madura fmi ch16-fromxml 417. - · pdf fileinstitutions is influenced by potential return, ......

16Foreign Exchange DerivativeMarkets

In recent years, various derivative instruments have been created tomanage or capitalize on exchange rate movements. These so-called foreignexchange derivatives (or “forex” derivatives) include forward contracts,currency futures contracts, currency swaps, and currency options. Foreignexchange derivatives account for about half of the daily foreign exchangetransaction volume.

The potential benefits from using foreign exchange derivatives aredependent on the expected exchange rate movements. Thus, it is necessaryto understand why exchange rates change over time before exploring the useof foreign exchange derivatives.

FOREIGN EXCHANGE MARKETSAs international trade and investing have increased over time, so has the need to ex-change currencies. Foreign exchange markets consist of a global telecommunications net-work among the large commercial banks that serve as financial intermediaries for suchexchange. These banks are located in New York, Tokyo, Hong Kong, Singapore, Frank-furt, Zurich, and London. Foreign exchange transactions at these banks have been in-creasing over time.

At any point in time, the price at which banks will buy a currency (bid price) isslightly lower than the price at which they will sell it (ask price). Like markets for othercommodities and securities, the market for foreign currencies is more efficient because offinancial intermediaries (commercial banks). Otherwise, individual buyers and sellers ofcurrency would be unable to identify counterparties to accommodate their needs.

Institutional Use of Foreign Exchange MarketsExhibit 16.1 summarizes the ways financial institutions utilize the foreign exchange mar-kets and foreign exchange derivatives. The degree of international investment by financialinstitutions is influenced by potential return, risk, and government regulations. Commer-cial banks use international lending as their primary form of international investing. Mu-tual funds, pension funds, and insurance companies purchase foreign securities. In recentyears, technology has reduced information costs and other transaction costs associatedwith purchasing foreign securities, prompting an increase in institutional purchases of for-eign securities. Consequently, financial institutions are increasing their use of the foreignexchange markets to exchange currencies. They are also increasing their use of foreign ex-change derivatives to hedge their investments in foreign securities.

CHAPTEROBJECTIVES

The specific objectives ofthis chapter are to:

■ explain how variousfactors affectexchange rates,

■ explain how toforecast exchangerates,

■ describe the use offoreign exchange ratederivatives, and

■ explain internationalarbitrage.

417

Exchange Rate QuotationsThe direct exchange rate specifies the value of a currency in U.S. dollars. For example,the Mexican peso may have a value such as $.10, while the British pound may have avalue such as $2.00. The indirect exchange rate specifies the number of units of a cur-rency equal to a U.S. dollar. For example, the indirect exchange rate of the peso may be10 pesos per dollar, while the indirect exchange rate of the British pound may be .50pounds equal one dollar. Notice that the indirect exchange rate is the reciprocal of thedirect exchange rate.

Forward Rate For widely used currencies, forward rates are available and are com-monly quoted next to the respective spot rates. The forward rates indicate the rate atwhich a currency can be exchanged in the future. If the forward rate is above the spotrate, it contains a premium. If the forward rate is below the spot rate, it contains a nega-tive premium (also called a discount).

Cross-Exchange Rates Most exchange rate quotation tables express currencies rel-ative to the dollar. In some instances, however, the exchange rate between two nondollarcurrencies is needed.

EXAMPLEIf a Canadian firm needs Mexican pesos to buy Mexican goods, it is concerned about the value

of the Mexican peso relative to the Canadian dollar. This type of rate is known as a cross-

exchange rate because it reflects the amount of one foreign currency per unit of another for-

eign currency. Cross-exchange rates can be easily determined with the use of foreign exchange

quotations. The general formula follows:

Value of 1 unit of Currency A in units of Currency B¼ Value of Currency A in $=Value of Currency B in $

Exhibit 16.1 Institutional Use of Foreign Exchange Markets

TYPE OF FINANCIALINSTITUTION USES OF FOREIGN EXCHANGE MARKETS

Commercial banks • Serve as financial intermediaries in the foreign exchange market by buying or sellingcurrencies to accommodate customers.

• Speculate on foreign currency movements by taking long positions in some currenciesand short positions in others.

• Provide forward contracts to customers.• Some commercial banks offer currency options to customers; unlike the standardized

currency options traded on an exchange, these options can be tailored to a customer’sspecific needs.

International mutual funds • Use foreign exchange markets to exchange currencies when reconstructing their portfolios.

• Use foreign exchange derivatives to hedge a portion of their exposure.

Brokerage firms and securitiesfirms

• Some brokerage firms and securities firms engage in foreign security transactions for theircustomers or for their own accounts.

Insurance companies • Use foreign exchange markets when exchanging currencies for their international operations.

• Use foreign exchange markets when purchasing foreign securities for their investmentportfolios or when selling foreign securities.


Pension funds • Require foreign exchange of currencies when investing in foreign securities for theirstock or bond portfolios.


WEB

www.bloomberg.comSpot rates of curren-cies and cross-exchange rates amongcurrencies.

418 Part 5: Derivative Security Markets

If the peso is worth $.07, and the Canadian dollar (C$) is worth $.70, the value of the peso in

Canadian dollars is calculated as follows:

Value of peso in C$ ¼ Value of peso in $=Value of C$ in $ ¼ $:07=$:70 ¼ :10

Thus, a Mexican peso is worth C$.10. The exchange rate can also be expressed as the number

of pesos equal to one Canadian dollar. This figure can be computed by taking the reciprocal:

.70/.07 = 10.0, which indicates that a Canadian dollar is worth 10.0 pesos according to the infor-

mation provided.�Types of Exchange Rate SystemsFrom 1944 to 1971, the exchange rate at which one currency could be exchanged for anotherwas maintained by governments within 1 percent of a specified rate. This period was knownas the Bretton Woods era, because the agreement establishing the system was negotiated atthe Bretton Woods Conference in Bretton Woods, New Hampshire. The manner by whichgovernments were able to control exchange rates is discussed later in the chapter.

By 1971, the U.S. dollar was clearly overvalued. That is, its value was maintained onlyby central bank intervention. In 1971, an agreement among all major countries (knownas the Smithsonian Agreement) allowed for devaluation of the dollar. In addition, theSmithsonian Agreement called for a widening of the boundaries from 1 percent to 21/4percent around each currency’s set value. Governments intervened in the foreign ex-change markets whenever exchange rates threatened to wander outside the boundaries.

In 1973, the boundaries were eliminated. Since then, the exchange rates of major cur-rencies have been floating without any government-imposed boundaries. A governmentmay still intervene in the foreign exchange markets to influence the market value of itscurrency, however. A system with no boundaries in which exchange rates are market de-termined but are still subject to government intervention is called a dirty float. This canbe distinguished from a freely floating system, in which the foreign exchange marketwould be totally free from government intervention.

Some countries today use a pegged exchange rate system. Hong Kong has tied thevalue of its currency (the Hong Kong dollar) to the U.S. dollar (HK$78 = $1) since1983. In 2000, El Salvador set its currency (the colon) to be valued at 8.75 per dollar.

China’s currency (the yuan) was pegged to the U.S. dollar until 2005. Many U.S. po-liticians argued that China was maintaining its currency at a level that was too low. Thelow value of the yuan meant that China’s products were priced cheap in dollars. In 2005,U.S. exports to China were about $50 billion, but U.S. imports from China were about$250 billion, resulting in a balance of trade deficit of $200 billion with China. Thus, U.S.politicians claimed that China was creating jobs at U.S. expense by preventing the yuan’svalue from floating. In July 2005, China revalued the yuan by 2.1 percent against thedollar and implemented a new system that allowed the yuan to float within narrowboundaries based on a set of major currencies. This change has had only a very limitedeffect on the relative pricing of Chinese versus U.S. products, however, and therefore onthe balance of trade between the two countries.

A country that pegs its currency does not have complete control over its local interestrates because they must be aligned with the interest rates of the currency to which itscurrency is tied.

EXAMPLEIf Hong Kong lowers its interest rates to stimulate its economy, its interest rates will be lower

than U.S. interest rates. Investors based in Hong Kong will then be enticed to exchange Hong

Kong dollars for U.S. dollars and invest in the United States where interest rates are higher.

Since the Hong Kong dollar is tied to the U.S. dollar, the investors will be able to exchange

their investment proceeds back to Hong Kong dollars at the end of the investment period with-

out concern about exchange rate risk because the exchange rate is fixed.�

Chapter 16: Foreign Exchange Derivative Markets 419

As the example illustrates, Hong Kong no longer has control of its interest rates, as itis subject to movements in U.S. interest rates. Nevertheless, a country may view such anarrangement as advantageous because its interest rates (and therefore its economic con-ditions) might be much more volatile if they were not tied to the U.S. interest rates.Hong Kong’s interest rate is typically equal to the U.S. interest rate plus a premium forrisk. For example, when the Hong Kong government borrows funds, its interest rate isequal to the U.S. Treasury rate plus a small risk premium. As the U.S. Treasury ratechanges, so does Hong Kong’s interest rate.

In addition, because the Hong Kong dollar’s value is fixed relative to the U.S. dollar,its value moves in tandem with the U.S. dollar against other currencies, including otherAsian currencies. Thus, if the Japanese yen depreciates against the U.S. dollar, it will alsodepreciate against the Hong Kong dollar.

One concern about pegging a currency is that its value may change dramatically whenthe controls are removed. Many governments such as Argentina, Indonesia, and Russiahave imposed restrictions to prevent their exchange rate from fluctuating, but when the con-trols were removed, the exchange rate abruptly adjusted to a new market-determined level.

FACTORS AFFECTING EXCHANGE RATESThe value of a currency adjusts to changes in demand and supply conditions, movingtoward equilibrium. In equilibrium, there is no excess or deficiency of that currency.

EXAMPLEA large increase in the U.S. demand for European goods and securities will result in an in-

creased demand for euros. Because the demand for euros will then exceed the supply of euros

for sale, the market-makers (commercial banks) will experience a shortage of euros and will re-

spond by increasing the quoted price of euros. Therefore, the euro will appreciate, or increasein value.

Conversely, if European corporations begin to purchase more U.S. goods and European inves-

tors purchase more U.S. securities, the opposite forces will occur. There will be an increased sale

of euros in exchange for dollars, causing a surplus of euros in the market. The value of the euro

will therefore depreciate, or decline, until it once again achieves equilibrium.�In reality, both the demand for euros and the supply of euros for sale can change si-

multaneously. The adjustment in the exchange rate will depend on the direction andmagnitude of these changes.

Supply of and demand for a currency are influenced by a variety of factors, including(1) differential inflation rates, (2) differential interest rates, and (3) government interven-tion. These factors are discussed in the following subsections.

Differential Inflation RatesBegin with an equilibrium situation and consider what will happen to the U.S. demandfor euros and the supply of euros for sale if U.S. inflation suddenly becomes much higherthan European inflation. The U.S. demand for European goods will increase, reflectingan increased U.S. demand for euros. In addition, the supply of euros to be sold for dol-lars will decline as the European desire for U.S. goods decreases. Both forces will placeupward pressure on the value of the euro.

Under the reverse situation, where European inflation suddenly becomes much higherthan U.S. inflation, the U.S. demand for euros will decrease, while the supply of euros forsale increases, placing downward pressure on the value of the euro.

A well-known theory about the relationship between inflation and exchange rates, pur-chasing power parity (PPP), suggests that the exchange rate will, on average, change by apercentage that reflects the inflation differential between the two countries of concern.

WEB

http://biz.yahoo.com/topic/currencyUpdated news of in-terest to speculatorsabout specific curren-cies that are frequentlytraded in the foreignexchange market.


EXAMPLEAssume an initial equilibrium situation where the British pound’s spot rate is $1.60, U.S. infla-

tion is 3 percent, and British inflation is also 3 percent. If U.S. inflation suddenly increases to 5

percent, the British pound will appreciate against the dollar by approximately 2 percent accord-

ing to PPP. The rationale is that as a result of the higher U.S. prices, U.S. demand for British

goods will increase, placing upward pressure on the pound’s value. Once the pound appreci-

ates by 2 percent, the purchasing power of U.S. consumers will be the same whether they pur-

chase U.S. goods or British goods. Although the prices of the U.S. goods will have risen by a

higher percentage, the British goods will then be just as expensive to U.S. consumers because

of the pound’s appreciation. Thus, a new equilibrium exchange rate results from the change in

U.S. inflation.�In reality, exchange rates do not always change as suggested by the PPP theory. Other

factors that influence exchange rates (discussed next) can distort the PPP relationship.Thus, all these factors must be considered when assessing why an exchange rate haschanged. Furthermore, forecasts of future exchange rates must account for the potentialdirection and magnitude of changes in all factors that affect exchange rates.

Differential Interest RatesInterest rate movements affect exchange rates by influencing the capital flows betweencountries. An increase in interest rates may attract foreign investors, especially if thehigher interest rates do not reflect an increase in inflationary expectations.

EXAMPLEAssume U.S. interest rates suddenly become much higher than European interest rates. The

demand by U.S. investors for European interest-bearing securities decreases, as these securi-

ties become less attractive. In addition, the supply of euros to be sold in exchange for dollars

increases as European investors increase their purchases of U.S. interest-bearing securities.

Both forces put downward pressure on the euro’s value.

In the reverse situation, opposite forces occur, resulting in upward pressure on the euro’s

value. In general, the currency of the country with a higher increase (or smaller decrease) in in-

terest rates is expected to appreciate, other factors held constant.�Central Bank InterventionCentral banks commonly consider adjusting a currency’s value to influence economicconditions. For example, the U.S. central bank may wish to weaken the dollar to increasedemand for U.S. exports, which can stimulate the economy. However, a weaker dollarcan also cause U.S. inflation by reducing foreign competition (by raising the prices offoreign goods to U.S. consumers). Alternatively, the U.S. central bank may prefer tostrengthen the dollar to intensify foreign competition, which can reduce U.S. inflation.

Direct Intervention A country’s government can intervene in the foreign exchangemarket to affect a currency’s value. Direct intervention occurs when a country’s centralbank (such as the Federal Reserve Bank for the United States or the European CentralBank for European countries that use the euro) sells some of its currency reserves for adifferent currency.

EXAMPLEAssume that the Federal Reserve and the European Central Bank desire to strengthen the value

of the euro against the dollar. They use dollar reserves to purchase euros in the foreign ex-

change market. In essence, they dump dollars in the foreign exchange market and increase

the demand for euros.�Central bank intervention can be overwhelmed by market forces, however, and there-

fore may not always succeed in reversing exchange rate movements. In fact, the efforts ofthe Fed and the European Central Bank to boost the value of the euro in 2000 were notsuccessful. Nevertheless, central bank intervention may significantly affect the foreign


exchange markets in two ways. First, it may slow the momentum of adverse exchangerate movements. Second, commercial banks and other corporations may reassess theirforeign exchange strategies if they believe the central banks will continue to intervene.

Indirect Intervention The Fed can affect the dollar’s value indirectly by influencingthe factors that determine its value. For example, the Fed can attempt to lower interestrates by increasing the U.S. money supply (assuming that inflationary expectations arenot affected). Lower U.S. interest rates tend to discourage foreign investors from invest-ing in U.S. securities, thereby putting downward pressure on the value of the dollar. Or,to boost the dollar’s value, the Fed can attempt to increase interest rates by reducing theU.S. money supply. It has commonly used this strategy along with direct intervention inthe foreign exchange market. Indirect intervention can be an effective means of influenc-ing a currency’s value.

When countries experience substantial net outflows of funds (which put severe down-ward pressure on their currency), they commonly use indirect intervention by raising in-terest rates to discourage excessive outflows of funds and therefore limit any downwardpressure on the value of their currency. This adversely affects local borrowers (govern-ment agencies, corporations, and consumers), however, and may weaken the economy.

Indirect Intervention during the Peso Crisis In 1994, Mexico experienced alarge balance of trade deficit, perhaps because the peso was stronger than it should havebeen and encouraged Mexican firms and consumers to buy an excessive amount of im-ports. By December 1994, there was substantial downward pressure on the peso. On De-cember 20, 1994, Mexico’s central bank devalued the peso by about 13 percent. Mexico’sstock prices plummeted, as many foreign investors sold their shares and withdrew theirfunds from Mexico in anticipation of further devaluation in the peso. On December 22,the central bank allowed the peso to float freely, and it declined by 15 percent. This wasthe beginning of the so-called Mexican peso crisis. The central bank increased interest ratesas a form of indirect intervention to discourage foreign investors from withdrawing theirinvestments in Mexico’s debt securities. The higher interest rates increased the cost of bor-rowing for Mexican firms and consumers, thereby slowing economic growth.

Indirect Intervention during the Asian Crisis In the fall of 1997, many Asiancountries experienced weak economies, and their banks suffered from substantial defaultson loans. Concerned about their investments, investors began to withdraw their fundsfrom these countries. Some countries (such as Thailand and Malaysia) increased their in-terest rates as a form of indirect intervention to encourage investors to leave their funds inAsia. However, the higher interest rates increased the cost of borrowing for firms that hadborrowed funds there, making it more difficult for them to repay their loans. In addition,the high interest rates discouraged new borrowing by firms and weakened the economies(see Appendix 16A for a more comprehensive discussion of the Asian crisis).

During the Asian crisis, investors also withdrew funds from Brazil and reinvestedthem in other countries, causing major capital outflows and putting extreme downwardpressure on the currency (the real). At the end of October, the central bank of Brazilresponded by doubling its interest rates from about 20 percent to about 40 percent.This action discouraged investors from pulling funds out of Brazil because they couldnow earn twice the interest from investing in some securities there. Although the bank’saction was successful in defending the real, it reduced economic growth because the costof borrowing funds was too high for many firms.

Indirect Intervention during the Russian Crisis A similar situation occurredin Russia in May 1998. Over the previous four months, the Russian currency (the ruble)


had consistently declined, and stock market prices had declined by more than 50 per-cent. Since the lack of confidence in Russia’s currency and stocks could cause massiveoutflows of funds, the Russian central bank attempted to prevent further outflows by tri-pling interest rates (from about 50 percent to 150 percent). The ruble was temporarilystabilized, but stock prices continued to decline as investors were concerned that thehigh interest rates would reduce economic growth.

Foreign Exchange ControlsSome governments attempt to use foreign exchange controls (such as restrictions on theexchange of the currency) as a form of indirect intervention to maintain the exchangerate of their currency. When there is severe pressure, however, they tend to let the cur-rency float temporarily toward its market-determined level and set new bands aroundthat level. For example, during the mid-1990s, Venezuela imposed foreign exchange con-trols on its currency (the bolivar). In April 1996, Venezuela removed its controls on for-eign exchange, and the bolivar declined by 42 percent the next day. This result suggeststhat the market-determined exchange rate of the bolivar was substantially lower than theexchange rate artificially set by the government.

FORECASTING EXCHANGE RATESMarket participants who use foreign exchange derivatives tend to take positions based ontheir expectations of future exchange rates. For example, U.S. portfolio managers maytake positions in foreign exchange derivatives to hedge the exposure of their Britishstocks, if they anticipate a decline in the value of the British pound. Speculators maytake positions in foreign exchange derivatives to benefit from the expectation that theJapanese yen will strengthen. Thus, the initial task is to develop a forecast of specific ex-change rates. Although there are various techniques for forecasting, no specific techniquestands out. Most techniques have had limited success in forecasting future exchangerates. Most forecasting techniques can be classified as one of the following:

• Technical forecasting• Fundamental forecasting• Market-based forecasting• Mixed forecasting

Technical ForecastingTechnical forecasting involves the use of historical exchange rate data to predict futurevalues. For example, the fact that a given currency has increased in value over four con-secutive days may provide an indication of how the currency will move tomorrow. Insome cases, a more complex statistical analysis is applied. For example, a computer pro-gram can be developed to detect particular historical trends.

There are also several time-series models that examine moving averages and thus allow aforecaster to develop some rule, such as “The currency tends to decline in value after a risein moving average over three consecutive periods.” Normally, consultants who use such amethod will not disclose their particular rule for forecasting. If they did, their potential cli-ents might apply the rules themselves rather than pay for the consultant’s advice.

Technical forecasting of exchange rates is similar to technical forecasting of stock prices.If the pattern of currency values over time appears random, then technical forecastingis not appropriate. Unless historical trends in exchange rate movements can be identified,examination of past movements will not be useful for indicating future movements.

WEB

www.oanda.comHistorical exchangerates.


Fundamental ForecastingFundamental forecasting is based on fundamental relationships between economicvariables and exchange rates. Given current values of these variables along with theirhistorical impact on a currency’s value, corporations can develop exchange rate projec-tions. For example, high inflation in a given country can lead to depreciation in itscurrency. Of course, all other factors that may influence exchange rates should also beconsidered.

A forecast may arise simply from a subjective assessment of the degree to which gen-eral movements in economic variables in one country are expected to affect exchangerates. From a statistical perspective, a forecast would be based on quantitatively mea-sured impacts of factors on exchange rates.

Market-Based ForecastingMarket-based forecasting, the process of developing forecasts from market indicators, isusually based on either (1) the spot rate or (2) the forward rate.

Use of the Spot Rate To clarify why the spot rate can serve as a market-based fore-cast, assume the British pound is expected to appreciate against the dollar in the verynear future. This will encourage speculators to buy the pound with U.S. dollars todayin anticipation of its appreciation, and these purchases could force the pound’s valueup immediately. Conversely, if the pound is expected to depreciate against the dollar,speculators will sell off pounds now, hoping to purchase them back at a lower price afterthey decline in value. Such action could force the pound to depreciate immediately.Thus, the current value of the pound should reflect the expectation of the pound’s valuein the very near future. Corporations can use the spot rate to forecast, since it representsthe market’s expectation of the spot rate in the near future.

Use of the Forward Rate The forward rate can serve as a forecast of the futurespot rate, because speculators would take positions if there was a large discrepancy be-tween the forward rate and expectations of the future spot rate.

EXAMPLEThe 30-day forward rate of the British pound is $1.40, and the general expectation of specula-

tors is that the future spot rate of the pound will be $1.45 in 30 days. Since speculators expect

the future spot rate to be $1.45, and the prevailing forward rate is $1.40, they might buy

pounds 30 days forward at $1.40 and then sell them when received (in 30 days) at the spot

rate existing then. If their forecast is correct, they will earn $.05 ($1.45 – $1.40) per pound. If a

large number of speculators implement this strategy, the substantial forward purchases of

pounds will cause the forward rate to increase until this speculative demand stops. Perhaps

this speculative demand will terminate when the forward rate reaches $1.45, since at this rate,

no profits will be expected by implementing the strategy. The forward rate should move to-

ward the market’s general expectation of the future spot rate. In this sense, the forward rate

serves as a market-based forecast because it reflects the market’s expectation of the spot rate

at the end of the forward horizon (30 days from now in this example).�Mixed ForecastingBecause no single forecasting technique has been found to be consistently superior to theothers, some multinational corporations (MNCs) use a combination of forecasting tech-niques. This method is referred to as mixed forecasting. Various forecasts for a particu-lar currency value are developed using several forecasting techniques. Each of thetechniques used is assigned a weight so that the weights total 100 percent; the techniquesthought to be more reliable are assigned higher weights. The actual forecast of the cur-rency by the MNC will be a weighted average of the various forecasts developed.


FOREIGN EXCHANGE DERIVATIVESForeign exchange derivatives can be used to speculate on future exchange rate move-ments or to hedge anticipated cash inflows or outflows in a given foreign currency. Asforeign security markets have become more accessible, institutional investors have in-creased their international investments, which has increased their exposure to exchangerate risk. Some institutional investors use foreign exchange derivatives to hedge their ex-posure. The most popular foreign exchange derivatives are forward contracts, currencyfutures contracts, currency swaps, and currency options contracts.

Forward ContractsForward contracts are contracts typically negotiated with a commercial bank that allowthe purchase or sale of a specified amount of a particular foreign currency at a specifiedexchange rate (the forward rate) on a specified future date. A forward market facilitatesthe trading of forward contracts. This market is not in one physical place, but is essen-tially a telecommunications network through which large commercial banks match par-ticipants who wish to buy a currency forward with other participants who wish to sell acurrency forward.

Many of the commercial banks that offer foreign exchange on a spot basis also offerforward transactions for the widely traded currencies. By enabling a corporation to lockin the price to be paid for a foreign currency, forward purchases or sales can hedge thecorporation’s risk that the currency’s value may change over time.

EXAMPLESt. Louis Insurance Company plans to invest about $20 million in Mexican stocks two months

from now. Because the Mexican stocks are denominated in pesos, the amount of stock that

can be purchased is dependent on the peso’s value at the time of the purchase. If St. Louis In-

surance Company is concerned that the peso will appreciate by the time of the purchase, it can

buy pesos forward to lock in the exchange rate.�A corporation receiving payments denominated in a particular foreign currency in the

future can lock in the price at which the currency can be sold by selling that currencyforward.

EXAMPLEThe pension fund manager of Gonzaga, Inc. plans to liquidate the fund’s holdings of British

stocks in six months, but anticipates that the British pound will depreciate by that time. The

pension fund manager can insulate the future transaction from exchange rate risk by negotiat-

ing a forward contract to sell British pounds six months forward. In this way, the British

pounds received when the stocks are liquidated can be converted to dollars at the exchange

rate specified in the forward contract.�The large banks that accommodate requests for forward contracts are buying forward

from some firms and selling forward to others for a given date.

EXAMPLECorvalis Company will need 1 million euros in one year. It can purchase euros one year for-

ward from Utah Bank. If the forward rate of the euro is $1.25, the firm will need $1,250,000

($1.25 × 1,000,000 euros) in one year, regardless of how the euro’s value changes over the

year. Meanwhile Salem Company will be receiving 1 million euros in one year and is con-

cerned that the euro may depreciate by the time it receives them. It calls Utah Bank, which

quotes a rate of $1.24 to buy the euros from Salem Company in one year. Thus, Salem will ex-

change the euros for dollars at Utah Bank and will receive $1,240,000 ($1.24 × 1,000,000 euros).

Utah Bank earned $.01 per unit or $10,000 on the spread between its ask price of $1.25 for

euros one year forward and its bid price of $1.24 for euros one year forward.�Many types of financial institutions rely on the forward market to hedge the exchange

rate risk resulting from their holdings of foreign securities.


If a bank’s forward purchase and sale contracts do not even out for a given date, thebank is exposed to exchange rate risk.

EXAMPLENebraska Bank has contracts committed to selling C$100 million and purchasing C$150 million

90 days from now. It will receive C$50 million more than it sells. An increase in the Canadian

dollar’s value 90 days from now will be advantageous, but if the Canadian dollar depreciates,

the bank will be adversely affected by its exposure to the exchange rate risk.�Estimating the Forward Premium The forward rate of a currency will some-times exceed the existing spot rate, thereby exhibiting a premium. At other times, itwill be below the spot rate, exhibiting a discount. Forward contracts are sometimes re-ferred to in terms of their percentage premium or discount rather than their actualrate. For example, assume that the spot rate (S) of the Canadian dollar is $.70 while the180-day (n = 180) forward rate (FR) is $.71. The forward rate premium (p) would be

p ¼ FR − SS

×360n

¼ $:71 − $:70$:70

×360180

¼ 2:86%

This premium simply reflects the percentage by which the forward rate exceeds the spotrate on an annualized basis.

Currency Futures ContractsAn alternative to the forward contract is a currency futures contract, which is a stan-dardized contract that specifies an amount of a particular currency to be exchanged ona specified date and at a specified exchange rate. A firm can purchase a futures contractto hedge payables in a foreign currency by locking in the price at which it could pur-chase that specific currency at a particular point in time. To hedge receivables denomi-nated in a foreign currency, it could sell futures, thereby locking in the price at which itcould sell that currency. A futures contract represents a standard number of units. Cur-rency futures contracts also have specific maturity (or “settlement”) dates from which thefirm must choose.

Futures contracts differ from forward contracts in that they are standardized, whereasforward contracts can specify whatever amount and maturity date the firm desires. For-ward contracts have this flexibility because they are negotiated with commercial banksrather than on a trading floor.

Currency SwapsA currency swap is an agreement that allows one currency to be periodically swapped foranother at specified exchange rates. It essentially represents a series of forward contracts.Commercial banks facilitate currency swaps by serving as the intermediary that links twoparties with opposite needs. Alternatively, commercial banks may be willing to take the po-sition counter to that desired by a particular party. In such a case, they expose themselves toexchange rate risk unless the position they have assumed will offset existing exposure.

Currency Options ContractsAnother instrument used for hedging is the currency option. Its primary advantage overforward and futures contracts is that it provides a right rather than an obligation to pur-chase or sell a particular currency at a specified price within a given period.

WEB

www.cmegroup.comClick on “FX Products”to find quotes on cur-rency futurescontracts.


A currency call option provides the right to purchase a particular currency at a speci-fied price (called the exercise price) within a specified period. This type of option can beused to hedge future cash payments denominated in a foreign currency. If the spot rateremains below the exercise price, the option will not be exercised, because the firm couldpurchase the foreign currency at a lower cost in the spot market. A fee (or a premium)must be paid for options, however, so there is a cost to hedging with options, even if theoptions are not exercised.

A put option provides the right to sell a particular currency at a specified price (exer-cise price) within a specified period. If the spot rate remains above the exercise price, theoption will not be exercised, because the firm could sell the foreign currency at a higherprice in the spot market. Conversely, if the spot rate is below the exercise price at thetime the foreign currency is received, the firm can exercise its put option.

When deciding whether to use forward, futures, or options contracts for hedging, afirm should consider the following characteristics of each contract. First, if the firm re-quires a tailor-made hedge that cannot be matched by existing futures contracts, a for-ward contract may be preferred. Otherwise, forward and futures contracts shouldgenerate somewhat similar results.

The choice of either an obligation type of contract (forward or futures) or an optionscontract depends on the expected trend of the spot rate. If the currency denominatingpayables appreciates, the firm will benefit more from a futures or forward contract thanfrom a call option contract. The call option contract requires an up-front fee, but it is awiser choice when the firm is less certain of the future direction of a currency. The calloption can hedge the firm against possible appreciation but still allow the firm to ignorethe contract and use the spot market if the currency depreciates. Put options may bepreferred over futures or forward contracts for hedging receivables when future currency

US ING THE WALL STREET JOURNAL

Currency Futures Contracts

The Wall Street Journal provides information on cur-

rency futures contracts, as shown here. Specifically, it

discloses the recent open price, range (high and low),

and final closing (settle) price over the previous trading

day. It also provides the amount of existing contracts

(open interest).

Source: Republished with permission of Dow Jones & Company,

Inc., from The Wall Street Journal, January 7, 2009, p. C9;

permission conveyed through the Copyright Clearance Center, Inc.

WEB

www.cmegroup.comClick on “FX Products”to find quotes on cur-rency optionscontracts.


movements are very uncertain, because the firm has the flexibility to let the options ex-pire if the currencies strengthen.

Conditional Currency Options Some currency options are structured with a con-ditional premium, meaning that the premium is conditioned on the actual movement inthe currency’s value over the period of concern.

EXAMPLECanyon Company, a U.S.-based MNC, needs to sell British pounds that it will receive in 60

days. Assume it can negotiate a traditional currency put option on pounds in which the exer-

cise price is $1.70 and the premium is $.02 per unit.

Alternatively, Canyon can negotiate with a commercial bank to obtain a conditional cur-

rency option that has an exercise price of $1.70 and a so-called trigger of $1.74. If the pound’s

value falls below the exercise price by the expiration date, Canyon will exercise the option, re-

ceiving $1.70 per pound, and does not need to pay a premium for the option. If the pound’s

value is between the exercise price ($1.70) and the trigger ($1.74), the option will not be exer-

cised, and Canyon will not need to pay a premium. If the pound’s value exceeds the trigger of

$1.74, Canyon will pay a premium of $.04 per unit. Notice that this premium may be higher

than the premium Canyon would pay if it purchases a basic put option. Canyon may not mind

this outcome, however, because it will be receiving a high dollar amount from converting its

pound receivables in the spot market.

Canyon must determine whether the potential advantage of the conditional option (avoiding

the payment of a premium under some conditions) outweighs the potential disadvantage (pay-

ing a higher premium than the premium for a traditional put option on British pounds). The po-

tential advantage and disadvantage are illustrated in Exhibit 16.2. At exchange rates below or

Exhibit 16.2 Comparison of Conditional and Basic Currency Options

Spot Rate

$1.60

$1.60

Basic Put Option: Exercise Price � $1.70, Premium � $.02.Conditional Put Option: Exercise Price � $1.70, Trigger � $1.74, Premium � $.04.

$1.62 $1.64 $1.66 $1.68 $1.70 $1.72 $1.74 $1.76 $1.78 $1.80

$1.62

$1.64

$1.66

$1.68

$1.70

$1.72

$1.74

$1.76BasicPut Option

ConditionalPut Option

ConditionalPut Option

Net A

mou

nt R

ecei

ved


equal to the trigger level ($1.74), the conditional option will result in a larger payment to Can-

yon by the amount of the premium that would have been paid for the basic option. Conversely,

at exchange rates above the trigger level, the conditional option results in a lower payment to

Canyon, as its premium of $.04 exceeds the premium of $.02 per unit paid on a basic option.

The choice of a basic option versus a conditional option is dependent on the firm’s expecta-

tions of the currency’s exchange rate over the period of concern. If Canyon is very confident

that the pound’s value will not exceed $1.74, it will prefer the conditional currency option.�Conditional currency options are also available for U.S. firms that need to purchase a for-

eign currency in the near future. For example, a conditional call option on the pound mayspecify an exercise price of $1.70 and a trigger of $1.67. If the pound’s value remains abovethe trigger of the call option, a premium will not have to be paid for the call option. If thepound’s value falls below the trigger, however, a large premium (such as $.04 per unit) willbe required. Some conditional options require a premium if the trigger is reached anytimeup until the expiration date; others require a premium only if the exchange rate is beyondthe trigger as of the expiration date.

Use of Foreign Exchange Derivatives for SpeculatingThe forward, currency futures, and currency options markets may be used for speculat-ing as well as for hedging. A speculator who expects the Singapore dollar to appreciatecould consider any of these strategies:

1. Purchase Singapore dollars forward; when they are received, sell them in the spot market.2. Purchase futures contracts on Singapore dollars; when the Singapore dollars are

received, sell them in the spot market.3. Purchase call options on Singapore dollars; at some point before the expiration date,

when the spot rate exceeds the exercise price, exercise the call option and then sellthe Singapore dollars received in the spot market.

Conversely, a speculator who expects the Singapore dollar to depreciate could considerany of these strategies:

1. Sell Singapore dollars forward and then purchase them in the spot market justbefore fulfilling the forward obligation.

2. Sell futures contracts on Singapore dollars; purchase Singapore dollars in the spotmarket just before fulfilling the futures obligation.

3. Purchase put options on Singapore dollars; at some point before the expiration date,when the spot rate is less than the exercise price, purchase Singapore dollars in thespot market and then exercise the put option.

Speculating with Currency Futures As an example of speculating with currencyfutures, consider the following information:

• Spot rate of the British pound is $1.56 per pound.• Price of a futures contract is $1.57 per pound.• Expectation of the pound’s spot rate as of the settlement date of the futures contract

is $1.63 per pound.

Given that the future spot rate is expected to be higher than the futures price, youcould buy currency futures. You would receive pounds on the settlement date for $1.57.If your expectations are correct, you would then sell the pounds for $.06 more per unitthan you paid for them. The risk of your speculative strategy is that the pound may de-cline rather than increase in value. If it declines to $1.55 by the settlement date, youwould have sold the pounds for $.02 less per unit than you paid.


To account for uncertainty, speculators may develop a probability distribution for thefuture spot rate:

FUTURE SPOT RATEOF BRITISH POUND PROBABILITY

$1.50 10%

1.59 20

1.63 50

1.66 20

This probability distribution suggests that four outcomes are possible. For each possibleoutcome, the anticipated gain or loss can be determined:

POSSIBLE OUTCOME FORFUTURE SPOT RATE PROBABILITY

GAIN OR LOSSPER UNIT

$1.50 10% –$.07

1.59 20 .02

1.63 50 .06

1.66 20 .09

This analysis measures the probability and potential magnitude of a loss from the specu-lative strategy.

Speculating with Currency Options Consider the information from the previousexample and assume that a British call option is available with an exercise price of $1.57 anda premium of $.03 per unit. Recall that your best guess of the future spot rate was $1.63. Ifyour guess is correct, you will earn $.06 per unit on the difference between what you paid(the exercise price of $1.57) and the price for which you could sell a pound ($1.63). After thepremium paid for the option ($.03 per unit) is deducted, the net gain is $.03 per unit.

The risk of purchasing this option is that the pound’s value might decline over time.If so, you will be unable to exercise the option, and your loss will be the premiumpaid for it. To assess the risk involved, a probability distribution can be developed. InExhibit 16.3, the probability distribution from the previous example is applied here.The distribution of net gains from the strategy is shown in the sixth column.

Exhibit 16.3 Estimating Speculative Gains from Options Using a Probability Distribution

(1)

POSSIBLEOUTCOME

FOR FUTURESPOT RATE

(2)

PROBABILITY

(3)WILL THEOPTION BEEXERCISED

BASED ON THISOUTCOME?

(4)

GAIN PERUNIT FROMEXERCISING

OPTION

(5)PREMIUMPAID PERUNIT FOR

THEOPTION

(6)

NET GAINOR

LOSS PERUNIT

$1.50 10% No — $.03 −$.03

1.59 20 Yes $.02 .03 −.01

1.63 50 Yes .06 .03 .03

1.66 20 Yes .09 .03 .06


Speculators should always compare the potential gains from currency options and currencyfutures contracts to determine which type of contract (if any) to trade. It is possible for twospeculators to have similar expectations about potential gains from both types of contracts, yetprefer different types of contracts because they have different degrees of risk aversion.

INTERNATIONAL ARBITRAGEExchange rates in the foreign exchange market are market determined. If they becomemisaligned, various forms of arbitrage will occur, forcing realignment. Common typesof international arbitrage are explained next.

Locational ArbitrageLocational arbitrage is the act of capitalizing on a discrepancy between the spot ex-change rate at two different locations by purchasing the currency where it is priced lowand selling it where it is priced high.

EXAMPLEThe exchange rates of the European euro quoted by two banks differ, as shown in Exhibit 16.4.

The ask quote is higher than the bid quote to reflect the transaction costs charged by each bank.

Because Baltimore Bank is asking $1.046 for euros and Sacramento Bank is willing to pay (bid)

$1.050 for euros, an institution could execute locational arbitrage. That is, it could achieve a risk-

free return without tying funds up for any length of time by buying euros at one location (Balti-

more Bank) and simultaneously selling them at the other location (Sacramento Bank).�As locational arbitrage is executed, Baltimore Bank will begin to raise its ask price on

euros in response to the strong demand. In addition, Sacramento Bank will begin to lowerits bid price in response to the excess supply of euros it has recently received. Once Balti-more’s ask price is at least as high as Sacramento’s bid price, locational arbitrage will nolonger be possible. Because some financial institutions (particularly the foreign exchangedepartments of commercial banks) watch for locational arbitrage opportunities, any dis-crepancy in exchange rates among locations should quickly be alleviated.

Triangular ArbitrageIf the quoted cross rate between two foreign currencies is not aligned with the two cor-responding exchange rates, there is a discrepancy in the exchange rate quotations. Underthis condition, investors can engage in triangular arbitrage, which involves buying orselling the currency that is subject to a mispriced cross-exchange rate.

EXAMPLEIf the spot rate is $.07 for the Mexican peso and $.70 for the Canadian dollar, the cross-exchange

rate should be C$1 = 10 pesos (computed as $.70/$.07). Assume that the Canadian dollar/peso ex-

change rate is quoted as C$1 = 10.3 pesos. In this case, the quote for the Canadian dollar is higher

than it should be. An investor could benefit by using U.S. dollars to buy Canadian dollars, using

those Canadian dollars to buy pesos, and then using the pesos to buy U.S. dollars. These transac-

tions would be executed at about the same time before the exchange rates change. With $1,000,

you could buy C$1,428.57 (computed as 1,000 divided by .70), convert those Canadian dollars into

14,714 pesos (computed as 1,428.57 × 10.3), and then convert the pesos into $1,030 (computed as

14,714 × .07). Thus, you would have a gain of $30. The gain would be much larger if you engaged

in triangular arbitrage with a larger amount of money.�Exhibit 16.4 Bank Quotes Used for Locational Arbitrage Example

BID RATE ON EUROS ASK RATE ON EUROS

Sacramento Bank $1.050 $1.056

Baltimore Bank $1.042 $1.046


Whenever there is a discrepancy in exchange rates, financial institutions with largeamounts of money will engage in triangular arbitrage, causing the quoted exchange rates toquickly adjust. The arbitrage transaction of using U.S. dollars to buy Canadian dollars willcause the exchange rate of the Canadian dollar to rise with respect to the U.S. dollar. Thearbitrage transaction of using Canadian dollars to buy pesos will cause the value of theCanadian dollar to depreciate against the peso. The arbitrage transaction of using pesos to buyU.S. dollarswill cause the value of the peso to depreciate against theU.S. dollar. Once the cross-exchange rate adjusts to its appropriate level, triangular arbitragewill no longer be feasible. Therates may adjust within a matter of seconds in response to the market forces. Quoted cross-exchange rates normally do not reflect a discrepancy because if they did, financial institutionswould capitalize on the discrepancy until the exchange rates were realigned.

Covered Interest ArbitrageThe coexistence of international money markets and forward markets forces a specialrelationship between a forward rate premium and the interest rate differential of two coun-tries, known as interest rate parity. The equation for interest rate parity can be written as

p ¼ ð1 þ ihÞð1 þ if Þ − 1

where p¼ forward premium of foreign currencyih¼home country interest rateif ¼ foreign interest rate

EXAMPLEThe spot rate of the New Zealand dollar is $.50, the one-year U.S. interest rate is 9 percent, and

the one-year New Zealand interest rate is 6 percent. Under conditions of interest rate parity, the

forward premium of the New Zealand dollar will be

p ¼ ð1 þ 9%Þð1 þ 6%Þ − 1

^ 2:8%

This means that the forward rate of the New Zealand dollar will be about $.514, to reflect a 2.8

percent premium above the spot rate.�A review of the equation for interest rate parity suggests that if the interest rate is lower

in the foreign country than in the home country, the forward rate of the foreign currencywill exhibit a premium. In the opposite situation, the forward rate will exhibit a discount.

Interest rate parity suggests that the forward rate premium (or discount) should beabout equal to the differential in interest rates between the countries of concern. If therelationship does not hold, market forces should occur that will restore the relationship.The act of capitalizing on the discrepancy between the forward rate premium and theinterest rate differential is called covered interest arbitrage.

EXAMPLEThe spot rate and the one-year forward rate of the Canadian dollar are $.80. The Canadian in-

terest rate is 10 percent, while the U.S. interest rate is 8 percent. U.S. investors can take advan-

tage of the higher Canadian interest rate without being exposed to exchange rate risk by

executing covered interest arbitrage. Specifically, they will exchange U.S. dollars for Canadian

dollars and invest at the rate of 10 percent. They will simultaneously sell Canadian dollars one

year forward. Because they are able to purchase and sell Canadian dollars for the same price,

their return is the 10 percent interest earned on their investment.�As the U.S. investors demand Canadian dollars in the spot market while selling Cana-

dian dollars forward, they place upward pressure on the spot rate and downward pres-


sure on the one-year forward rate of the Canadian dollar. Thus, the Canadian dollar’sforward rate will exhibit a discount. Once the discount becomes large enough, the inter-est rate advantage in Canada will be offset. What U.S. investors gain on the higher Ca-nadian interest rate is offset by having to buy Canadian dollars at a higher (spot) ratethan the selling (forward) rate. Consequently, covered interest arbitrage will no longergenerate a return that is any higher for U.S. investors than an alternative investment inthe United States. Once the forward discount (or premium) offsets the interest rate dif-ferential in this manner, interest rate parity exists.

The interest rate parity equation determines the forward discount that the Canadiandollar must exhibit to offset the interest rate differential:

p ¼ ð1 þ ihÞð1 þ if Þ − 1

¼ ð1 þ 8%Þð1 þ 10%Þ − 1

^ �1:82%

If the forward rate is lower than the spot rate by 1.82 percent, the interest rate is offset,and covered interest arbitrage would yield a return to U.S. investors similar to the U.S.interest rate.

The existence of interest rate parity prevents investors from earning higher returnsfrom covered interest arbitrage than can be earned in the United States. Nevertheless,international investing may still be feasible if the investing firm does not simultaneouslycover in the forward market. Of course, failure to do so usually exposes the firm to ex-change rate risk; if the currency denominating the investment depreciates over the in-vestment horizon, the return on the investment is reduced.

SUMMARY

■ Exchange rates are influenced by differential infla-tion rates, differential interest rates, and centralbank intervention. There is upward pressure on aforeign currency’s value when its home countryhas relatively low inflation or relatively high interestrates. Central banks can place upward pressure on acurrency by purchasing that currency in the foreignexchange markets (by exchanging other currenciesheld in reserve for that currency). Alternatively,they can place downward pressure on a currency byselling that currency in the foreign exchange marketsin exchange for other currencies.

■ Exchange rates can be forecasted using technical, fun-damental, and market-based methods. Each methodhas its own advantages and limitations.

■ Foreign exchange derivatives include forward con-tracts, currency futures contracts, currency swaps,and currency options contracts. Forward contractscan be purchased to hedge future payables or sold

to hedge future receivables in a foreign currency.Currency futures contracts can be used in a mannersimilar to forward contracts to hedge payables or re-ceivables in a foreign currency. Currency swaps canbe used to lock in the exchange rate of a foreigncurrency to be received or purchased at a future pointin time. Currency call options can be purchased tohedge future payables in a foreign currency, whilecurrency put options can be purchased to hedge fu-ture receivables in a foreign currency. Currency op-tions offer more flexibility than the other foreignexchange derivatives, but a premium must be paidfor them.

Foreign exchange derivatives can also be used tospeculate on expected exchange rate movements.When speculators expect a foreign currency to ap-preciate, they can lock in the exchange rate at whichthey may purchase that currency by purchasingforward contracts, futures contracts, or call options


on that currency. When speculators expect a currencyto depreciate, they can lock in the exchange rate atwhich they may sell that currency by selling forwardcontracts or futures contracts on that currency. Theycould also purchase put options on that currency.

■ International arbitrage ensures that foreign ex-change market prices are set properly. If exchangerates vary among the banks that serve the foreignexchange market, locational arbitrage will be possi-ble. Foreign exchange market participants will pur-chase a currency at the bank with a low quote and

sell it to another bank where the quote is higher. If aquoted cross-exchange rate is misaligned with thecorresponding exchange rates, triangular arbitragewill be possible. This involves buying or sellingthe currency that is subject to the mispriced exchangerate. If the interest rate differential is not offset by theforward rate premium (as suggested by interest rateparity), covered interest arbitrage will be possible.This involves investing in a foreign currency and si-multaneously selling the currency forward. Arbitragewill occur until interest rate parity is restored.

POINT COUNTER-POINT

Do Financial Institutions Need to Consider Foreign Exchange Market ConditionsWhen Making Domestic Security Market Decisions?

Point No. If there is no exchange of currencies, there isno need to monitor the foreign exchange market.

Counter-Point Yes. Foreign exchange market condi-tions can affect an economy or an industry and there-fore affect the valuation of securities. In addition, the

valuation of a firm can be affected by currency move-ments because of its international business.

Who Is Correct? Use the Internet to learn more aboutthis issue. Offer your own opinion on this issue.

QUESTIONS AND APPLICATIONS

1. Exchange Rate Systems Explain the ex-change rate system that existed during the 1950sand 1960s. How did the Smithsonian Agreement in1971 revise it? How does today’s exchange ratesystem differ?

2. Dirty Float Explain the difference between afreely floating system and a dirty float. Which type ismore representative of the U.S. system?

3. Impact of Quotas Assume that European coun-tries impose a quota on goods imported from the UnitedStates, and the United States does not plan to retaliate.How could this affect the value of the euro? Explain.

4. Impact of Capital Flows Assume that stocksin the United Kingdom become very attractive to U.S.investors. How could this affect the value of the Britishpound? Explain.

5. Impact of Inflation Assume that Mexico sud-denly experiences high and unexpected inflation. Howcould this affect the value of the Mexican peso ac-cording to purchasing power parity (PPP) theory?

6. Impact of Economic Conditions Assumethat Switzerland has a very strong economy, puttingupward pressure on both inflation and interest rates.Explain how these conditions could put pressure on thevalue of the Swiss franc, and determine whether thefranc’s value will rise or fall.

7. Central Bank Intervention The Bank of Japandesires to decrease the value of the Japanese yen againstthe dollar. How could it use direct intervention to do this?

8. Bank Speculation When would a commercialbank take a short position in a foreign currency? Along position?

9. Risk from Speculating Seattle Bank was longin Australian dollars and short in Canadian dollars.Explain a possible future scenario that could adverselyaffect the bank’s performance.

10. Impact of a Weak Dollar How does a weakdollar affect U.S. inflation? Explain.

11. Speculating with Foreign Exchange Deri-vatives Explain how U.S. speculators could use for-


eign exchange derivatives to speculate on the expectedappreciation of the Japanese yen.

Advanced Questions

12. Interaction of Capital Flows and YieldCurve Assume a horizontal yield curve exists. How doyou think the yield curve would be affected if foreigninvestors in short-term securities and long-term secu-rities suddenly anticipate that the value of the dollarwill strengthen? (You may find it helpful to refer backto the discussion of the yield curve in Chapter 3.)

13. How the Euro’s Value May Respond toPrevailing Conditions Consider the prevailingconditions for inflation (including oil prices), theeconomy, interest rates, and any other factors thatcould affect exchange rates. Based on these conditions,do you think the euro’s value will likely appreciate ordepreciate against the dollar for the remainder of thissemester? Offer some logic to support your answer.Which factor do you think will have the biggest impacton the euro’s exchange rate?

Interpreting Financial News

Interpret the following statements made by Wall Streetanalysts and portfolio managers:

a. “Our use of currency futures has completely chan-ged our risk-return profile.”

b. “Our use of currency options resulted in an upgradein our credit rating.”

c. “Our strategy of using forward contracts to hedgebackfired on us.”

Managing in Financial Markets

Using Forex Derivatives for Hedging You arethe manager of a stock portfolio for a financial institu-tion, and about 20 percent of the stock portfolio that youmanage is in British stocks. You expect the British stockmarket to perform well over the next year, and plan tosell the stocks one year from now (and will convert theBritish pounds received to dollars at that time). How-ever, you are concerned that the British pound may de-preciate against the dollar over the next year.

a. Explain how you could use a forward contract tohedge the exchange rate risk associated with your po-sition in British stocks.

b. If interest rate parity exists, does this limit the ef-fectiveness of a forward rate as a hedge?

c. Explain how you could use an options contract tohedge the exchange rate risk associated with your po-sition in stocks.

d. Assume that although you are concerned about thepotential decline in the pound’s value, you also believethat the pound could appreciate against the dollar overthe next year. You would like to benefit from the po-tential appreciation but also wish to hedge against thepossible depreciation. Should you use a forward contractor options contracts to hedge your position? Explain.

PROBLEMS

1. Currency Futures Using the followinginformation, determine the probability distributionof per unit gains from selling Mexican pesofutures:

• Spot rate of peso is $.10.

• Price of peso futures per unit is $.102.

• Your expectation of the peso spot rate at maturityof the futures contract is:

POSSIBLE OUTCOMEFOR FUTURESPOT RATE PROBABILITY

$.09 10%

.095 70

.11 20

2. Currency Call Options Using the followinginformation, determine the probability distribution ofnet gains per unit from purchasing a call option onBritish pounds:

• Spot rate of British pound is $1.45.

• Premium on British pound option is $.04 per unit.

• Exercise price of a British pound option is $1.46.

• Your expectation of the British pound spot rateprior to the expiration of the option is:

POSSIBLE OUTCOME FORFUTURE SPOT RATE PROBABILITY

$1.48 30%

1.49 40

1.52 30


3. Locational Arbitrage Assume the followingexchange rate quotes on British pounds:

Explain how locational arbitrage would occur. Also ex-plain why this arbitrage will realign the exchange rates.

4. Covered Interest Arbitrage Assume thefollowing information:

• British pound spot rate = $1.58

• British pound one-year forward rate = $1.58

• British one-year interest rate = 11%

• U.S. one-year interest rate = 9%

Explain how U.S. investors could use covered interestarbitrage to lock in a higher yield than 9 percent.What would be their yield? Explain how the spot andforward rates of the pound would change as coveredinterest arbitrage occurs.

5. Covered Interest Arbitrage Assume the fol-lowing information:

• Mexican one-year interest rate = 15%

• U.S. one-year interest rate = 11%

If interest rate parity exists, what would be the forwardpremium or discount on the Mexican peso’s forwardrate? Would covered interest arbitrage be moreprofitable to U.S. investors than investing at home?Explain.

FLOW OF FUNDS EXERCISE

Hedging with Foreign Exchange Derivatives

Carson Company expects that it will receive alarge order from the government of Spain. If theorder occurs, Carson will be paid about 3 millioneuros. All of Carson’s expenses are in dollars.Carson would like to hedge this position. Carsonhas contacted a bank with brokerage subsidiariesthat can help it hedge with foreign exchangederivatives.

a. How could Carson use currency futures to hedgeits position?

b. What is the risk of hedging with currency futures?

c. How could Carson use currency options to hedgeits position?

d. Explain the advantage and disadvantage to Carsonof using currency options instead of currency futures.

INTERNET/EXCEL EXERCISES

Use the website www.oanda.com to assess exchange rates.

1. What is the most recent value of the Australiandollar in U.S. dollars? For large transactions, howmany British pounds does a U.S. dollar buy?

2. Review the pound’s value over the past year. Offera possible explanation for the recent movements in thepound’s value.

3. What is the most recent value of the Hong Kongdollar in U.S. dollars? Do you notice anything unusualabout this value over time? What could explain anexchange rate trend such as this?

WSJ EXERCISE

Assessing Exchange Rate Movements

Use a recent issue of The Wall Street Journal to de-termine how a particular currency’s value has chan-ged against the dollar since the beginning of the

year. The table called “Currencies” lists the percent-age change in many currencies since the beginningof the year.

BID ASK

Orleans Bank $1.46 $1.47

Kansas Bank 1.48 1.49


APPENDIX 16AImpact of the Asian Crisis onForeign Exchange Markets andOther Financial Markets

The Asian crisis provides an excellent example of the linkages between the foreign ex-change markets and all of the major financial markets. During the crisis, problems inthe foreign exchange markets caused abrupt price movements in securities in all markets.In fact, the high degree of integration among financial markets today makes each finan-cial market susceptible to events in any other financial market.

CRISIS IN THAILANDUntil July 1997, Thailand was one of the world’s fastest-growing economies. In fact, Thai-land was the fastest-growing country over the 1985–1994 period. Thai consumers spentfreely, which resulted in lower savings than in other Southeast Asian countries. The highlevel of spending and low level of saving put upward pressure on prices of real estate andproducts and on the local interest rate. Normally, countries with high inflation tend tohave a weak currency because of forces from purchasing power parity. Prior to July 1997,however, Thailand’s currency (the baht) was linked to the dollar; this link made Thailandan attractive site for foreign investors, because they could earn a high interest rate on in-vested funds while being protected (until the crisis) from a large depreciation in the baht.

Flow of Funds SituationThe large inflow of funds made Thailand highly susceptible to a massive outflow offunds if the foreign investors ever lost confidence in the Thai economy. Given the largeamount of risky loans and the potential for a massive outflow of funds, Thailand wassometimes described as a house of cards, waiting to collapse.

Export CompetitionDuring the first half of 1997, the dollar strengthened against the Japanese yen and Euro-pean currencies. Since the baht was linked to the dollar over this period, the bahtstrengthened against the yen and European currencies as well, and Thailand’s productsbecame more expensive to various importers.

437

Pressure on the Thai BahtThe baht experienced downward pressure in July 1997 when some foreign investors rec-ognized its potential weakness. The outflow of funds expedited the currency’s weakeningas foreign investors exchanged their baht for their home currencies. The baht’s value rel-ative to the dollar was pressured by the large sales of baht in exchange for dollars. OnJuly 2, 1997, the baht was detached from its link to the dollar. Thailand’s central bankattempted to maintain the baht’s value by intervention. Specifically, it swapped its bahtreserves for dollar reserves at other central banks and then used its dollar reserves topurchase the baht in the foreign exchange market (the swap agreement required Thai-land to reverse this transaction by exchanging dollars for baht at a future date). Thebank hoped that its intervention would offset the sales of baht by foreign investors inthe foreign exchange market, but its efforts were overwhelmed by market forces. Thesupply of baht for sale exceeded the demand for baht in the foreign exchange market,which caused the government to surrender in its effort to defend the baht’s value. InJuly 1997, the value of the baht plummeted, declining by more than 20 percent againstthe dollar over a five-week period.

Rescue Package for ThailandOn August 5, 1997, the International Monetary Fund (IMF) and several countries agreedto provide Thailand with a $16 billion rescue package. Japan and the IMF each contrib-uted $4 billion, and other countries provided the rest. This was the second largest bailoutplan for a single country (Mexico received $50 billion in 1995). In return for the mone-tary support, Thailand agreed to reduce its budget deficit, prevent inflation from risingabove 9 percent, raise its value-added tax from 7 to 10 percent, and clean up the finan-cial statements of its banks, which had many undisclosed bad loans.

SPREAD OF THE CRISIS THROUGHOUT SOUTHEAST ASIAThe crisis in Thailand proved contagious to other countries in Southeast Asia. TheSoutheast Asian economies are somewhat integrated because of their trade contacts.The crisis weakened Thailand’s economy and therefore reduced Thai demand for pro-ducts from the other countries of Southeast Asia. As the demand for the other countries’products declined, so did their national incomes and their own demand for productsfrom other Southeast Asian countries.

The other Southeast Asian countries were similar to Thailand in that they had rela-tively high interest rates, and their governments tended to stabilize their currency. Con-sequently, these countries had also attracted a large amount of foreign investment, butthe foreign investors now realized that the other countries were vulnerable as well. Theseinvestors began to withdraw funds from these countries.

Impact of the Asian Crisis on South KoreaSouth Korea also experienced financial problems, as many of its corporations were un-able to repay their loans. On December 3, 1997, the IMF agreed to a $55 million rescuepackage for South Korea. The World Bank and the Asian Development Bank joined withthe IMF to provide a standby credit line of $35 billion. In exchange for the funding,South Korea agreed to reduce its economic growth and to impose restrictions on its con-glomerates to prevent excessive borrowing. These measures led to some bankruptcies andunemployment, because the banks could no longer automatically provide loans to allconglomerates that needed funds unless the funding was economically justified.


Impact of the Asian Crisis on JapanJapan was also affected by the Asian crisis for several reasons. It exports productsthroughout Southeast Asia, and many of its corporations have subsidiaries in other Asiancountries and were therefore affected by the local economic conditions. Many of Japan’scorporations experienced financial distress and could not repay their loans.

During the spring of 1998, the Japanese yen continued to weaken against the dollar.The yen’s decline placed more pressure on other Asian currencies, because the Asiancountries wanted to gain a competitive advantage in exporting to the United States as aresult of their weak currencies. In April 1998, the Bank of Japan used more than $20billion to purchase yen in the foreign exchange market. This effort to boost the yen’svalue was unsuccessful.

EFFECTS ON ASIAN CURRENCIESIn July and August of 1997, the values of the Malaysian ringgit, Singapore dollar, Philippinepeso, Taiwan dollar, and Indonesian rupiah also declined. The Philippine peso was devaluedin July. Malaysia initially attempted to maintain the ringgit’s value within a narrow band,but then surrendered and let the ringgit float to its market-determined level.

In August 1997, Bank Indonesia (the central bank) used more than $500 million indirect intervention to purchase rupiah in the foreign exchange market in an attempt toboost the currency’s value. By mid-August, however, the bank gave up on its effort tomaintain the rupiah’s value within a band and let the rupiah float to its natural level.This decision to let the rupiah float may have been influenced by the failure of Thai-land’s costly efforts to maintain the baht. The market forces were too strong and couldnot be offset by direct intervention. In the spring of 1998, the IMF provided Indonesiawith a rescue package worth about $43 billion.

Impact of the Asian Crisis on Hong KongOn October 23, 1997, prices on the Hong Kong stock market declined by 10.2 percenton average; considering the three previous trading days as well, the cumulative four-dayeffect was a decline of 23.3 percent. The decline was primarily attributed to speculationthat Hong Kong’s currency might be devalued and that it could experience financial pro-blems similar to those of the Southeast Asian countries. The decline of almost one-fourthin the market value of Hong Kong companies over a four-day period demonstrated theperceived exposure of Hong Kong to the crisis.

Hong Kong maintained its pegged exchange rate system during this period, as its dol-lar was tied to the U.S. dollar. Nevertheless, it had to increase interest rates to discourageinvestors from transferring their funds out of the country.

Impact of the Asian Crisis on ChinaIronically, China did not experience the adverse economic effects of the crisis because itsgrowth in the years prior to the crisis was not as strong as that of the countries in South-east Asia. The Chinese government had more control over economic conditions thanother Asian governments because it still owned most real estate and controlled most ofthe banks that provided credit to support growth. Thus, China experienced fewer bank-ruptcies as a result of the crisis. In addition, the government was able to maintain thevalue of the Chinese currency (the yuan) against the dollar, which limited speculativeflows of funds out of China. Although interest rates increased during the crisis, they re-mained relatively low. This allowed Chinese firms to obtain funding at a reasonable costand enabled them to continue to meet their interest payments.


Nevertheless, concerns about China mounted because it relies heavily on exports tostimulate its economy and was now at a competitive disadvantage relative to the South-east Asian countries whose currencies had depreciated. Thus, importers from the UnitedStates and Europe shifted some of their purchases to countries where the currencies hadweakened substantially. In addition, the decline in the other Asian currencies against theChinese yuan encouraged Chinese consumers to purchase imports rather than locallymanufactured products.

Impact of the Asian Crisis on RussiaDuring the crisis, investors also lost confidence in the value of the Russian ruble and beganto transfer funds out of Russia. In response to the downward pressure these outflows placedon the ruble, the central bank of Russia engaged in direct intervention, using dollars to pur-chase rubles in the foreign exchange market. It also used indirect intervention, raising inter-est rates to make them more attractive to investors and discourage additional outflows.

In July 1998, the IMF organized a loan package (with some help from Japan and the WorldBank) worth $22.6 billion to Russia. The package required that Russia boost its tax revenue,reduce its budget deficit, and create a more capitalist environment for its businesses.

During August 1998, Russia’s central bank frequently intervened to prevent the rublefrom declining substantially. On August 26, however, it gave up its fight to defend theruble’s value, and market forces caused the ruble to decline by more than 50 percentagainst most currencies on that day. This led to fears of a new crisis, and the next day(called “Bloody Thursday”) paranoia swept stock markets around the world. Some stockmarkets (including the U.S. markets) experienced declines of more than 4 percent.

Impact of the Asian Crisis on Latin American CountriesThe Asian crisis also affected Latin American countries. Countries such as Chile, Mexico,and Venezuela were adversely affected because they export to Asia and demand for theirproducts declined due to the weak Asian economies. In addition, the Latin Americancountries lost business as other importers switched to Asian products because the sub-stantial depreciation of the Asian currencies had made those goods cheaper than thoseof Latin America.

The adverse effects on Latin American countries placed pressure on Latin Americancurrency values, as there was concern that speculative outflows of funds would weakenthese currencies in the same way that Asian currencies had weakened. In particular, Bra-zil’s currency (the real) came under pressure in late October 1997. Some speculators be-lieved that because most Asian countries had failed to maintain their currencies withinbands, Brazil, too, would be unable to stabilize its currency.

In a form of direct intervention, the central bank of Brazil used about $7 billion ofreserves to purchase real in the foreign exchange market and protect the currency fromdepreciation. The bank also used indirect intervention by raising short-term interestrates. This encouraged foreign investment in Brazil’s short-term securities to capitalizeon the high interest rates and also encouraged local investors to invest locally ratherthan in foreign markets. The increase in interest rates signaled that the bank was seriousabout maintaining the stability of the real. This type of intervention is costly, however,because it increases the cost of borrowing for households, corporations, and governmentagencies and thus can reduce economic growth. If Brazil’s currency had weakened, thespeculative forces might have spread to the other Latin American currencies as well.

The Asian crisis also caused bond ratings of many large corporations and governmentagencies in Latin America to be downgraded. For example, in November 1997, whentop-grade government-backed bonds in South Korea were reduced to junk-level status


in the international credit markets, rumors that banks were dumping Asian bonds cre-ated fears that all emerging market debt would be dumped in the bond markets. Further-more, there was concern that many banks experiencing financial problems (because theirloans were not being repaid) would sell bond holdings in the secondary market to raisefunds. Consequently, prices of bonds issued in emerging markets, including those ofLatin American countries, declined.

Impact of the Asian Crisis on EuropeDuring the Asian crisis, European countries were experiencing strong economic growth.Nevertheless, many European firms were adversely affected by the crisis. Like firms inLatin America, some firms in Europe experienced reduced demand for their exports toAsia. In addition, they lost some exporting business to Asian exporters as a result of theweakened Asian currencies that reduced Asian prices from an importer’s perspective.

Impact of the Asian Crisis on the United StatesThe effects of the Asian crisis were even felt in the United States. Stock values of U.S.firms such as IBM, Motorola, Hewlett-Packard, and Nike that conducted much businessin Asia were adversely affected. Many U.S. engineering and construction firms were ad-versely affected as Asian countries curtailed their plans to improve infrastructure. Stockvalues of U.S. exporters to those countries were adversely affected because of the declinein spending by Asian consumers and corporations and because the weakening of theAsian currencies made U.S. products more expensive.

LESSONS FROM THE ASIAN CRISISThe Asian crisis demonstrated that financial markets can be exposed to the financialproblems of other countries, as explained next.

Exposure to Effects on Exchange RatesThe Asian crisis demonstrated that currencies are susceptible to depreciation in responseto a lack of confidence in central banks’ ability to stabilize their local currencies. If inves-tors and firms had believed that the central banks could prevent the free fall in currencyvalues, they would not have transferred their funds to other countries. This would haveremoved the downward pressure on the currency values.

Exhibit 16A.1 shows how exchange rates of some Asian currencies changed againstthe U.S. dollar within one year of the crisis (from June 1997 to June 1998). In particular,the currencies of Indonesia, Malaysia, South Korea, and Thailand declined substantially.

Exposure to Effects on Interest RatesThe Asian crisis also demonstrated how much interest rates could be affected by the flowof funds out of countries. Exhibit 16A.2 illustrates how interest rates changed from June1997 (just before the crisis) to June 1998 for various Asian countries. The increases ininterest rates can be attributed to the indirect interventions intended to prevent the localcurrencies from depreciating further, or to the massive outflows of funds, or to both ofthese conditions. In particular, interest rates in Indonesia, Malaysia, and Thailand in-creased substantially from their precrisis levels. Countries whose local currencies experi-enced more depreciation had higher upward adjustments. Since the substantial increasesin interest rates (which tend to reduce economic growth) may have been caused by theoutflows of funds, they may be indirectly due to the lack of confidence of investors andfirms in the ability of the Asian central banks to stabilize their local currencies.


Exposure to Effects on Security PricesExhibit 16A.3 provides a summary of how the Asian crisis affected financial marketprices in Thailand. The exhibit is equally applicable to the other Asian countries that ex-perienced financial distress during the crisis. For clarity, bonds, bank loans, and moneymarket instruments are combined and simply referred to as debt securities in the exhibit.

Exhibit 16A.1 How Exchange Rates Changed during the Asian Crisis (June 1997–June 1998)

India�41%

Thailand�38% Malaysia

�37% Singapore�15%

Philippines�37%

Hong Kong0%

Indonesia�84%

South Korea�41%China

0%

Taiwan�20%

Exhibit 16A.2 How Interest Rates Changed during the Asian Crisis (Number before slash is the annualizedinterest rate as of June 1997; number after slash is the annualized interest rate as of June 1998)

India12/7

Thailand11/24 Malaysia

7/11 Singapore3/7

Philippines11/14

Hong Kong6/10

Indonesia16/47

South Korea14/17China

8/7

Taiwan5/7


The initial conditions that instigated the crisis in Thailand were a weak economy,heavy reliance on foreign funding to finance growth, and excessive credit problems.These conditions scared investors and encouraged them to sell their investments andwithdraw their funds from Thailand. The prices of debt securities issued in Thailandare primarily driven by the required rate of return by investors who may purchase debtsecurities, which is influenced by the local risk-free rate and the default risk premium.During the crisis, Thailand experienced higher interest rates because of the speculativeoutflows by investors, which reduced the supply of funds available, and because of thecentral bank’s efforts to boost interest rates. The default risk premium increased becauseof the weak economic conditions and the increased market awareness of the credit pro-blems experienced by many local firms. In fact, the rescue package provided by the IMFmay even have increased the default risk premium because the IMF required that thelocal banks increase credit standards, which may have made it more difficult for firmsin Thailand to obtain funding and pushed them one step closer to bankruptcy. Since therisk-free rate increased and the default risk premium increased, the required rate of re-turn on Thailand’s debt securities increased, and prices of debt securities decreased.

Stock prices in Thailand are dependent on the expected cash flows of the firms thatissued the stocks and the required rate of return by investors who may invest in them.

Exhibit 16A.3 How the Asian Crisis Affected Thailand’s Security Prices

Required Returnon Debt

IndirectCentralBank

Intervention

VolatileStock MarketConditions

ExpectedCash Flows

of Corporations

DefaultRisk

Premium

Weak Economic Conditions

Lack of Confidence in Markets

Net Capital Outflows

Debt Security Prices

Value of Local Currency

Risk-Free Rate MarketRisk

Premium

RequiredReturn on

Stocks

Stock Prices


The expected cash flows for firms in Thailand were reduced because of the weak econ-omy and the limited amount of credit that was being extended. In addition, the increasein interest rates was expected to reduce borrowing because higher rates increase the costof financing projects and therefore were expected to have an additional adverse effect oneconomic growth and expected cash flows. The required return on Thailand stocks isgenerally dependent on the risk-free rate and the stock market risk premium. The risk-free rate had risen as explained earlier, while the stock market risk premium increasedbecause of the increased awareness of poor economic conditions and more uncertainty.Thus, both factors caused a higher required return on stocks. The combination of expec-tations of reduced cash flows and a higher required rate of return on stocks caused theprices of Thailand stocks to plummet.

The weakness of the stock and debt security markets reduced the wealth of local in-vestors and had an additional adverse effect on the economy. The linkages between theeconomy, the currency, the stock markets, and the debt markets in Thailand created acycle of adverse effects, further reducing the confidence of consumers, firms, and inves-tors with every adverse effect.

Exhibit 16A.4 summarizes how the Asian crisis affected the security prices of manyother Asian countries. In these countries, as in Thailand, the lack of confidence in acountry’s financial markets caused foreign investors to flee, which placed downwardpressure on the currency’s value. The outflow of funds combined with central bank in-tervention placed upward pressure on interest rates, which increased the required returnon investments. In addition, the weak economic conditions and high degree of uncer-tainty raised the risk premium on investments. Furthermore, the weak economic condi-tions resulted in lower cash flows for corporations.

Exposure to Capital FlightMany other Asian countries also experienced weak economies and credit problems andrelied heavily on foreign investment to finance growth. Thus, these countries were ex-

Exhibit 16A.4 How Stock Market Levels Changed during the Asian Crisis

India�51%

Thailand�86% Malaysia

�75% Singapore�60%

Philippines�67%

Hong Kong�25%

Indonesia–88%

South Korea�78%


posed to the same type of speculative outflows as Thailand. The crisis in Thailand sooninfected them.

Some Latin American countries also had weak economies and credit problems, andtheir currencies were subject to potential depreciation. This scared foreign investors andcaused some speculative outflows of funds from these countries as well. Consequently,these countries also experienced an increase in interest rates, which adversely affectedthe stock and debt security markets.

The impact of the Asian crisis on prices in stock and debt security markets does notimply that every adverse situation will adversely affect all markets simultaneously. It isunusual for an event to cause higher interest rates, default risk premiums, and marketrisk premiums in one country and simultaneously affect other countries. Nevertheless,an obvious lesson from the Asian crisis is that when countries rely on funding (invest-ments) from foreign investors to support their growth, they are susceptible to the mas-sive withdrawal of that funding if adverse conditions within the country scare investors.Any countries that are exposed to an abrupt outflow of funds are exposed to a potentialabrupt increase in interest rates, which can harm stock markets and debt security mar-kets and reduce economic growth.

Degree of Global IntegrationThe Asian crisis also demonstrated how integrated country economies are, especiallyduring a crisis. Just as the U.S. and European economies can affect emerging markets,they are susceptible to conditions in emerging markets. Even if a central bank can with-stand the pressure on its currency that is caused by conditions in other countries, it isnot necessarily able to insulate its economy from other countries that are experiencingfinancial problems.

DISCUSSION QUESTIONS

The following discussion questions related to the Asiancrisis illustrate how foreign exchange market condi-tions are integrated with other financial marketsaround the world. Thus, participants in any of thesemarkets must understand the dynamics of the foreignexchange market. These questions can be used in sev-eral ways. They may serve as an assignment on a daythat the professor is unable to attend class. They areespecially useful for group exercises. The class couldbe divided into small groups; each group will assessall of the issues and determine a solution. Each groupshould have a spokesperson. For each issue, one groupwill be randomly selected and asked to present theirsolution; then other students not in that group maysuggest alternative answers if they feel that the solutioncan be improved. Some of the issues have no perfectsolution, which allows students to present differentpoints of view.

1. Was the depreciation of the Asian currencies dur-ing the Asian crisis due to trade flows or capital flows?Why might the degree of movement over a short pe-

riod depend on whether the reason is trade flows orcapital flows?

2. Why do you think the Indonesian rupiah wasmore exposed to an abrupt decline in value than theJapanese yen during the Asian crisis (even though theeconomies of Indonesia and Japan experienced thesame degree of weakness)?

3. During the Asian crisis, direct intervention did notprevent depreciation of currencies. Offer your expla-nation for why the interventions did not work.

4. During the Asian crisis, some local firms in Asiaborrowed dollars rather than local currency to supportlocal operations. Why did they borrow dollars whenthey really needed their local currency to support op-erations? Why did this strategy backfire?

5. The Asian crisis showed that a currency crisiscould affect interest rates. Why did the crisis placeupward pressure on interest rates in Asian countries?Why did it place downward pressure on U.S. interestrates?


6. If high interest rates reflect high expected inflation,how would expectations of Asian exchange rateschange after interest rates in Asia increased? Why? Isthe underlying reason logical?

7. During the Asian crisis, why did the discount onthe forward rate of Asian currencies change? Do youthink it increased or decreased? Why?

8. During the Asian crisis, the Hong Kong stock mar-ket declined substantially over a four-day period due toconcerns in the foreign exchange market. Why wouldstock prices decline due to concerns in the foreign ex-change market? Why would some countries be moresusceptible to this type of situation than others?

9. On August 26, 1998, when Russia decided to let theruble float freely, the ruble declined by 50 percent. Onthe following day, “Bloody Thursday,” stock marketsaround the world (including the U.S. markets) declinedby more than 4 percent. Why do you think the declinein the ruble had such a global impact on stock prices?Was the markets’ reaction rational? Would the effecthave been different if the ruble’s plunge had occurred atan earlier time, such as four years earlier? Why?

10. Normally, a weak local currency is expected tostimulate the local economy. Yet it appears that theweak currencies of Asia adversely affected their econ-omies. Why do you think the weakening of the cur-rencies did not initially improve the countries’economies during the crisis?

11. During the Asian crisis, Hong Kong and Chinasuccessfully intervened (by raising their interest rates)to protect their local currencies from depreciating.Nevertheless, these countries were also adversely af-fected by the Asian crisis. Why do you think the ac-tions to protect the values of their currencies affectedtheir economies? Why do you think the weakness ofother Asian currencies against the dollar and the sta-bility of the Hong Kong and Chinese currencies againstthe dollar adversely affected their economies?

12. Why do you think the values of bonds issued byAsian governments declined during the crisis? Whydo you think the values of Latin American bonds de-clined in response to the crisis?

13. Why do you think the depreciation of the Asiancurrencies adversely affected U.S. firms? (There are atleast three reasons, each related to a different type ofexposure of some U.S. firms to exchange rate risk.)

14. During the Asian crisis, the currencies of manyAsian countries declined even though their respectivegovernments attempted to intervene with direct inter-vention or by raising interest rates. Given that theabrupt depreciation of currencies was attributed to anabrupt outflow of funds in the financial markets, whatalternative action by the Asian governments mighthave been more successful in preventing a substantialdecline in their currency’s value? Are there any possibleadverse effects of your proposed solution?


APPENDIX 16BCurrency Option Pricing

Understanding what drives the premiums paid for currency options makes it easier torecognize the various factors that must be monitored when anticipating future move-ments in currency option premiums. Since participants in the currency options markettypically take positions based on their expectations of how the premiums will changeover time, they can benefit from understanding how options are priced.

BOUNDARY CONDITIONSThe first step in pricing currency options is to recognize boundary conditions that forcethe option premium to be within lower and upper bounds.

Lower BoundsThe call option premium (C) has a lower bound of at least zero or the spread betweenthe underlying spot exchange rate (S) and the exercise price (X), whichever is greater, asshown here:

C ≥ MAXð0; S − XÞThis floor is enforced by arbitrage restrictions. For example, assume that the premiumon a British pound call option is $.01, while the spot rate of the pound is $1.62 and theexercise price is $1.60. In this example, the spread (S − X) exceeds the call premium,which would allow for arbitrage. One could purchase the call option for $.01 per unit,immediately exercise the option at $1.60 per pound, and then sell the pounds in thespot market for $1.62 per unit. This would generate an immediate profit of $.01 perunit. Arbitrage would continue until the market forces realigned the spread (S − X) tobe less than or equal to the call premium.

The put option premium (P) has a lower bound of zero or the spread between theexercise price (X) and the underlying spot exchange rate (S), whichever is greater, asshown next:

P ≥ MAXð0;X − SÞThis floor is also enforced by arbitrage restrictions. For example, assume that the pre-mium on a British pound put option is $.02, while the spot rate of the pound is $1.60and the exercise price is $1.63. One could purchase the pound put option for $.02 perunit, purchase pounds in the spot market at $1.60, and immediately exercise the option

447

by selling the pounds at $1.63 per unit. This would generate an immediate profit of $.01per unit. Arbitrage would continue until the market forces realigned the spread (X − S)to be less than or equal to the put premium.

Upper BoundsThe upper bound for a call option premium is equal to the spot exchange rate (S), as shown:

C ≤ S

If the call option premium ever exceeds the spot exchange rate, one could engage in arbi-trage by selling call options for a higher price per unit than the cost of purchasing the under-lying currency. Even if those call options were exercised, one could provide the currency thatwas purchased earlier (the call option was covered). The arbitrage profit in this examplewould be the difference between the amount received when selling (which is the premium)and the cost of purchasing the currency in the spot market. Arbitrage would occur until thecall option’s premium was less than or equal to the spot rate.

The upper bound for a put option is equal to the option’s exercise price (X), as shown here:

P ≤ X

If the put option premium ever exceeds the exercise price, one could engage in arbitrageby selling put options. Even if the put options were exercised, the proceeds received fromselling the put options would exceed the price paid (which is the exercise price) at thetime of exercise.

Given these boundaries that are enforced by arbitrage, option premiums lie withinthese boundaries.

APPLICATION OF PRICING MODELSAlthough boundary conditions can be used to determine the possible range for a cur-rency option’s premium, they do not precisely indicate the appropriate premium forthe option. However, pricing models have been developed to price currency options.Based on information about an option (such as the exercise price and time to maturity)and about the currency (such as its spot rate, standard deviation, and interest rate), pric-ing models can derive the premium on a currency option. The currency option pricingmodel of Biger and Hull (1983) is

C ¼ e−R�f TS � Nðd1Þ − e−Rf TX � Nðd1 − σ

ffiffiffiffi

Tp Þ

where d1 ¼ f½InðS=XÞ þ ðRf −R�f þ ðσ2=2ÞÞT�=σ ffiffiffiffi

Tp g

C ¼ price of the currency call optionS¼ underlying spot exchange rateX ¼ exercise priceRf ¼ U:S: riskless rate of interestR�f ¼ foreign riskless rate of interestσ ¼ instantaneous standard deviation of the return on a holding

of foreign currencyT ¼ time to option maturity expressed as a fraction of a year

Nð�Þ ¼ standard normal cumulative distribution function

This equation is based on the stock option pricing model (OPM) when allowing forcontinuous dividends. Since the interest gained on holding a foreign security (R*f) isequivalent to a continuously paid dividend on a stock share, this version of the OPM


holds completely. The key transformation in adapting the stock OPM to value currencyoptions is the substitution of exchange rates for stock prices. Thus, the percentagechange of exchange rates is assumed to follow a diffusion process with constant meanand variance.

Bodurtha and Courtadon (1987)1 have tested the predictive ability of the currency op-tion pricing model. They computed pricing errors from the model using 3,326 call op-tions. The model’s average percentage pricing error for call options was −6.90 percent,which is smaller than the corresponding error reported for the dividend-adjusted Black-Scholes stock OPM. Hence, the currency option pricing model has been more accuratethan the counterpart stock OPM.

The model developed by Biger and Hull is sometimes referred to as the Europeanmodel because it does not account for early exercise.2 Unlike American currency options,European currency options do not allow for early exercise (before the expiration date).The extra flexibility of American currency options may justify a higher premium thanon European currency options with similar characteristics. However, there is not aclosed-form model for pricing American currency options. Although various techniquesare used to price American currency options, the European model is commonly appliedto price American currency options because it can be just as accurate. Bodurtha andCourtadon (1987) found that the application of an American currency option pricingmodel does not improve predictive accuracy. Their average percentage pricing error was−7.07 percent for all sample call options when using the American model.

Given all other parameters, the currency option pricing model can be used to imputethe standard deviation σ. This implied parameter represents the option’s market assess-ment of currency volatility over the life of the option.

Pricing Currency Put Options According to Put-Call ParityGiven the premium of a European call option (C), the premium for a European put op-tion (P) on the same currency and with the same exercise price (X) can be derived fromput-call parity as follows:

P ¼ C þ Xe−Rf T − Se−R�f T

where Rf is the riskless rate of interest, Rf* is the foreign rate of interest, and T is the

option’s time to maturity expressed as a fraction of the year. If the actual put option pre-mium is less than is suggested by the put-call parity equation just shown, arbitrage canbe conducted. Specifically, one could (1) buy the put option, (2) sell the call option, and(3) buy the underlying currency. The purchases would be financed with the proceedsfrom selling the call option and from borrowing at the rate Rf. Meanwhile, the foreigncurrency that was purchased can be deposited to earn the foreign rate Rf

*. Regardlessof the scenario for the path of the currency’s exchange rate movement over the life ofthe option, the arbitrage will result in a profit. First, if the exchange rate is equal to theexercise price such that each option expires worthless, the foreign currency can be con-verted in the spot market to dollars, and this amount will exceed the amount required torepay the loan. Second, if the foreign currency appreciates and therefore exceeds the ex-ercise price, there will be a loss from the call option being exercised. Although the putoption would expire, the foreign currency would be converted in the spot market to

1James N. Bodurtha, Jr., and George R. Courtadon, “Efficiency Tests of the Foreign Currency OptionsMarket,” Journal of Finance (March 1987): 151–161.2Nahum Biger and John Hull, “The Valuation of Currency Options,” Financial Management (Spring 1983):24–28.


dollars, and this amount will exceed the amount required to repay the loan and theamount of the loss on the call option. Third, if the foreign currency depreciates andtherefore is below the exercise price, the amount received from selling the put optionplus the amount received from converting the foreign currency to dollars will exceedthe amount required to repay the loan. Since the arbitrage generates a profit under anyexchange rate scenario, it will force an adjustment in the option premiums so that put-call parity is no longer violated.

If the actual put option premium is more than is suggested by put-call parity, arbi-trage would again be possible. The arbitrage strategy would be the reverse of that usedwhen the actual put option premium is less than suggested by put-call parity (as just de-scribed). The arbitrage would force an adjustment in option premiums so that put-callparity is no longer violated. The arbitrage that can be applied when there is a violation ofput-call parity on American currency options differs slightly from the arbitrage applica-ble to European currency options. Nevertheless, the concept still holds that the premiumof a currency put option can be determined according to the premium of a call optionon the same currency and with the same exercise price.


PART 5 INTEGRAT IVE PROBLEM

Choosing among Derivative Securities

This problem requires an understanding of futures contracts (Chapter 13), optionsmarkets (Chapter 14), interest rate swap markets (Chapter 15), and foreign exchangederivative markets (Chapter 16). It also requires an understanding of how economicconditions affect interest rates and security prices.

Assume that the United States just experienced a mild recession. As a result, interestrates have declined to their lowest levels in a decade. The U.S. interest rates appear tobe influenced more by changes in the demand for funds than by changes in the supply ofU.S. savings, because the savings rate does not change much regardless of economic con-ditions. The yield curve is currently flat. The federal budget deficit has improved latelyand is not expected to rise substantially.

The federal government recently decided to reduce personal tax rates significantly forall tax brackets as well as corporate tax rates. The U.S. dollar has just recently weakened.Economies of other countries were somewhat stagnant but have improved in the pastquarter. Your assignment is to recommend how various financial institutions should re-spond to the preceding information.

Questions

1. A savings institution holds 50 percent of its assets as long-term fixed-rate mortgages.Virtually all of its funds are in the form of short-term deposits. Which of the followingstrategies would be most appropriate for this institution?

• Use a fixed-for-floating swap.• Use a swap of floating payments for fixed payments.• Use a put option on interest rate futures contracts.• Remain unhedged.

Defend your recommendation.

2. An insurance company maintains a large portfolio of U.S. stocks. Which of the fol-lowing would be more appropriate?

• Sell stock index futures contracts.• Remain unhedged.

Defend your recommendation.451

3. A pension fund maintains a large bond portfolio of U.S. bonds. Which of the fol-lowing would be most appropriate?

• Sell bond index futures.• Buy bond index futures.• Remain unhedged.

Defend your recommendation.

4. An international mutual fund sponsored by a U.S. securities firm consists of bondsevenly allocated across the United States and the United Kingdom. One of the portfo-lio managers has decided to hedge all the assets by selling futures on a popular U.S.bond index. The manager has stated that because the fund concentrates only on risk-free Treasury bonds, the only concern is interest rate risk. Assuming that interest raterisk is the only risk of concern, will the hedge described above be effective? Why orwhy not? Is there any other risk that deserves to be considered? If so, how would youhedge that risk?


madura fmi ch16-fromxml 417. - · pdf fileinstitutions is influenced by potential return, ......

Documents