10 - foreign exchange derivative market
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CHAPTER
1616ForeignExchange
Derivative
Market
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Chapter ObjectivesChapter Objectives
Explain ho# various $actors a$$ect exchange
rates
Describe ho# $oreign exchange risk can behe"ge" #ith $oreign exchange "erivatives
Describe ho# to use $oreign exchange
"erivatives to capitali%e &speculate' onexpecte" exchange rate movements
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Background On Foreign ExchangeBackground On Foreign Exchange
MarketsMarkets
Exchanging currencies is nee"e" #hen(
Tra"e &real' prompts nee" $or $orex
Capital $lo#s &$inancial' prompts nee" $or $orex
Foreign exchange tra"ing )ia global telecommunications net#ork bet#een
mostly large banks
*i"+ask sprea"
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Foreign Exchange RatesForeign Exchange Rates
,uote" t#o #ays(
Foreign currency per -. "ollar
Dollar cost o$ unit o$ $oreign exchange
!ppreciation+"epreciation o$ currency !ppreciation / more $orex to buy
Purchase more $orex #ith Depreciation / $oreign goo"s cost more
Total return to $oreign investor "ecreases
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Background on Foreign ExchangeBackground on Foreign Exchange
MarketsMarkets
Exchange rate 1uotations are available in the
$inancial press an" on the nternet #ith spot
exchange rate 1uotes $or imme"iate "elivery
For#ar" exchange rate is $or "elivery at some
speci$ie" $uture point in time
For#ar" premium is the percent annuali%e"
appreciation o$ a currency
For#ar" "iscount is the percent annuali%e"
"epreciation o$ a currency
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Background on Foreign ExchangeBackground on Foreign Exchange
MarketsMarkets
Exchange rates involve "i$$erent kin"s o$
1uotes $or comparing the value o$ the -.
"ollar to various $oreign currencies 3 unit o$ $oreign currency #orth some amount o$
-. "ollars4eg 50 -. per Cana"ian Dollar
3 -. "ollar6s value in terms o$ some amount o$
$oreign currency7 eg CD389 per -. "ollar :ote reciprocal relationship
Cross;exchange rates express relative values
o$ t#o "i$$erent $oreign currencies per 3 -.
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Background on Foreign ExchangeBackground on Foreign Exchange
MarketsMarkets
Cross;exchange rates are $oreign exchangerates o$ t#o currencies relative to a currency
)alue o$ one unit o$ currency ! in units o$currency * / value o$ currency ! in "ivi"e" by value o$ currency * in
*ritish Poun" / 38
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Background on Foreign ExchangeBackground on Foreign Exchange
MarketsMarkets
Currency terminology !ppreciation means a currency6s value increases
relative to another currency
Depreciation means a currency6s value "ecreases
relative to another currency
.upply an" "eman" in$luences the values o$
currencies Many $actors can simultaneously a$$ect supply
an" "eman"
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Background on Foreign ExchangeBackground on Foreign Exchange
MarketsMarkets
3?8873?53 kno#n as the *retton Boo"s Era overnment maintaine" exchange rates #ithin a
3 range e1uire" government intervention an" control
*y 3?53 the -. "ollar #as clearly
overvalue"
*ackgroun" on Foreign Exchange Markets
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Background on Foreign ExchangeBackground on Foreign Exchange
MarketsMarkets
.mithsonian !greement &3?53' among maor
countries allo#e" "ollar "evaluation an"
#i"ene" boun"aries aroun" set values $or each
currency
:o $ormal agreements since 3?59 to $ix
exchange rates $or maor currencies
Freely $loating exchange rates involve values set
by the market #ithout government intervention
Dirty $loat involves some government intervention
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Classification of Exchange RateClassification of Exchange Rate
ArrangementArrangement
There is a #i"e variation in ho# countries
approach managing or in$luencing their
currency6s value Float #ith perio"ic intervention
Pegge" to the "ollar or some kin" o$ composite
.ome countries have both controlle" an" $loating
rates
.ome arrangements are temporary an" others
more permanent
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Factors Affecting Exchange Rates RealFactors Affecting Exchange Rates Real
!ector!ector
Di$$erential country in$lation rates a$$ect theexchange rate $or euros an" "ollars i$ in$lationis su""enly higher in Europe
Theory o$ Purchasing Po#er Parity suggeststhe exchange rate #ill change to re$lect thein$lation "i$$erential4in$luence $rom real
sector o$ economy Currency o$ the higher in$lation country &euro'
"epreciates compare" to the lo#er in$lationcountry &'
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Factors Affecting Exchange RatesFactors Affecting Exchange Rates
Financial !ectorFinancial !ector
Di$$erential interest rates a$$ect exchange rates by in$luencing capital $lo#s bet#een countries
For exampleG the interest rates are su""enlyhigher in the -nite" .tates than in Europe
nvestors #ant to buy "ollar;"enominate"securities an" sell European securities
Euros are sol"G "ollars bought to buy -.securities
Do#n#ar" pressure on the euroG appreciation
o$ the "ollar
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Factors Affecting Exchange RatesFactors Affecting Exchange Rates
Direct intervention occurs #hen a country6s
central bank buys+sells currency reserves
For exampleG the -. central bankG theFe"eral eserve sells one currency an" buys
another .ale by central bank creates excess supply an" that
currency6s value "rops relative to the one
purchase"
Market $orces o$ supply an" "eman" can
over#helm the intervention
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Factors Affecting Exchange RatesFactors Affecting Exchange Rates
n"irect intervention involves in$luencing the
$actors that a$$ect exchange rates rather than
central bank purchases or sales o$ currencies
nterest ratesG money supply an" in$lationary
expectations a$$ect exchange rates
Historical perspective on in"irect intervention Peso crisis in 3??8
!sian crisis in 3??5
ussian crisis in 3??>
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Factors Affecting Exchange RatesFactors Affecting Exchange Rates
.ome countries use $oreign exchange controls
as a $orm o$ in"irect intervention to maintain
their exchange rates
Place restrictions on the exchange o$ currency
May change base" on market pressures on the
currency
)ene%uela in mi";3??0s illustrates the issues
involve" in controlling rates via intervention
an" the a$$ect o$ market $orces
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Movements in Exchange RatesMovements in Exchange Rates
Foreign exchange rate changes can have an
important e$$ect on the per$ormance o$
multinational $irms an" economic con"itions
Many market participants $orecast rates
Market participants take positions in "erivatives
base" on their expectations o$ $uture rates
.peculators attempt to anticipate the "irection o$
exchange rates
There are several $orecasting techni1ues
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Forecasting "echni#uesForecasting "echni#ues
Technical Forecasting
Fun"amental Forecasting
Market;base"
Forecasting
Mixe" Forecasting
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Forecasting Exchange Rates "echnicalForecasting Exchange Rates "echnical
Technical $orecasting is a techni1ue that uses
historical exchange rate "ata to pre"ict the
$uture
-ses statistics an" "evelops rules about the
price patterns4"epen"s on or"erly cycles
$ price movements are ran"omG this metho"
#on6t #ork
Mo"els may #ork #ell some o$ the time an"
not #ork other times
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Forecasting Exchange RatesForecasting Exchange Rates
FundamentalFundamental
Fun"amental $orecasting is base" on$un"amental relationships bet#een economicvariables an" exchange rates
May be statistical an" base" on 1uantitativemo"els or be base" on subective u"gement
egression use" to $orecast i$ values o$
in$luential $actors have a lagge" impact :ot all $actors are kno#n an" some have an
instant impact so sensitivity analysis is use" to"eal #ith uncertainty
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Forecasting Exchange RatesForecasting Exchange Rates
FundamentalFundamental
Iimitation o$ $un"amental $orecasting
metho"s( .ome $actors that are important to "etermining
exchange rates are not easily 1uanti$iable
an"om events can an" "o a$$ect exchange rates
Pre"ictor mo"els may not account $or these
unexpecte" events
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Forecasting Exchange Rates Market$Forecasting Exchange Rates Market$
BasedBased
Market;base" $orecasting uses market
in"icators like the spot an" $or#ar" rates to
"evelop a $orecast
.pot rate( recogni%es the current value o$ the
spot rate as base" on expectations o$
currency6s value in the near $uture
For#ar" rate( use" as the best estimate o$ the
$uture spot rate base" on the expectations o$
market participants
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Forecasting Exchange Rates MixedForecasting Exchange Rates Mixed
Mixe" $orecasting is use" because no one
metho" has been $oun" superior to another
Multinational corporations use a combination
o$ metho"s
!ssign a #eight to each techni1ue an" the
$orecast is a #eighte" average
Perhaps a #eighte" combination o$ technicalG
$un"amentalG an" market;base" $orecasting
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Forecasting Exchange Rate %olatilit&Forecasting Exchange Rate %olatilit&
Market participants $orecast not only
exchange rates but also volatility
)olatility $orecast ecogni%es ho# "i$$icult it is to $orecast the actual
rate
Provi"es a range aroun" the $orecast
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Forecasting Exchange Rate %olatilit&Forecasting Exchange Rate %olatilit&
)olatility o$ historical "ata
-se a times series o$ volatility patterns in
previous perio"s Derive the exchange rate6s implie" stan"ar"
"eviation $rom the currency option pricing
mo"el
Metho"s -se" To Forecast )olatility
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!peculation in Foreign Exchange Markets!peculation in Foreign Exchange Markets
For exampleG a "ealer takes a short position ina $oreign currency to pro$it $rom expecte""epreciation
Dealer $orecasts currency 3 to "epreciaterelative to $oreign currency 2 so the $irst stepis to borro# currency 3 an" then exchange
currency 3 $or currency 2 nvest in currency 2 an" receive the investment
returns at maturity
Convert back to $oreign currency 3 an" pay back
loan "enominate" in currency 3
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Foreign Exchange 'erivative ContractsForeign Exchange 'erivative Contracts
Currency Futures
Currency Futures
He"ge or .peculate
For#ar" Contracts Currency .#aps
Currency Jptions
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Foreign Exchange 'erivatives$(edgeForeign Exchange 'erivatives$(edge
For#ar" contracts :egotiate" #ith a counterparty
.peci$y a maturity "ateG amount an" #hich
currency to buy or sell
:egotiate" in over;the;counter market
-se" to lock in the price pai" or price receive" $or
a $uture currency transaction Classic he"ging contract
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Foreign Exchange 'erivatives$(edgeForeign Exchange 'erivatives$(edge
For#ar" contracts can be use" to he"ge i$ acorporation must pay a $oreign currencyinvoice in the $uture
Purchase $oreign currency $or amount+"ate o$invoice
Iocks in cost o$ invoice
He"ges $oreign exchange risk o$ transaction
For#ar" contracts are also use" by he"gers#ho have a $oreign currency in$lo# on some$uture "ate
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Foreign Exchange 'erivativesForeign Exchange 'erivatives
For#ar" rate premium or "iscount
P = % annualized premium or discount
FR = Forward exchange rate
S = Spot exchange rate
n = number of days forward
Where:
xFR - S
S
3!
n
p =
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Foreign Exchange 'erivatives$(edgeForeign Exchange 'erivatives$(edge
Currency $utures contracts tra"e on
exchangesG are stan"ar"i%e" in terms o$ the
maturity an" amount
Currency s#aps allo# one currency to be
perio"ically s#appe" $or another at a speci$ie"
exchange rate
Currency options contracts o$$er one;#ay
insurance to buy &call' or sell &put' a currency
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Foreign Exchange 'erivatives$(edgeForeign Exchange 'erivatives$(edge
*uying a call option on a $oreign currency is
the right to purchase a speci$ie" amount o$
currency at the strike price #ithin the
speci$ie" time perio" Exercise the option i$ the spot rate rises above the
strike price
Do not exercise i$ the spot rate "oes not reach orexcee" the strike price
-. business that o#es Cana"ian in A0 "ays buys
currency call options to he"ge spot $orex risk
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Foreign Exchange 'erivatives$(edgeForeign Exchange 'erivatives$(edge
*uying a put option on a $oreign currency is the right
to sell a speci$ie" amount o$ currency at the strike
price #ithin the speci$ie" time perio"
Exercise the option i$ the spot rate $alls belo# the strike price
Do not exercise i$ the spot rate "oes not "ecline belo# the
strike price
-. business he"ges Cana"ian "ollar payment it #illreceive in 90 "ays by buying CD currency put options4i$
CD "epreciates against -.G gain #ill o$$set spot loss
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Foreign Exchange 'erivatives$!peculateForeign Exchange 'erivatives$!peculate
*usiness or person has no spot interest in
un"erlying asset4takes position base" on
$orecast o$ currency movements
For#ar" contracts
*uy+sell $oreign currency $or#ar"
Bhen receive"G sell in the spot market
Purchase+sell $utures contracts
Purchase call+put options
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Foreign Exchange 'erivatives$Foreign Exchange 'erivatives$
!peculation!peculation
For exampleG #hat position in "erivates #oul"
a speculator take i$ he+she anticipates a
"epreciation in a currencyK
For#ar" contracts
.ell $oreign currency $or#ar"
!t maturityG buy in the spot market
.ell $utures contracts
Purchase put options
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)nternational Arbitrage)nternational Arbitrage
!rbitrage takes a"vantage o$ a temporary
price "i$$erence in t#o locations to make
pro$its buying at a lo#er price than you can
receive via the simultaneous sale o$ an assetG$inancial instrument or currency
isk $ree because the purchase an" sale price
are locke" in simultaneously
!s arbitrage occursG prices in both locations
change until e1uilibrium &one price' returns
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)nternational Arbitrage)nternational Arbitrage
Covere" interest arbitrage activity creates a
relationships bet#een spot ratesG interest rates an"
$or#ar" rates
*orro# in country 3 Convert the $un"s to currency $or country 2 using the
spot rate= buy $or#ar" contract $or return
nvest in country 2 an" earn an investment rate o$return
Convert back to country 3 currency using $or#ar"
contractG repay loan
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)nternational Arbitrage)nternational Arbitrage
Covere" interest arbitrage activity makes$or#ar" premium approximately e1ual to the"i$$erential in interest rates bet#een t#o
countries $ $or#ar" premium "oes not e1ual the interest
rate "i$$erentialG covere" interest arbitrage is
possible $ the $or#ar" premium or "iscount e1uals the
interest rate "i$$erentialG there are noopportunities $or arbitrage
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)nternational Arbitrage)nternational Arbitrage
E1uation $or covere" interest arbitrage
P = Forward premium or discount
ih = "ome country interest rate
if = Foreign interest rate
Where:
#$ & ih'
$ & if '
P =
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Explaining *rice Movements of ForeignExplaining *rice Movements of Foreign
Exchange 'erivativesExchange 'erivatives
n"icators o$ $oreign exchange "erivatives are
closely monitore" by market participants
He"gers an" speculators continuously $orecast
"irection an" "egree o$ movement an"
monitor n$lation rates bet#een countries
nterest rates
Economic in"icators
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Foreign Exchange MarketsForeign Exchange Markets
Exchanging Currencies s :ee"e" Bhen(
Tra"e &real' prompts nee" For $orex
Capital $lo#s &$inancial' prompts nee" $or $orex
Foreign Exchange Tra"ing )ia global telecommunications net#ork bet#een
mostly large banks
*i"+ask sprea"
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Foreign Exchange RatesForeign Exchange Rates
,uote" T#o Bays(
Foreign currency per -. Dollar
Dollar cost J$ unit J$ $oreign exchange
!ppreciation+Depreciation o$ Currency !ppreciation / more $orex To buy
Purchase more $orex #ith
Depreciation / $oreign goo"s cost more
eturn To $oreign investor "ecreases
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Exchange Rate !&stemsExchange Rate !&stems
*retton Boo"s Era &3?88;3?53'
Fixe" Jr pegge" $orex rates
Central bank maintaine" rates
Coul" not a"ust To maor economic change
.mithsonian !greement &3?53' Devalue" "ollar
Bi"ene" tra"ing range J$ $orex
First .tep To#ar" Market;Determine" Forex
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Exchange Rate !&stemsExchange Rate !&stems
Market;Determine" ates &3?59'
Dirty Float
Exchange ate Mechanisms(Currencies pegge" to another
European currency unit &EC-'
Central *ank involvement
EM problems
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Major Factors Affecting ForexMajor Factors Affecting Forex
Di$$erential in$lation rates bet#een countries
oo"s an" services impact "eman"+supply $or
$oreign exchange
n$lating currency "eclines to provi"e@
Purchasing po#er parity
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Major Factors Affecting ForexMajor Factors Affecting Forex
Di$$erential interest rates bet#een countries
e$lect expecte" "i$$erential in$lation rates
lobal Fisher E$$ect
overnmental ntervention Domestic Economic Policy
Direct nterventionG egG Forex Controls
Market Forces eignLLL
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Forecasting Foreign Exchange RatesForecasting Foreign Exchange Rates
Technical $orecasting
Fun"amental $orecasting
Market;base" $orecasting Mixe" $orecasting
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Forecasting Forex %olatilit&Forecasting Forex %olatilit&
Forex prices "i$$icult to $orecast
Forecasting volatility creates range o$
probable $orex rates
-se best; an" #orst;case scenarios in planning De$ine $uture perio"
Consi"er historical volatility
Time series o$ previous volatility
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!peculation )n Forex Market!peculation )n Forex Market
Take position base" on $orex expectations
Expect To appreciate
Take long position &buy'
For#ar" contract to buy
*uy $orex currency $utures contract
*uy $orex call options
!ction taken i$ "epreciation expecte"KK
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Foreign Exchange 'erivativesForeign Exchange 'erivatives
.peculate vs He"ging
For#ar" contracts
Contract To buy+sell $orex at speci$ie" price on
speci$ie" "ate
JTC market characteristics
e$lects expecte" $uture spot rate
Premium vs Discount $rom spot
nterest rate parity concept
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Other Forex 'erivativesOther Forex 'erivatives
Currency $utures contracts
Currency s#aps
Currency option contracts
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)nternational Arbitrage)nternational Arbitrage
!rbitrage "e$ine"
Iocational arbitrage
Covere" interest arbitrage Maintains interest rate parity
For#ar"+spot "i$$erential /Di$$erential in$lation rates
nterest rate "i$$erentials
Expecte" $uture spot rate
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)nstitutional +se Of Forex Market)nstitutional +se Of Forex Market
nterme"iary or "ealer o$ $or#ar"s or other
"erivative contracts
.peculating+he"ging Future investment $lo#s &loansG interest'
Future $inancing $lo#s &principal an" interest'
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