Currency Exchange Rates, Hedging, and Arbitrage

Jennie MorseBA 543

Evening Section

Agenda• Intro• Exchange Rates• Forex Market• Hedging vs. Arbitrage• Currency Derivatives

– Forward Contracts– Futures Contracts– Options– Swaps

• Conclusion and Questions

Introduction

• Exchange rates becoming increasingly important due to:– Globalization– Technology

• Importance of exchange risk to – Investors– Borrowers

Exchange Rates

• Exchange Rate: the price of one currency in terms of another

Examples:– Yahoo Finance

Quoting Exchange Rates

• Direct vs. Indirect

From US Perspective: Direct:$$$$ €

Indirect:€€€€ $

American vs. European

European: - USD is base currency

American:- USD is counter currency

Quoting order: EUR, GBP, AUD, NZD, USD

Foreign Exchange Market

• Decentralized OTC market– Top 3 exchange locations:

London, US, Japan• Very liquid market

– Spot transactions (2 days)• Pegged vs. Floating rates

– 3 factors that cause flucuation:• Economic conditions• Political events• Market Psychology

Hedging & Arbitrage

• Hedging– Used to offset potential

losses and evade potential losses, but is not risk-free

– Ex: SW airlines fuel• Arbitrage

– Risk-free strategy used to capitalize on mispriced assets

– Ex: Triangular Arbitrage

Triangular Arbitrage

Currency Derivatives

• Four Instruments used for mitigating exchange rate risk:– Forward Contracts– Futures Contracts– Options– Currency Swaps

Forward Contracts• Most common way to

alleviate exchange rate risk

• Traded in OTC markets• Locks in future rate:

– Eliminate risk of adverse rate swings

– Relinquish opportunity to benefit from advantageous price changes

• Not good for LT use

Futures Contracts

• Standardized• Traded on exchanges• Only for major

national currencies• 1 year maximum; does

not protect against LT risk

Currency Options• Major currencies

traded on exchanges• Customized options

traded in OTC market• 2 types:

– Regular option where underlying is a currency and strike price is an exchange rate

– Futures Options

Currency Swaps

• Transactionally efficient vehicle to protect against LT risk

• Also used to capitalize on arbitrage opportunities where a borrower could raise funds at a lower rate than what is available domestically

Currency Swaps

• Two companies issue bonds in the other’s bond market– Swap money raised

from bond sale– Make coupon payments

to each other to cover the other’s debt

– Swap par value of bonds on maturity date

Conclusion

• Take-aways:– Definition of exchange rate – How rates are quoted– What exchange rate risk is– Key facts about Forex market:

• Decentralized OTC market; floating rates• Spot Transactions completed in 2 days

– 4 methods to protect against exchange risk• Forwards, Futures, Options, Swaps

Questions