Multinational Finance - Michigan State University

Multinational Finance - Michigan State University

A classroom exercise to simulate the foreign exchange market Learning objectives To develop practice in dealing with foreign exchange To develop intuition regarding market forces, including arbitrage Market Participants Dealers make a market in fx; that is, quote bid and offer (or ask) prices

Traders trade for their own account Rules of the game Buy low and sell high One contract One million U.S. dollars Trades can be for up to 10 contracts Record each transaction as a purchase or sale Maximum bid-offer spread is 1 basis point (1 bp = 0.0001/$) Dealer quotes are good for 2 minutes Buy low and sell high

Bank A: 0.8220/$ bid and 0.8221/$ ask Bank B: 0.8222/$ bid and 0.8223/$ ask Bank A Bank B 0.8223/$ ask Buy from A 0.8221/$ ask 0.8220/$ bid 0.8222/$ bid Sell to B Arbitrage profit 0.0001/$ Riskless arbitrage profit Buy 1 million dollars from Bank A at their 0.8221/ ask price

Sell 1 million dollars to Bank B at their 0.8222/ bid price Arbitrage Profit = (0.0001/$)($1 million) = 100 with Arbitrage Profit = no net investment and no risk Sample foreign exchange ledger $1 million /$ Cumulative Counterparty contracts 1 Deutsche Bank

2 Citi price balance BUY 1 0.8221 BUY 3 0.8222 +4 3 Barclays SELL 2 0.8223 +2 4 UBS AG SELL 4 0.8223

-2 5 ... +1 Opening prices: 0.8221/$ BID & 0.8222/$ OFFER News announcements The European Central Bank announces that they are buying euros in an effort to stabilize the value of the euro The European Central Bank announces that in

an effort to stimulate economic activity it is lowering short-term Eurozone interest rates The European Central Bank reports that Eurozone money supply increased by 1 billion more than expected in the most recent quarter The Impact of News Events The ECB announces that they are buying euros in an effort to stabilize the value of the euro Supply and demand for the euro S P' P D

D' Q As the demand for euros rises, the dollar will depreciate and the spot rate S/$ will fall The Impact of News Events The ECB announces that in an effort to stimulate economic activity it is lowering short-term Eurozone interest rates This makes it easier for European businesses to borrow and increases economic activity. If this also increases euro inflation, then the value of the euro should fall. This will result in an appreciation of the dollar against the euro. An increase in the domestic discount rate usually, but not always, leads to an increase in the value of the domestic currency.

The Impact of News Events The ECB reports that Eurozone money supply increased by 1 billion more than expected in the most recent quarter This would appear to result in a larger supply of euros and hence a lower value for the euro. However, the increase in the money supply has already occurred and should already be reflected in the market price of the euro. On the other hand, if the ECB is likely to increase the discount rate to slow down the economy, then the euro could rise in anticipation of this monetary policy. If the euro rises against the dollar, then the dollar will fall against the euro.

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