purchasing power
- Another way of saying this is: 1 of any currency must have the same purchasing
power worldwide.
- If external PP > internal PP → Overvalued currency – Buy goods abroad and sell
them at home – Overvalued currencies must weaken (depreciate).
- If internal PP > external PP → Undervalued currency – Buy goods at home and sell
them abroad – Undervalued currencies must strengthen (appreciate).
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Internal PP and External PP – Exercise (For You)
- Suppose that the aggregate price level in Greece is EUR1,618 per consumption
bundle, the price level in Argentina is ARS178,593 per consumption bundle, and the
spot exchange rate is ARS203.27/EUR. If you have EUR45,000 where would you
prefer to spend this money? Which currency is overvalued?
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Comparing the PPP-implied spot rate with the spot rate
- If the PPP-implied spot rate () > the actual spot rate on the FX market, then the
currency being expressed is undervalued. We expect that ____________________.
- If the PPP-implied spot rate () < the actual spot rate on the FX market, then the
currency being expressed is overvalued. We expect that ____________________.
- If the PPP-implied spot rate () = the actual spot rate on the FX market, then the
currency being expressed is fairly valued.
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Comparing the PPP Implied Rate & the Actual Rate
Source: The World Bank, Macrotrends.
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Comparing the PPP Implied Rate & the Actual Rate
Source: OECD, Macrotrends.
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Comparing the PPP Implied Rate & the Actual Rate
Source: The World Bank, Macrotrends.
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Reasons for Deviation from PPP
Firstly let’s consider what are the assumptions behind PPP:
- Perfectly competitive markets.
- Identical goods.
- No transaction costs by any party in exchange.
- No tariffs or quotas.
Other reasons include:
- The price indices used to measure PPP may use different weights or different goods
and services.
- Since some goods and services used in the indices are not traded, there could be
price discrepancies between countries.
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
International Parity Condition 2:
Relative Purchasing Power Parity (RPPP)
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Relative PPP (RPPP)
- Changes in exchange rates between two currencies reflect changes in the two
countries’ price levels (inflation/deflation). The one-period expression for RPPP is:
(1 + ℎ
)
1 +
ℎ/ = (ℎ/)
- If ℎ/ is the spot rate and (ℎ/,) is the expected spot rate at time , then relative
PPP implies:
1 + ℎ
1 +
ℎ/ = (ℎ/,)
- Currencies with high expected inflation rates should depreciate relative to currencies
with lower inflation rates.
- However, what assumption does this multi-period expression of RPPP make?
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Relative PPP (RPPP) – Example 1
- Suppose the USD/AUD exchange rate is USD0.79/AUD at time = 0, and expected
inflation rates in the US and Australia are 3% and 10%, respectively. What is the
forecast exchange rate for = 1?
1 +
1 +
/ = (/)
1 + 0.03 1
1 + 0.10 1
0.79/ = 0.7397/
- Notice, that since the expected rate of inflation in Australia is higher than that of the
US, the Australian dollar has depreciated against the USD.
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Relative PPP (RPPP) – Example 2
- Suppose the EUR/GBP exchange rate is EUR1.19/GBP at time = 0, and expected
inflation rates in the UK and Germany are 5% and 2%, respectively. What is the
forecast exchange rate for = 1?
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
RPPP Exchange Rate – Example 1
- Between 2005 and 2022, the NZD/USD exchange rate changed from NZD1.904/USD
to NZD1.788/USD. The price level in New Zealand increased from 105.77 to 118.83,
while the price level in the US increased from 88.93 to 111.25.
- What should the PPP NZD/USD exchange rate be in 2022?
118.83
105.77
111.25
88.93
1.904/ = 1.710/
- Thus, there is a ________% divergence between what materialized and what PPP
theory predicted should materialize.
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
RPPP Exchange Rate – Example 2
- Between 2015 and 2022, the DKK/CHF exchange rate changed from DKK7.4705/CHF
to DKK6.8429/CHF. The price level in Switzerland changed from 104.53 to 116.96,
while the price level in Denmark changed from 110.78 to 105.31.
- What should the PPP DKK/CHF exchange rate be in 2022?
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
The Generalised RPPP Equation
- There is no reason to assume that expectations of inflation rates are constant per
period. In practice, expectations change.
- Thus, the -period formulation of RPPP is:
ς=1
1 + ℎ,
ς=1
1 + ,
ℎ/ = ℎ/,
- This expression of RPPP is general and allows for both constant and non-constant
expectations of the rate of inflation in a country.
Note: These notes are property of the author (Mohamad Mourad). They are for the exclusive use of students enrolled in FINS3616 International
Business Finance for Term 3,2023. Reproduction, distribution and re-use of these notes outside the scope of the course, in any way, shape or
form is strictly prohibited. The author and UNSW bear no responsibility for any loss, injury or claims made by any party, entity or individual,
however defined, if these notes are used in valuations or providing investment advice for private or commercial purposes.
Week 2 BONUS Exercise
You are a fund manager and see the following spot
rates:
€0.8171/USD
USD1.4650/£
€1.1910/£
Suppose you have $5,000,000. Can you make a
profit? If yes, what is your return?
