CHAPTER 16 Foreign Exchange Derivative Market. Chapter Objectives n Explain how various factors...
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Transcript of CHAPTER 16 Foreign Exchange Derivative Market. Chapter Objectives n Explain how various factors...
CHAPTER
1616Foreign Exchange
Derivative
Market © 2003 South-Western/Thomson Learning
Chapter ObjectivesChapter Objectives
Explain how various factors affect exchange rates
Describe how foreign exchange risk can be hedged with foreign exchange derivatives
Describe how to use foreign exchange derivatives to capitalize (speculate) on expected exchange rate movements
Background On Foreign Exchange Background On Foreign Exchange MarketsMarkets
Exchanging currencies is needed when: Trade (real) prompts need for forex Capital flows (financial) prompts need for forex
Foreign exchange trading Via global telecommunications network between
mostly large banks Bid/ask spread
Foreign Exchange RatesForeign Exchange Rates
Quoted two ways: Foreign currency per U.S. dollar Dollar cost of unit of foreign exchange
Appreciation/depreciation of currency Appreciation = more forex to buy $ Purchase more forex with $ Depreciation = foreign goods cost more $ Total return to foreign investor decreases
Background on Foreign Exchange Background on Foreign Exchange MarketsMarkets
Exchange rate quotations are available in the financial press and on the Internet with spot exchange rate quotes for immediate delivery
Forward exchange rate is for delivery at some specified future point in time
Forward premium is the percent annualized appreciation of a currency
Forward discount is the percent annualized depreciation of a currency
Background on Foreign Exchange Background on Foreign Exchange MarketsMarkets
Exchange rates involve different kinds of quotes for comparing the value of the U.S. dollar to various foreign currencies 1 unit of foreign currency worth some amount of
U.S. dollars—e.g. $.70 U.S. per Canadian Dollar 1 U.S. dollar’s value in terms of some amount of
foreign currency– e.g. CD$1.43 per U.S. dollar Note reciprocal relationship
Cross-exchange rates express relative values of two different foreign currencies per $1 U.S.
Background on Foreign Exchange Background on Foreign Exchange MarketsMarkets
Cross-exchange rates are foreign exchange rates of two currencies relative to a currency.
Value of one unit of currency A in units of currency B = value of currency A in $ divided by value of currency B in $
British Pound = $1.4555; Euro = $.8983 Value of Pound in Euros = $1.4555/$.8983
or… 1.62 Pounds per Euro using the forex rates per
U.S. dollar
Background on Foreign Exchange Background on Foreign Exchange MarketsMarkets
Currency terminology Appreciation means a currency’s value increases
relative to another currency Depreciation means a currency’s value decreases
relative to another currency Supply and demand influences the values of
currencies Many factors can simultaneously affect supply
and demand
Background on Foreign Exchange Background on Foreign Exchange MarketsMarkets
1944–1971 known as the Bretton Woods Era Government maintained exchange rates within a
1% range Required government intervention and control
By 1971 the U.S. dollar was clearly overvalued
Background on Foreign Exchange Markets
Background on Foreign Exchange Background on Foreign Exchange MarketsMarkets
Smithsonian Agreement (1971) among major countries allowed dollar devaluation and widened boundaries around set values for each currency
No formal agreements since 1973 to fix exchange rates for major currencies Freely floating exchange rates involve values set
by the market without government intervention Dirty float involves some government intervention
Classification of Exchange Rate Classification of Exchange Rate ArrangementArrangement
There is a wide variation in how countries approach managing or influencing their currency’s value Float with periodic intervention Pegged to the dollar or some kind of composite Some countries have both controlled and floating
rates Some arrangements are temporary and others
more permanent
Factors Affecting Exchange Rates: Real Factors Affecting Exchange Rates: Real SectorSector
Differential country inflation rates affect the exchange rate for euros and dollars if inflation is suddenly higher in Europe
Theory of Purchasing Power Parity suggests the exchange rate will change to reflect the inflation differential—influence from real sector of economy
Currency of the higher inflation country (euro) depreciates compared to the lower inflation country ($)
Factors Affecting Exchange Rates: Factors Affecting Exchange Rates: Financial SectorFinancial Sector
Differential interest rates affect exchange rates by influencing capital flows between countries
For example, the interest rates are suddenly higher in the United States than in Europe
Investors want to buy dollar-denominated securities and sell European securities
Euros are sold, dollars bought to buy U.S. securities
Downward pressure on the euro, appreciation of the dollar
Factors Affecting Exchange RatesFactors Affecting Exchange Rates
Direct intervention occurs when a country’s central bank buys/sells currency reserves
For example, the U.S. central bank, the Federal Reserve sells one currency and buys another Sale by central bank creates excess supply and that
currency’s value drops relative to the one purchased
Market forces of supply and demand can overwhelm the intervention
Factors Affecting Exchange RatesFactors Affecting Exchange Rates
Indirect intervention involves influencing the factors that affect exchange rates rather than central bank purchases or sales of currencies
Interest rates, money supply and inflationary expectations affect exchange rates
Historical perspective on indirect intervention Peso crisis in 1994 Asian crisis in 1997 Russian crisis in 1998
Factors Affecting Exchange RatesFactors Affecting Exchange Rates
Some countries use foreign exchange controls as a form of indirect intervention to maintain their exchange rates
Place restrictions on the exchange of currency May change based on market pressures on the
currency Venezuela in mid-1990s illustrates the issues
involved in controlling rates via intervention and the affect of market forces
Movements in Exchange RatesMovements in Exchange Rates
Foreign exchange rate changes can have an important effect on the performance of multinational firms and economic conditions
Many market participants forecast rates Market participants take positions in derivatives
based on their expectations of future rates Speculators attempt to anticipate the direction of
exchange rates There are several forecasting techniques
Forecasting TechniquesForecasting Techniques
Technical Forecasting
Fundamental Forecasting
Market-based Forecasting
Mixed Forecasting
Forecasting Exchange Rates: TechnicalForecasting Exchange Rates: Technical
Technical forecasting is a technique that uses historical exchange rate data to predict the future
Uses statistics and develops rules about the price patterns—depends on orderly cycles
If price movements are random, this method won’t work
Models may work well some of the time and not work other times
Forecasting Exchange Rates: Forecasting Exchange Rates: FundamentalFundamental
Fundamental forecasting is based on fundamental relationships between economic variables and exchange rates
May be statistical and based on quantitative models or be based on subjective judgement
Regression used to forecast if values of influential factors have a lagged impact
Not all factors are known and some have an instant impact so sensitivity analysis is used to deal with uncertainty
Forecasting Exchange Rates: Forecasting Exchange Rates: FundamentalFundamental
Limitation of fundamental forecasting methods: Some factors that are important to determining
exchange rates are not easily quantifiable Random events can and do affect exchange rates Predictor models may not account for these
unexpected events
Forecasting Exchange Rates: Market-Forecasting Exchange Rates: Market-BasedBased
Market-based forecasting uses market indicators like the spot and forward rates to develop a forecast
Spot rate: recognizes the current value of the spot rate as based on expectations of currency’s value in the near future
Forward rate: used as the best estimate of the future spot rate based on the expectations of market participants
Forecasting Exchange Rates: MixedForecasting Exchange Rates: Mixed
Mixed forecasting is used because no one method has been found superior to another
Multinational corporations use a combination of methods
Assign a weight to each technique and the forecast is a weighted average
Perhaps a weighted combination of technical, fundamental, and market-based forecasting
Forecasting Exchange Rate VolatilityForecasting Exchange Rate Volatility
Market participants forecast not only exchange rates but also volatility
Volatility forecast Recognizes how difficult it is to forecast the actual
rate Provides a range around the forecast
Forecasting Exchange Rate VolatilityForecasting Exchange Rate Volatility
Volatility of historical data Use a times series of volatility patterns in
previous periods Derive the exchange rate’s implied standard
deviation from the currency option pricing model
Methods Used To Forecast Volatility
Speculation in Foreign Exchange MarketsSpeculation in Foreign Exchange Markets
For example, a dealer takes a short position in a foreign currency to profit from expected depreciation
Dealer forecasts currency 1 to depreciate relative to foreign currency 2 so the first step is to borrow currency 1 and then exchange currency 1 for currency 2 Invest in currency 2 and receive the investment
returns at maturity Convert back to foreign currency 1 and pay back
loan denominated in currency 1
Foreign Exchange Derivative ContractsForeign Exchange Derivative Contracts
Currency Futures
Currency Futures
Hedge or Speculate
Forward Contracts Currency Swaps
Currency Options
Foreign Exchange Derivatives-HedgeForeign Exchange Derivatives-Hedge
Forward contracts Negotiated with a counterparty Specify a maturity date, amount and which
currency to buy or sell Negotiated in over-the-counter market Used to lock in the price paid or price received for
a future currency transaction Classic hedging contract
Foreign Exchange Derivatives-HedgeForeign Exchange Derivatives-Hedge
Forward contracts can be used to hedge if a corporation must pay a foreign currency invoice in the future Purchase foreign currency for amount/date of
invoice Locks in cost of invoice Hedges foreign exchange risk of transaction
Forward contracts are also used by hedgers who have a foreign currency inflow on some future date
Foreign Exchange DerivativesForeign Exchange Derivatives
Forward rate premium or discount
P = % annualized premium or discount
FR = Forward exchange rate
S = Spot exchange rate
n = number of days forward
Where:
xFR - S
S
360
np =
Foreign Exchange Derivatives-HedgeForeign Exchange Derivatives-Hedge
Currency futures contracts trade on exchanges, are standardized in terms of the maturity and amount
Currency swaps allow one currency to be periodically swapped for another at a specified exchange rate
Currency options contracts offer one-way insurance to buy (call) or sell (put) a currency
Foreign Exchange Derivatives-HedgeForeign Exchange Derivatives-Hedge
Buying a call option on a foreign currency is the right to purchase a specified amount of currency at the strike price within the specified time period Exercise the option if the spot rate rises above the
strike price Do not exercise if the spot rate does not reach or
exceed the strike price U.S. business that owes Canadian in 60 days buys
currency call options to hedge spot forex risk
Foreign Exchange Derivatives-HedgeForeign Exchange Derivatives-Hedge
Buying a put option on a foreign currency is the right to sell a specified amount of currency at the strike price within the specified time period Exercise the option if the spot rate falls below the strike
price Do not exercise if the spot rate does not decline below the
strike price U.S. business hedges Canadian dollar payment it will
receive in 30 days by buying CD currency put options—if CD depreciates against U.S., gain will offset spot loss
Foreign Exchange Derivatives-SpeculateForeign Exchange Derivatives-Speculate
Business or person has no spot interest in underlying asset—takes position based on forecast of currency movements
Forward contracts Buy/sell foreign currency forward When received, sell in the spot market
Purchase/sell futures contracts Purchase call/put options
Foreign Exchange Derivatives-Foreign Exchange Derivatives-SpeculationSpeculation
For example, what position in derivates would a speculator take if he/she anticipates a depreciation in a currency?
Forward contracts Sell foreign currency forward At maturity, buy in the spot market
Sell futures contracts Purchase put options
International ArbitrageInternational Arbitrage
Arbitrage takes advantage of a temporary price difference in two locations to make profits buying at a lower price than you can receive via the simultaneous sale of an asset, financial instrument or currency
Risk free because the purchase and sale price are locked in simultaneously
As arbitrage occurs, prices in both locations change until equilibrium (one price) returns
International ArbitrageInternational Arbitrage
Covered interest arbitrage activity creates a relationships between spot rates, interest rates and forward rates
Borrow in country 1 Convert the funds to currency for country 2 using the
spot rate; buy forward contract for return Invest in country 2 and earn an investment rate of
return Convert back to country 1 currency using forward
contract, repay loan
International ArbitrageInternational Arbitrage
Covered interest arbitrage activity makes forward premium approximately equal to the differential in interest rates between two countries
If forward premium does not equal the interest rate differential, covered interest arbitrage is possible
If the forward premium or discount equals the interest rate differential, there are no opportunities for arbitrage
International ArbitrageInternational Arbitrage
Equation for covered interest arbitrage
P = Forward premium or discount
ih = Home country interest rate
if = Foreign interest rate
Where:
–( 1 + ih)
(1 + if ) 1P =
Explaining Price Movements of Foreign Explaining Price Movements of Foreign Exchange DerivativesExchange Derivatives
Indicators of foreign exchange derivatives are closely monitored by market participants
Hedgers and speculators continuously forecast direction and degree of movement and monitor Inflation rates between countries Interest rates Economic indicators
Foreign Exchange MarketsForeign Exchange Markets
Exchanging Currencies Is Needed When: Trade (real) prompts need For forex Capital flows (financial) prompts need for forex
Foreign Exchange Trading Via global telecommunications network between
mostly large banks Bid/ask spread
Foreign Exchange RatesForeign Exchange Rates
Quoted Two Ways: Foreign currency per U.S. Dollar Dollar cost Of unit Of foreign exchange
Appreciation/Depreciation of Currency Appreciation = more forex To buy $ Purchase more forex with $ Depreciation = foreign goods cost more $ Return To foreign investor decreases
Exchange Rate SystemsExchange Rate Systems
Bretton Woods Era (1944-1971) Fixed Or pegged forex rates Central bank maintained rates Could not adjust To major economic change
Smithsonian Agreement (1971) Devalued dollar Widened trading range Of forex First Step Toward Market-Determined Forex
Exchange Rate SystemsExchange Rate Systems
Market-Determined Rates (1973) Dirty Float Exchange Rate Mechanisms:
Currencies pegged to another European currency unit (ECU) Central Bank involvement ERM problems
Major Factors Affecting Forex Major Factors Affecting Forex
Differential inflation rates between countries Goods and services impact demand/supply for
foreign exchange Inflating currency declines to provide…. Purchasing power parity
Major Factors Affecting ForexMajor Factors Affecting Forex
Differential interest rates between countries Reflect expected differential inflation rates Global Fisher Effect
Governmental Intervention Domestic Economic Policy Direct Intervention, e.g., Forex Controls Market Forces Reign!!!
Forecasting Foreign Exchange RatesForecasting Foreign Exchange Rates
Technical forecasting Fundamental forecasting Market-based forecasting Mixed forecasting
Forecasting Forex VolatilityForecasting Forex Volatility
Forex prices difficult to forecast Forecasting volatility creates range of
probable forex rates Use best- and worst-case scenarios in planning
Define future period Consider historical volatility Time series of previous volatility
Speculation In Forex MarketSpeculation In Forex Market
Take position based on forex expectations Expect To appreciate
Take long position (buy) Forward contract to buy Buy forex currency futures contract Buy forex call options
Action taken if depreciation expected??
Foreign Exchange DerivativesForeign Exchange Derivatives
Speculate vs. Hedging Forward contracts
Contract To buy/sell forex at specified price on specified date
OTC market characteristics Reflects expected future spot rate Premium vs. Discount from spot Interest rate parity concept
Other Forex DerivativesOther Forex Derivatives
Currency futures contracts Currency swaps Currency option contracts
International ArbitrageInternational Arbitrage
Arbitrage defined Locational arbitrage Covered interest arbitrage
Maintains interest rate parity Forward/spot differential =
Differential inflation rates Interest rate differentials Expected future spot rate
Institutional Use Of Forex MarketInstitutional Use Of Forex Market
Intermediary or dealer of forwards or other derivative contracts
Speculating/hedging Future investment flows (loans, interest) Future financing flows (principal and interest)