Arbitrage
purchase of securities or commodities on one market for immediate resale on another in order to profit from a price discrepancy
Arbitrageurs
market participants who seek to earn risk-free profits by taking advantage of differences in prices of assets, commodities, or interest rates between markets.
At-the-Money Option
Exercise (strike price) = Spot exchange rate. No Profit Change.
Balance of Payments
net value of ALL economic transactions - including trade in goods, transfer payments, loans, and investments - between residents of the same country and those of all other countries.
Calculate the Appreciation and Depreciation of Money-
� Increases 17.2%
Old: $0.93/�1
New: $1.09/�1
Appreciation/Depreciation: 1.09-0.93/0.93 =17.20%
$ Decreases 14.68%
Call Options
contract that gives the holder the right - not the obligation - to buy a given asset, such as currency, at a set price and expiration date.
Capital Account
Net result of public and private international investment and lending activities.
Capital Markets Imperfections
distortions in the pricing of risk, usually attributable to government regulations and asymmetries in the treatment of different types of investment income.
Central Bank
nation's official monetary authority, it's job is to use the instruments of monetary policy, including the sole power to create money, to achieve one or more of the following: price stability, low interest rates, or a target currency value.
Tools: Interes
Chicago Mercantile Exchange
largest market in the world for trading standardized futures and options contracts on a wide variety of commodities, including currencies and bonds.
Competitive Devaluations
also known as a currency war, strategically devaluing currency to make imports more expensive, leading to an increase in employment and domestic industry
Cross Rate
the exchange rate between two currencies, neither of which is the US dollar, calculated by using the dollar rates for both currencies.
$/� ? �/� ? $/�?
CAD/EUR = 1.3497/1
MXN/EUR = 18.0103/1
What is the exchange rate of the Mexican Peso to the Canadian do
Currency Arbitrage
taking advantage of divergences in exchange rates in different money markets by buying a currency in one and selling it in another.
Currency Futures
contract for future delivery of a specific quantity of a given currency, with the exchange rate fixed at the time the contract is entered. Futures contracts are similar to forward contracts except that hey are traded on organized futures exchanges and the
Currency Options
a financial contract that gives the buyer the right, but not the obligation, to buy (call) or sell (put) a specified number of foreign currency units to the option seller at a fixed dollar price, up to the option's expiration date.
Currency Swap
Debt denominated in a currency is swapped for debt denominated in a 2nd different currency
Principal is swapped at beginning and end
Interest payments are swapped
Reduce interest cost and exchange rate risk
Current Account
net flow of goods, services, and unilateral transactions (gifts) between countries.
Devaluation
decrease in the spot value of a currency
Direct Quotation
gives the home currency price of a foreign currency
If the base currency is something other than your home currency
$0.012251/�
Economic Risk
Risk based on the economic stability of a country (this is somewhat related to political risk)
Eurocurrency
a currency deposited in a bank outside the country of its origin
European Central Bank
the central bank for the European Monetary Union. It has the sole power to issue a single European currency called the euro.
European Monetary System
monetary system formed by the major European countries under which the members agreed to maintain their exchange rates within a specific margin around agreed-upon, fixed central exchange rates. These central exchange rates were denominated in currency uni
Exchange Rate
the price of one nation's currency in terms of another currency.
Fiat Money
nonconvertible paper money backed only by faith that the monetary authorities will not cheat (by issuing more money).
Financial Account
a balance-of-payments account that records inflows and outflows of capital
Fischer Effect
states that the nominal interest differential between two countries should equal the inflation differential between those counties
I.e. Nominal Interest Rates= real rate of return + inflation premium
Inflation increases; interest increases
Inflation decre
Fixed-Rate System
exchange rate system whereby exchange rates are set by the governments involved
Floating Currency
value is set by market forces
Foreign Direct Investment
the acquisition abroad of physical assets such as plant and equipment, with operation control residing in the parent corporation.
Foreign Exchange Market
market in which one currency is traded for another currency
Foreign Exchange Risk
variability of a firm's (or asset's) value that is due to uncertain exchange rate changes.
Forward Contract
agreement between a bank and a customer (which could be another bank) that calls for delivery, at a fixed future date, of a specified amount of one currency against dollar payment; the exchange rate is fixed at the time the contract is entered into.
Forward Discount
forward rate < spot rate
Forward Market
contracts are made to buy or sell currencies for future delivery
Forward Premium
forward rate > spot rate
Forward Prices
same as forward rate
Forward Rate
the rate quoted today for delivery at a fixed future date of a specified amount of one currency against dollar payments.
Free Float
an exchange rate system characterized by the absence if government intervention. Aka clean float
Freely Floating Exchange Rate
the exchange rate that prevails in the absence of government intervention in the foreign exchange market.
Futures Contract
standardized contracts for delivery of specific quantities of currencies or other commodities that trade on organized futures markets for specific delivery dates only. The price and the delivery date are fixed at the time the contract is entered into
G-7 Nations
United States, France, Japan, Great Britain, Germany + Italy and Canada
Globalization
the process of doing business - sourcing inputs and making and selling goods - on a global rather than domestic basis.
Hedgers
market participants, mostly multinational firms, who engage in forward contracts to protect the home currency value of various foreign currency,denominated assets and liabilities on their balance sheets that are not to be realized over the life of the con
In-the-Money Option
Exercise (strike price) < Spot exchange rate
Profit
Indirect Quotation
gives the foreign currency price of the home currency if the base currency is the home currency
�81.63/$
Interest Rate Differential
difference in interest rates between two countries
Interest Rate Parity
the interest differential between two currencies is equal to the forward differential between two currencies
Country A: Interest Rate 1%
Country B: Interest Rate 4%
Country B would have a forward discount by 3%
Country A would have a forward premium
Count
Interest Rate Swap
Debt denominated in one currency is swapped for debt denominated in the same currency. No Principal is swapped. Net interest payments are swapped. Reduce interest cost
International Fischer Effect
the interest differential between two countries should be an unbiased predictor of the future change in the spot rate.
interest increases; currency decreases
interest decreases; currency increases
Combines the Fisher Effect and Purchasing Power Parity
Cou
International Monetary Fund
international organization created at Bretton Woods, NH, in 1944 to promote exchange rate stability, including the provision of temporary assistances to member nations trying to defend their currencies against transitory phenomena.
International Monetary System
the set of policies, institutions, practices, regulations and mechanisms that determine the rate at which one currency is exchanged for another.
Law of One Price
theory that exchange-adjusted prices on identical tradable goods and financial assets must be within transaction costs of equality worldwide
Is enforced through Arbitrage
London Interbank Offered Rate (LIBOR)
the deposit rate on interbank transactions in the Eurocurrency market.
Managed Float
aka dirty float. This is a system of floating exchange rates with central bank intervention to reduce currency fluctuations
Monetary Base
a measure of the money supply that is equal to the amount of currency in circulation plus bank reserves.
Monetization of Debt (Deficit)
financing the public-sector deficit by buying government debt with newly created money, thereby expanding the money supply and lending to inflation.
Nominal Interest Rate
the price quoted on lending and borrowing transactions. It is expressed as the rate of exchange between current and future units of currency unadjusted for inflation.
Open-Market Operation
purchase or sale of government securities by the monetary authorities to increase or decrease the domestic money supply.
Out-of-the-Money Option
Exercise (strike price) > Spot exchange rate Loss
Pegged Currency
value set by government
Political Risk
uncertain government action that affects the value of a firm
Privatization
the act of returning state-owned or state-run companies back to the private sector, usually by selling them off.
Protectionism
protecting domestic industry from import competition by means tariffs, quotas, and other trade barriers.
Purchasing Power Parity
the ratio between domestic and foreign price levels should equal the equilibrium exchange rate between domestic and foreign currencies.
Currencies with higher rates of inflation should depreciate to currencies with lower rates of inflation
interest increa
Put Options
contract that gives the holder the right - not the obligation - to sell (put) another financial instrument at a set price and expiration date.
Real Exchange Rate
the spot rate adjusted for relative price level changes since a base period (inflation adjusted).
Real Interest Rate
the nominal interest rate adjusted for expected inflation over the life of the loan; it is the exchange rate between current and future goods.
Revaluation
an increase in the spot value of currency
Settlement Risk
the risk that a bank will deliver currency on one side of a foreign exchange deal only to find that its counterparty has not sent any money in return.
Speculators
participants who actively expose themselves to currency risk by buying or selling currencies forward in order to profit from exchange. Their participation depends on prevailing forward rates and their expectations for spot exchange rates in the future.
Spot Market
market in which currencies are traded for immediate delivery, which is actually within two business days after the transaction has been concluded.
Spot Prices
same as spot rate
Spot Rate
the price at which foreign exchange can be bought or sold with payment set for the same day.
Sterilized Intervention
foreign exchange market intervention in which the monetary authorities have insulated their domestic money supplies from the foreign exchange transactions with offsetting sales or purchase of domestic assets.
Systematic Risk
non-diversifiable. The element of an asset's risk that cannot be eliminated no matter how diversified an investor's portfolio.
Trade Deficit
A current account deficit (a country is importing more than it is exporting)
Trade Surplus
A current account surplus ( a country is exporting more than it is importing)
Traders
in the forward market, the category of participants who use forward contracts to eliminate or cover the risk of loss on export or import orders that are denominated in foreign currencies.
Unsterilized Intervention
foreign exchange market intervention in which the monetary authorities have not insulated their domestic money supplies from the foreign exchange transactions.
Unsystematic Risk
diversifiable. That element of risk that can be eliminated by holding a well-diversified portfolio.
World Bank
a bank that offers its services (specifically loans) to developing countries and to businesses entering new developing markets