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


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.


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


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


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


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


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


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


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 =


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


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


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


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


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


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


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)

chapter 16 foreign exchange derivative market. chapter objectives n explain how various factors...

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