Students name : Kemenangan Tiba
Course number and Name : FIN 456 - International Financial Management
Instructors Name : Brittany Holloman
Date : 19/01/2024
INTERNATIONAL FINANCIAL MARKETS
A. Introduction:
The global financial market is not a foreign matter in global economic relations, which is
a significant part of the financial business between countries, with the existence of global
financial markets certainly facilitating the movement of foreign exchange and capital. In the
majority of domestic financial markets, the need for budget loans and financing is provided
by appropriate domestic creditors or investors. At the extreme where international business
is banned, creditors and investors will be forced to keep their funds within the country.
At the other extreme, the presence of perfect markets without constraints in financial
markets and real wealth markets would lead to creditors and investors conducting business
in a single, integrated market. In this kind of extreme situation, the financial markets would
merge in an international manner to such an extent that there is no market opportunity that is
exclusive to one country. The existence of a fully integrated real wealth market will cause
economic circulation in all countries to move in a seamless manner harmonized direction.
The stunning reality is that the shape of the global financial market lies between these two
extremes. Some barriers restrict real and financial wealth markets from fully integrating,
such as fiscal comparisons, import duties, allocations, the inability of labor to switch,
differences in customs, financial information comparisons, and substantial information
transmission expenses between countries. However, these barriers can also result in
exceptional opportunities for specialized markets to attract a global market of creditors and
investors.
B. DEFINITION OF FINANCIAL MARKETS INTERNATIONAL:
The capital market is a financial market for long-term business budgets and is an actual
market. The capital market is a place where parties, especially industry, sell shares (stock)
and debt securities (bond) with the aim of the marketing results that will later be used as a
budget bonus or to strengthen industrial capital (Fahmi, 2012). The global financial market
is a meeting between consumers and traders whose subjects are related countries, to market
financial products in various methods listed utilization of the stock exchange, by direct
means between traders and consumers (over- the- counter).
C. MARKET GLOBALIZATION FINANCE:
Globalization means the combination (integration) of financial markets around the world
into a global financial market. Due to the globalization of financial markets, potential
investors and issuers do not only conduct business within a limited domestic scope. For Best
profit Future (2018), the factors that urge the creation of financial market integration are:
1.
Deregulation or liberalization of markets and activities of market members in major
financial centers,
2.
Technological developments that enable monitoring of world markets, application of
orders and analysis of financial opportunities,
3.
Increase in financial market institutionalization.
D. FINANCIAL MARKET GROUPINGS WORLD:
From a country perspective, financial markets can be categorized as follows:
1.
Internal market:
The internal market is also known as the national market. This market is also categorized
into domestic markets and foreign markets. The domestic market is the market where the
industry that produces deposit securities is domiciled in the country. The foreign market is
the market where deposit securities are bought and sold from industries that are not
domiciled in the country. Foreign deposit securities are regulated by the authorities in the
country where the deposit securities are distributed. For example, depositary securities
issued in the US by non-US industries are subject to US depositary securities laws. Non-
Japanese industries that wish to issue shares in Japan must comply with the regulations
issued by the Japanese monetary unit. Nicknames have been submitted to various foreign
markets. For example, the foreign market in the United States is often called the Yankee
Market, in Japan the Samurai Market, in the United Kingdom the Bulldog Market, in the
Netherlands the Rembrandt Market and in Spain the Matador Market.
2.
The external market, also known as the global market, includes deposit securities with
the following characteristics:
a.
At the time of issuance, these deposit securities were offered on a regular basis to
investors in various countries, and
b.
The deposit securities are issued outside the jurisdiction of a single country. The
external market is usually called the off shore market, or more popularly the Euro
market (although this market is not limited to Europe, it was only started in Europe).
E. INTERNATIONAL FINANCIAL MARKET DIVERSITY
1.
Eurocurrency Market:
The Eurocurrency market facilitates the transfer of international budgets, especially
those with a short credit duration. In this market, commercial banks act as intermediaries:
accepting short-term deposits in various currencies and then using this money to distribute
short-term loans. Generally business is attempted in the "large trade" type, with large
business values. The principal depositors and borrowers in this market are large industries
and state institutions. Eurocurrency business capacity in a particular zone is generally
related to the size of the international business sector in that zone (Yuliati and Prasetyo,
2005).
The origin of the Eurocurrency market cannot be separated from the emergence of the
Eurodollar market. The Eurodollar market was born because many US industries deposited
US dollars with banks in Europe. Banks located in mainland Europe would want to receive
deposits in dollars because they can then lend the dollars to various customers in Europe.
Since the US dollar is largely used as a medium of exchange in global economic
transactions, there will always be a demand for dollars in Europe. Deposits in US dollars
held at banks in Europe are popularly known as Eurodollars.
The Eurocurrency market is largely comprised of banks in Asia that accept deposits and
make loans in foreign currencies (primarily dollars). The Eurocurrency market in Asia
(often called the Asian market) is focused primarily in Hong Kong and Singapore. The
comparison between the Asian and European Eurocurrency markets is a matter of position.
The Asian dollar market has developed to meet the demands of businesses that use the US
dollar (and other "paper" currencies) as a medium of exchange in global trade. Entrepreneurs
doing business in Asia cannot rely solely on banks in Europe because of the distance and
time difference. Moreover, Singapore's rulers handed out relief tax breaks in the form of
abolition of 40% withholding tax on interest paid to foreigners in 1968 as well as reducing
the tax on their profits especially Asian dollar off shore loans from 40% to 10% in 1973.
This kind of tax relief and elimination had a significant impact on the development of the
Asian dollar market.
2.
Eurocredit Market:
The Eurocredit market caters to budget-strapped parts of the economy, especially in
medium-term installments. Medium-term loan terms are generally more than one year and
the maturity period is usually 5 years. An important comparison between installments in the
Eurocredit and Eurocurrency markets is the duration of the loans. Commercial banks that
function actively in the Eurocurrency market as intermediaries can also play in the
Eurocredit market. Industry and governments usually reap the highest possible budget from
this market. Eurobanks welcome short-term deposits and often make loans over a longer
period of time, so there is often a mismatch between their assets and liabilities. This can
worsen the bank's ability to cope with rising interest rates because they may have borrowed
Eurocredit while the interest rate on deposits that they are obliged to pay tends to increase.
To avoid this, many Eurobanks now use floating interest rates when borrowing Eurocredit
(floating- rate Eurocredit loans). These floating interest rates can be linear with the interest
rate movements of some money markets, which are the interest rates usually charged for the
security of various banks in Europe.
For illustration, a Eurocredit loan could have an interest rate that is matched every 6
months and is pegged at "LIBOR plus 1%". One percent in this illustration is the bonus that
must be paid on top of LIBOR and its size is related to the effect of the borrower's
installments.
3.
Eurobond Market:
The Eurobond market makes it easier to move money over longer periods of time from
those with budget surpluses to those with budget shortfalls. It can be said that the Eurobond
market fills the gap of long-dated budgetary supply that the Eurocurrency and Eurocredit
markets cannot deliver. Some commercial banks participate in this market by purchasing
Eurobonds as capital. An important obligation of these banks is to serve large industries and
authorities in selling debt securities. Typically, these banks place Eurobonds with
institutional investors such as the insurance industry, pension funds, and bond mutual funds.
The emergence of the Eurobond market was partly due to the interest equalizer tax that was
introduced by the US authorities in 1963 to prevent US investors from buying foreign
securities. As a result, borrowers from outside the US who had previously sold securities to
US investors began to turn to markets other than the US. This was the beginning of the
Eurobond market.
4.
International Financial Markets:
International financial markets cater to moving long-term budgets in the form of equity
investments. The prestigious development of the global equity business is largely due to the
emergence of International mutual funds. The latter, not only have more data on foreign
companies, but also have easier access to global markets than private investors. As such,
they can aggregate the budgets of individual investors to create a global stock portfolio.
5.
Currency swaps, futures, options, and forwards markets:
Moving global funds in the global financial market often puts economic executives in a
situation where they can easily suffer from forex risk, interest rate risk, or interest rate risk.
These risks, in application, can be minimized through currency swaps, futures, options, and
forwards markets. Economic operators use these markets to exercise judgment and hedge.
Commercial banks and the deposit securities industry are important intermediaries in the
swap market. The securities industry handles futures and options business.
F. INTENT TO INVEST INTERNATIONAL:
Some general concepts for investors and creditors to penetrate the global financial
market. These concepts have been proven to suppress the internationalization of financial
markets.
1.
The investor concept carries out capitalization in the global market:
a.
Economic situation: companies in certain countries generally want the ability to be more
profitable by operating in other countries.
b.
The desire for foreign exchange: the majority of investors buy securities denominated in
a currency whose value is expected to appreciate in the currency of the investor's
country. From the perspective of foreign investors, this kind of capitalization ability is
closely linked to the movement of currency rates.
c.
Global diversification: large investors may benefit from diversifying their portfolio
wealth in a global way. It is an empirical fact that a significant amount of risk reduction
can seriously take place in global diversification. The benefits in the form of risk
reduction can be explained by the comparison of economic situations between countries,
as a result of which all the portfolios of an investor are not only related to the economic
situation of a country. Not only that, access to foreign markets also allows investors to
invest in a wider range of industries that may not be available in the country.
2.
Creditor concept to provide installments in global markets
a.
High global interest rates: many countries are experiencing a shortage of loanable funds,
which in turn leads to relatively high domestic interest rates. This kind of situation
would urge foreign creditors to try to capitalize on it by offering capital to the country's
market. High domestic interest rates reflect the high inflationary dreams of the country.
This is because inflation can lead to the depreciation of the local currency against
foreign currencies.
The high interest rates in the country could have been capped by the weakening of the
local currency during that particular timeframe.
b.
desire for foreign exchange: creditors generally think of supplying capital to countries
whose currency is expected to appreciate against the currency of the creditor's country.
Whether the form of business attempted takes the form of debt securities or a global
loan, the creditor will benefit if the currency leading the transaction appreciates against
the currency of the creditor's country.
c.
Global diversification: creditors can benefit from global diversification, which reduces
the likelihood of borrowers going bankrupt at the same time. The effectiveness of this
type of strategy is related to the relationship of economic activity between countries.
Diversification between countries will be less efficient if the countries in question tend
to experience similar business cycles.
G. MOTIVES FOR USING INTERNATIONAL FINANCIAL MARKETS:
The presence of constraints prevents real asset markets or financial assets from merging
in a perfect way. These constraints include tax comparisons, entry tariffs, allocations, labor
migration difficulties, differences in customs, differences in financial reporting, and hefty
information communication budgets between countries. But the existence of these limits
also shares opportunities that can attract foreign creditors and investors. The existence of
such boundaries makes the economic situation of one country different from another. The
characteristics of the economy of a country that shares the advantages of attracting foreign
creditors and investors to do business in that country. This results in the internationalization
of financial markets.
1.
Some concepts for distributing credit in foreign markets:
a.
High foreign interest rates. Some countries face a shortage of borrowed funds, resulting
in high interest rates in the country.
b.
Estimated currency rates. In general, creditors want to put their capital in a country
where the currency is expected to strengthen against the currency of the loan. Creditors
want to benefit when the currency of the loan strengthens against the currency of the
collector.
c.
Global diversification. The advantage of global verification is that it can reduce the
likelihood of a borrower's downturn at the same time. If the countries to which the loans
are given tend to have uniform effort cycles then diversification will be less profitable.
2.
Some concepts for borrowing from foreign markets:
a.
Small interest rates. Some countries have fairly large budget reserves which results in
relatively small interest rates. Borrowers will seek to borrow funds from creditors in that
country because of the lower interest rates.
b.
Estimated foreign exchange rates. If the local currency is about to depreciate to the
foreign currency, the MNC will want to borrow in the local currency. The reverse is
also true.
H. SUMMARY MATERIAL:
1.
The international financial market is a meeting between consumers and traders whose
subjects are related countries, to market financial products in a variety of methods including
the use of stock exchanges, in a direct way between traders and consumers.
2.
The factors that push for financial market integration are:
a.
Deregulation or liberalization of markets and activities of market members in major
financial centers,
b.
Technological developments that enable monitoring of world markets, application of
orders and analysis of financial opportunities,
c.
Increase in financial market institutionalization.
3.
The internal market is the market within the national scope. This market is also categorized
into domestic markets and foreign markets. The domestic market is the market where the
industry that produces deposit securities is domiciled in the country. The foreign market is
the market where deposit securities are bought and sold from industries that are not
domiciled of the country. The external market, also known as the global market, includes
deposit securities with the following characteristics:
a.
At the time of issuance, these deposit securities were offered on a regular basis to
investors in various countries, and
b.
The deposit securities are issued outside the jurisdiction of a single country. The
external market is usually called the off shore market, or more popularly the Euromarket
(although this market is not limited to Europe, it only started in Europe).
4.
Types of international financial markets:
a.
Eurocurrency Market
b.
Eurocredit Market
c.
Eurobond Market
d.
International Financial Markets
e.
Currency swaps, futures, options, and forwards markets
5.
Some general concepts for investors and creditors to penetrate the global financial market.
These concepts have been proven to suppress the internationalization of financial markets.
TASKS AND EVALUATION:
1.
What are international financial markets?
2.
Explain the importance of companies transacting in international financial markets!
3.
Explain the factors in the formation of international financial markets!
4.
Explain the types of international financial markets!
5.
What are the motives of financial transactions in international capital markets, explain
and give examples!
FORWARD CONTRACT
A. Introduction:
For multinational companies that use foreign currencies in some of their transactions,
there is a risk of changes in foreign exchange rates. Changes in exchange rates or foreign
currencies that are volatile can have an impact on the level of profitability, net cash flow,
and market value of the company.
However, the risk that will occur due to changes in exchange rates can be mitigated by
hedging using several hedging techniques as follows:
1.
Forward contract:
An agreement between a commercial bank and its client regarding the exchange of two
currencies to be made at some future time (with a range of 1,2,3,6 and 12 months) at a
certain rate set at present, but delivery is made at a future time, as agreed.
2.
Future Contract:
an agreement to trade/exchange Forex, where the delivery of Forex is made in the future, in
a certain amount, a certain time, a certain place and a certain price.
3.
Option Contract:
Options give the forex holder the right to choose to buy (Call) or sell (Put) a certain
currency, so transactions in the Options market do not have to be followed by settlement.
Understanding the use of appropriate hedging techniques is very necessary to be
mastered by practitioners in the field, especially financial managers. Because companies that
conduct cross-border transactions such as multinational companies that have export-import
transactions will generally be faced with the risk of changes in foreign exchange rates, or
have foreign exchange exposure. And the risk of exchange rate changes will have a potential
impact on the level of profitability, net cash flow and market value of the company. To
discuss further about foreign exchange hedging techniques and derivatives, we will explain
each of the following sub-discussions.
B. MARKET FORWARD:
Forward contract, is an agreement between a commercial bank and its client regarding
the exchange of two currencies to be carried out at a future time (with a range of 1,2,3,6 and
12 months) at a certain rate set at this time, but delivery is made at a future time, as agreed.
Forward rate & Forward market arises because of the uncertainty and fluctuations in
foreign exchange rates due to the implementation of the floating rate system (Floating Rate),
so many banking companies and business entities hold Forward Contracts, this aims to
protect international trade & financial transactions from the risk of loss & from forex traders
who speculate for the purpose of seeking profits from fluctuations in Forward Rate.
Sample Problem:
PT Gajah Mada Indonesia purchases goods from Wolfpack & Co in Germany, with a
contract value of DEM 1,000,000, with a payment term of 3 months yad. To reduce the risk
of uncertainty in the exchange rate of IDR against DEM (3 months yad), PT GMI can buy
DEM 1,000,000 in the Forward market with a time of 3 months. If it is known that the Spot
Rate today, Nov. 16th. 2009 = IDR 4,125/DEM & Forward Rate for 3 months yad (Feb 16,
2010) is IDR 4,210/DEM. Since it is expected that DEM will appreciate against Rupiah
(IDR), PT GMI enters into a Forward contract for 3 months yad.
Ask:
How many Rupiah should PT GMI pay to get DEM 1,000,000 on February 16, 2010
Answer:
On February 16, 2010 PT.GMI will pay DEM 1,000,000 x IDR 4.210/DEM = IDR
4,210,000,000, If the spot rate today February 16, 2010 IDR 4.275/DEM then PT.GMI will
pay DEM 1,000,000 x IDR 4.275 = IDR 4,275,000,000.
(if PT.GMI does not enter into a Forward contract then PT.GMI will suffer a loss of IDR
4,275,000 - IDR 4,210 million = IDR 65 million.
C. MARKET FUTURES:
Currency Future Market (CFM) is an agreement to trade/exchange Forex, where the
delivery of forex is made in the future, in a certain amount, a certain time, a certain place
and a certain price. CFM is used by businessmen forex traders to hedge their forex positions
or to speculate on making profits against fluctuations in the Forward Rate.Currency Future
Contract trading transactions are carried out face to face on the trading floor prepared by the
International Monetary Market (IMM) through a broker, which is different from Forward
Contracts which are negotiated over the phone.
CFM maturity dates are every Wednesday of the 3rd week of March, June, September
and December. Brokers who execute buy/sell orders for Currency Futures contracts charge a
transaction fee in the form of a bid-ask spread, i.e. they buy a Currency Futures contract at a
"Buy" price and simultaneously sell the contract to another party at a slightly higher price
(the "Sell" price). The difference between the buy and sell price of the smallest Futures
contract can be as much as $7.5, but this amount is a larger % of the transaction fee for the
Forward contract Example Problem:
On October 15, 2009 Charlie & Co in the US requires GBP 575,000 in funds for a period
of 40 days later, or on November 25, 2009. In this case Charlie & Co can protect/maintain
its forex position by doing CFM:
1.
The closest IMM Contract option was on Wednesday of the 3rd week of December
2009.
2.
For the purpose of the funds mentioned above, Charlie & Co can choose 2 possible
CFM purchases as follows:
a.
Purchase 9 x Future Contracts -9 x GBP 62,500 = GBP 562,500
b.
Purchase 10 x Future Contract - 10 x GBP 62,500 = GBP 625,000
This way Charlie & Co. will get certainty and avoid the possible risk of loss, due to GBP
appreciation.
D. CURRENCY OPTIONS MARKET ( MARKET/COM):
COM is to give the forex holder the right to choose to buy (Call) or sell (Put) a certain
currency, so transactions in the Options market do not have to be followed by the settlement
of the transaction.
There are 2 types of options:
1.
Call options are: granting the option holder the right to buy a currency at a certain
agreed exchange rate called the Strike price/Exercise price.
2.
Put Options are: granting the option holder the right to sell the currency at a certain
agreed exchange rate called the Strike price/Exercise price.
Some conclusions to facilitate the understanding of option types are as follows:
1.
Option one
a.
Call Option Buyers, will exercise their rights if the Strike price < Spot Rate.
b.
Put option holders, will exercise their rights if the Strike price >
Spot Rate.
c.
In both the above conditions, the call option & put option holders are said to be in the
money because
both options bring in cash inflows.
2.
Option two
a.
Call Option Buyers, will not exercise their rights if Strike price > Spot Rate.
b.
Put option holders, will not exercise their rights if the strike price is below the strike
price.
< Spot Rate.
c.
In both of the above conditions,
holders of call options & put options are said to be out of the money because both
options do not bring in cash inflows.
3.
Holders of Call Options & Put options are called At the Money, if Strike Price = Spot rate,
because in this condition the holders of both options will not feel the difference, whether to
exercise their rights or not.
To make it easier to see the cash flow conditions, here is an example of a transaction in
the Currency Option Market (COM)
E. SPECULATIVE ACTIVITIES WITH OPTIONS:
Speculation is an investment approach where the investor aims to buy or sell stocks,
currencies or other assets solely to make a quick profit. In this case, companies or investors
carry out speculation activities by means of options. As follows.
1.
Speculate in Currency Call Option:
Exercising the right to buy currency at a certain agreed exchange rate called the Strike
price/Exercise price.
a.
November 16, 2009 Mr. Jim (speculator) purchased a Pound Call Option that has a
Strike Price of $1.40 and a maturity date of December 16, 2009.
b.
Spot rate on November 16, 2009 was $1.39
c.
Mr. Jim pays a premium of $0.012 per unit Call Option
(assuming no brokerage fees)
d.
On December 10th, the British Pound spot rate reached $1.41
e.
At this point Mr. Jim exercises his option and then immediately sells the Pound in the
Spot Market to a bank.
To determine the Profit/Loss experienced by Mr. Jim (buyer), we must:
a.
Calculate revenue from the sale of Pounds.
b.
Reduced by the pound purchase price when the option is exercised (-)
c.
Reduced by purchase premium (-)
•
The calculation is as follows (assuming 1 standard pound options contract consists of 31,250
units)
•
Formula Profit= Sales Price- Purchase Price- Premium
option purchase
To determine the Profit/Loss experienced by Mrs. Linda (seller), we must:
a.
Calculate revenue from the sale of Pounds.
b.
Reduced by the Pound purchase price at the time the option is exercised. (-)
c.
Plus purchase premium (+)
2.
Speculate in Currency Put Option:
Exercising the right to sell the currency at a certain agreed exchange rate called the
Strike price/Exercise price.
Unknown:
a.
British Pound Put Option Premium = $0.04 per unit
b.
Strike Price = $1.40
c.
The option contract represents $31,250
d.
The current spot rate is $1.30 Based on this information, the net profit received by the
buyer of the Put Option.
F. Material Summary:
Multinational companies that use foreign currencies in some of their transactions are at
risk of changes in foreign exchange rates. Changes in exchange rates or fluctuating foreign
currencies can have an impact on the level of profitability, net cash flow, and market value
of the company. The use of appropriate hedging techniques really needs to be mastered by
practitioners in the field, especially financial managers. Because companies that conduct
cross-border transactions such as multinational companies that have export-import
transactions will generally be faced with the risk of changes in foreign exchange rates, or
have foreign exchange exposure. And the risk of exchange rate changes will have a potential
impact on the level of profitability, net cash flow and market value of the company. The
currency hedging and derivative techniques include the Forward Market, the Futures
Market, the Currency Option Market (COM), and speculative activities with options.
TASKS AND EVALUATION:
1.
Speculate in Currency Call Option
Unknown:
a.
November 20, 2009 Mr. Jhon purchased a Pound Call Option with Strike Price $1.45 &
maturity date on December 20, 2009
b.
Spot rate on November 20, 2009 was $1.44
c.
Mr. Jhon pays a premium of $0.12 per Call Option unit
d.
On December 15, the spot rate of the British pound reached $1.46.
e.
At this point Mr. Jhon exercises his option and then immediately sells the Pound in the
Spot Market to a bank.
Ask: calculate how much profit is received by the buyer & seller
2.
Speculate in Currency Put Option,
Unknown:
a.
British Pound Put Option Premium = $0.07 per unit
b.
Strike Price = $1.43
c.
The option contract represents £31,250
d.
Current spot rate $1.33
Ask: Calculate how much profit is received by the buyer & seller?
ARBITRAGE AND INTEREST RATE PARITY
A. Introduction:
Currently, trade between countries is in a state of limitlessness due to the effects of
globalization. The emergence of international companies or Multi National Corporation
(MNC) is evidence of the expansion of business activities between countries and even
between continents. Along with the expansion of international economic activities, the use
of foreign currencies or forex is also increasing. The value of forex is always changing or
fluctuating. Changes in the value of forex are caused by many things, among others;
inflation rates, people's income levels, interest rates, government control over the economy,
including people's expectations or estimates of future economic conditions also affect
changes in currency exchange rates.
The existence of forex changes will encourage efforts to obtain the maximum profit or
known as "International Arbitrage". In principle, an arbitrageur or arbitregeur will buying
a commodity, in this case a currency, at the lowest possible price and then selling it at the
highest possible price in order to make a profit. So an arbitrageur always expects currency
differentials to be high and unstable. This has led to the implementation of the law of one
price where trade in goods and services, including other commodities between countries
must have the same transaction costs around the world. Therefore, the exchange rate
between domestic currency and domestic commodities should be the same as the exchange
rate between domestic currency and foreign commodities, in other words, one unit of
domestic currency should have the same purchasing power around the world.
Changes in exchange rates and interest rates are interrelated in an equilibrium pattern
known as Interest Rate Parity (IRP). Interest rate of parity is used as one of the
considerations of investors in measuring the level of profit to be obtained in investing in
different currencies.
B. DEFINITION OF ARBITRATION:
Arbitrage can generally be defined as an attempt to profit from the difference between
two financial markets. There is a transaction adjustment where the profit obtained comes
from the difference in the price of one financial market and the other. In arbitrage, the term
"risk free profit" is known, which is a condition in which there will be no negative cash flow
under any circumstances and a positive cash flow in at least one circumstance the arbitragee
is called arbitrageur in English. Arbitrage occurs in various commodities and financial
instruments such as bonds, stocks, derivatives, and currencies.
Arbitrage in foreign exchange occurs due to differences in the exchange rate of the same
currency in several different places, such as at different banks or dealers. Arbitrage activities
will eventually cause the exchange rate to be the same in different places.
C. CHARACTERISTICS OF ARBITRATION:
The occurrence of arbitration will be possible under the following conditions:
1.
The same asset does not trade at the same price in every market.
2.
Two assets with identical cash flows do not trade at the same price.
3.
An asset with a known forward contract value, where the asset is not currently trading at
the forward contract price less a discount based on risk-free interest rates (or there are
non-negligible warehouse storage costs for the asset).
In the real world, arbitrage opportunities rarely arise. Forex traders usually have
advanced computer equipment or programs to automate the process. So, that minimizes the
gains due to transaction processing time lags. Also, arbitrage opportunities are reduced due
to the transaction costs involved. The price difference between exchange rates is very, very
small. Therefore, for this arbitrage to be feasible, the transaction must involve a very large
volume. Most of the times, transactions utilize margin trading to amplify returns. In
addition, a forex trader must be aware of transaction costs. High transaction costs have the
potential to wipe out profits from price differences.
D. TYPES OF ARBITRATION:
There are several types of arbitration, including:
1.
Merger Arbitration or merger arbitration:
Combined arbitrage or merger arbitrage will occur when two companies or two
divisions become one in an effort to balance the company's financial profits. Although
usually the company or division that does not make a profit will be acquired by the company
so that the one that makes a profit is the stronger company. This merger is what makes the
term merger arbitrage the risk of this arbitrage is if the deal fails and the price range
becomes very wide.
2.
Convertible bond arbitration:
In the Convertible Bond Arbitrage type, investors can return the bond to the issuing
company in exchange for a predetermined number of shares in the company. A Convertible
Bond is like a private bond with a stock option attached to it. The price of the convertible
bond itself is very sensitive to three things:
a.
Interest rate
If interest rates move up, the price of convertible bonds will move down, but the call
option portion of the convertible bonds will increase and the overall price will tend to
decrease.
b.
Share price
If the price of shares that can be converted from bonds moves up, the price of bonds
will tend to rise.
c.
Credit spread bonds.
If the creditworthiness of the issuer decreases (e.g. the credit rating is downgraded)
and the range of credit spreads widens, then bond prices tend to move down.
3.
Depository Receipts:
Depository receipts are securities that are offered in lieu of shares on foreign markets
due to the limited amount of capital and investors on local exchanges, e.g. an Indian
company wants to raise money so it can issue depository receipts on the New York Stock
Exchange. Depository receipts type arbitrage generally occurs in stock or foreign exchange
markets that have a control function. This makes stock and foreign exchange trading profit-
optimized. In another sense, these depository receipts act as a security that is offered as a
share follower in the foreign market. This security itself is known as ADR (American
Depository Receipts).
Please also note that there will be a difference between the stated value and the actual
value. ADRs that are traded at a lower value will make the person who buys the ADRs
profitable. However, there will be a risk if the value of the stock drops
4.
Arbitration Rules:
Regulatory arbitrage is a form of decision taken by companies when financial risk
occurs. This arbitrage is taken to benefit from the difference between real risk or economic
risk and the existing regulatory position. An example is when applying for a loan from the
company to the bank. The company must follow the rules to get a bank loan. On the other
hand, the company also faces the risk of default, although the risk is small because they
apply good securities.
E. TYPES OF ARBITRATION IN FOREIGN EXCHANGE:
1.
Local Arbitrage:
Local Arbitrage is the process of buying currency in a particular location where it is
cheap and immediately selling the currency in another location at a higher price. The
profitability of local arbitrage depends on the amount of money used to capitalize on
exchange rate differences, as well as the value of those differences. The concept of local
arbitrage is relevant because it explains why exchange rates between banks in different
locations generally do not differ much. This concept applies not only to banks located on the
same street or in the same city but also to all banks around the world. Technology allows
foreign exchange rates at banks to be directly connected. Here's an example of location
arbitrage:
1)
With this information, is arbitration possible?
2)
If yes, explain the steps involved in the arbitration!
3)
Calculate the profit earned from the arbitrage if you have $1,000,000 in funds
2.
Triangular Arbitrage:
It is a type of arbitrage that is done by comparing cross exchange rates between 3
different locations. Its activity runs for 24 hours from Monday to Friday, due to the time
difference between various international financial centers.
Example:
An investor or capital owner in Jakarta wants to make a profit by doing triangular
arbitrage. He contacted his forex dealer to enter into a forex trading contract with one of the
BNI banks for USD 1,000,000.
From the mutation above, it turns out that with a capital of USD 1,000,000.00 (Paris) in
the end investors get a result of USD 1,237,500 (New York). This means that investors get a
profit of USD 237,500 before deducting commissions, transfer fees in a short time.
3.
Covered Interest Arbitrage:
It is the process of utilizing the interest rate differential between two countries to hedge
against exchange rate risk.
Example:
Data or information known to a USD fund investor
2,000,000 as follows:
a.
Spot rate: USD 1.50/GBP
b.
90-day forward rate: USD 1.49/GBP
c.
Interest rate in the USA: 2 %
d.
Interest rates abroad: 4 %
With the above information, investors will conduct the CIA by way of:
a.
Convert USD 1,000,000 into GBP at the Spot rate of USD 1.50/GBP, thus: 2,000,000
X 1/ 1.50= GBP 1,333,333.33
b.
Invest 90 days in a GBP security with an interest rate of 4%, so that on the maturity
date it will earn:
GBP 1,333,333.33 X 1.04 X 90/360= GBP 346,666.66
c.
At the same time as the above investment, a GBP forward contract is made with a
forward rate of USD 1.49 / GBP, so that it becomes: 346,666.66 X USD 1.49 = USD
516533.32
d.
Whereas if the investment is made domestically (USA), the investor will only get:
USD 2,000,000.00 X 1.02 X 90/360= USD 500,000
This means that by doing CIA the investor can get a profit of : USD 516533.32-USD
500,000= USD 16533.32
F. INTEREST RATE PARITY:
Interest rate parity, or sometimes known as the International Fisher Effect, is a
theoretical identity, and usually follows from assumptions imposed in economic models.
Interest rate parity is:
a.
Parity is the payment made for the use of a certain amount of money.
b.
The interest rate is the amount Parity pays per unit of time or one has to pay for the
opportunity to borrow money.
The International Rate Of Parity (IRP) theory states that the difference in interest rates
(securities) at IMM = Forward rate premium/discount.
G. MATERIAL SUMMARY:
1.
Arbitrage is an attempt to profit from differences in the value of foreign exchange.
2.
Arbitrage in foreign exchange occurs due to differences in the exchange rate of the same
currency in several different places, such as at different banks or dealers. Arbitrage activities
will eventually cause the exchange rate to be the same in different places.
3.
The occurrence of arbitration will be possible under the following conditions:
a.
The same asset does not trade at the same price in every market.
b.
Two assets with identical cash flows do not trade at the same price.
c.
An asset with a known forward contract value, where the asset is not currently trading at
the forward contract price less a discount based on risk-free interest rates (or there are
non-negligible warehouse storage costs for the asset).
4.
There are 3 types of forex arbitrage, including:
a.
Local Arbitrage
Location Arbitrage is the process of buying currency in a particular location where it is
cheap and immediately selling the currency in another location at a higher price.
b.
Triangular Arbitrage
Is a type of arbitrage that is done by comparing
cross exchange rate between 3 different locations.
c.
Covered Interest Arbitrage is the process of utilizing the interest rate differential
between two countries to protect against exchange rate risk.
5.
The International Rate of Parity (IRP) theory states that the difference in interest rates
(securities) at IMM = Forward rate premium/discount.
6.
Investors will invest or keep funds in foreign currency deposits if the foreign rate of return
(rf) is equal to or at least higher than the domestic interest rate / home country interest.
TASKS AND EVALUATION:
1.
In real life, it is not easy for an arbitrator to make large profits in arbitration activities.
Explain the conditions that allow an arbitrator to earn a sizable amount of profit!
2.
There are several conditions that make triangular arbitrage possible, explain the conditions
for triangular arbitrage opportunities!
3.
Explain the relationship between the theory of Interest Rate Parity and the decision to invest
or deposit funds by an investor!
4.
The information on the buying and selling rates of two banks is as follows:
a.
With this information, is arbitration possible?
b.
If yes, explain the steps involved in the arbitration!
c.
Calculate the profit earned from the arbitrage if you have $1,000,000 in funds
5.
Below is the exchange rate and interest rate in 1 year: If you have $100,000 to invest for one
year. Will you benefit from interest rate protection arbitrage?
