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Fi8000 Exchange Rates Forwards, Futures Milind Shrikhande.

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Presentation on theme: "Fi8000 Exchange Rates Forwards, Futures Milind Shrikhande."— Presentation transcript:

1 Fi8000 Exchange Rates Forwards, Futures Milind Shrikhande

2 Final Exam ☺30% of your grade ☺The exam is comprehensive – covers everything on the syllabus ☺1.5-2 hours, 4-5 questions ☺Bring your calculator and a formula sheet (one page, letter, you may write on both sides) ☺StockTrak written assignment – type and bring with you to the exam.

3 Tonight and Next Week ☺Currency exchange rate ☺Spot ☺Forward ☺Debt instruments ☺Types ☺Ratings (default risk) ☺Spot and forward interest rate ☺The yield curve ☺Duration

4 Currency Exchange Rate (Spot) ☺A spot currency transaction is an exchange of one currency for another. ☺The currency exchange rate is a simple conversion factor: ☺The direct exchange rate is the number of $US to be paid for 1 unit of foreign currency (usually for the £UK and the Euro); ☺The indirect exchange rate is the number of foreign currency units paid for 1 $US (usually for the Swiss franc and Japanese yen).

5 Currency Exchange Rate Numeric Example: The exchange rate between the $US and £UK is $US/ £UK - i.e. one has to pay $ for £1 (direct). The same exchange rate can be presented as 1/ = £UK /$US - i.e. one has to pay £ for $1 (indirect).

6 Currency Exchange Rate Example continued: The exchange rate between the $US and £UK is $US/ £UK. The exchange rate between the $US and J¥ is $US/J¥. What should be the exchange rate between the £UK and the J¥?

7 Currency Arbitrage ☺There are at least two ways to convert pounds to yen: ☺Direct conversion of £UK to J¥ ☺Conversion using an intermediary currency: ☺Convert £UK to $ US ☺Convert $ US to J¥ ☺If there is no opportunity to make arbitrage profits, both conversion methods must imply the same pound to yen exchange rate.

8 Currency Exchange Rate Example (data): $US/£UKor £UK/$US $US/J¥or J¥/$US. We will use the no-arbitrage argument to calculate the £UK/J¥ (or J¥/£UK) exchange rate.

9 Currency Exchange Rate Conversion using an intermediary currency: Convert £UK to $US: the cost of 1 $US is £UK Convert $US to J¥: the cost of 1 J¥ is $US The £UK cost of 1 J¥: £UK/$US * $US/ J¥ = £UK/ J¥ £UK/ J¥

10 Currency Exchange Rate The Pound-Yen no-arbitrage exchange rate: The £UK/ J¥ exchange rate is , i.e. the cost of 1 J¥ is £UK. The J¥/ £UK exchange rate is 1/ = , i.e. the cost of 1 £UK is J¥.

11 Currency Exchange Arbitrage Example continued: The $US/ £UK exchange rate is The $US/J¥ exchange rate is Is there an arbitrage opportunity if the £UK/J¥ exchange rate is ? Yes! The £UK/J¥ exchange rate in the market is different from the no-arbitrage rate (two-stage currency exchange): Market: £UK/J¥ > £UK/J¥ :No-arbitrage How can we make an arbitrage profit?

12 Currency Exchange Arbitrage Cross currency (triangle) arbitrage strategy: Sell the expensive J¥ – convert J¥ to £UK in one step: 1. Sell J¥ for £UK (i.e., Buy £UK with J¥ or convert £UK to J¥) Buy the cheap J¥ - convert £UK to J¥ in two steps, using the $US as an intermediary: 2. Buy $US with £UK (convert £UK to $US) 3. Buy J¥ with $US (convert $US to J¥) Note: this is a round trip transaction. You start with J¥ (before step 1) and you end up with J¥ (after step 3).

13 Currency Exchange Arbitrage Cross currency (triangle) arbitrage strategy: Sell the expensive J¥ - conversion using the direct £UK to J¥ exchange rate: 1. Sell 1 J¥ for £UK (i.e., Buy £UK for 1 J¥) (i.e., Buy £UK for 1 J¥) Buy the cheap J¥ - conversion from £UK to J¥ in two stages, using the $US as an intermediary: 2. Buy $US for £UK (you can buy £UK * $US/£UK = $US) £UK * $US/£UK = $US) 3. Buy J¥ for $US (you can buy $US * J¥/$US = J¥) $US * J¥/$US = J¥) Arbitrage profit: you start with 1 J¥ and end up with J¥.

14 Currency Exchange Arbitrage Cross currency arbitrage strategy (end up with $US): 2. Sell J¥ for £UK (you can buy J¥ * £UK/J¥ = £UK) J¥ * £UK/J¥ = £UK) 3. Buy $US for £UK (you can buy £UK * $US/£UK = $US) £UK * $US/£UK = $US) 1. Buy J¥ for 1 $US (you can buy 1 $US * J¥/$US = J¥) 1 $US * J¥/$US = J¥) Arbitrage profit: you start with 1 $US and end up with $US. An arbitrage profit of $US.

15 Currency Exchange Rate (Forward) ☺Forward or Futures Contracts ☺An agreement between a buyer and a seller, to trade at a specific date in the future, a specific quantity of a specific currency for an agreed exchange rate. ☺Forward – tailored OTC market contracts for creditworthy traders and large trades. ☺Futures – formal markets of standardized contracts (International Monetary Market in Chicago, London International Financial Futures Exchange).

16 Covered Interest Arbitrage ☺There are at least two ways to invest money without risk for one year: ☺Domestic risk-free investment ☺Buy US Treasury Bills ☺Foreign risk-free investment ☺Convert $US for foreign currency ☺Buy foreign risk-free bonds for 1 year ☺Convert the foreign currency back to $US (forward contract) ☺If there is no opportunity to make arbitrage profits, both investment strategies should have the same dollar denominated percentage return.

17 Covered Interest Arbitrage Numeric Example: Suppose you would like to invest $100,000 in a risk-free instrument. In the US the annual risk free rate is 5.00%, while in the UK the annual risk free rate is 5.20%. Is there an arbitrage opportunity? – Compare the domestic and foreign investment strategies.

18 Covered Interest Arbitrage Numeric Example Continued: We need the spot and forward (one year) $US/£UK exchange rates to answer that question. Note that if we do not use a forward contract to “lock in” the exchange rate, the foreign alternative becomes a risky (exchange rate risk) rather than a risk-free investment strategy. Is there an opportunity to make arbitrage profits, if the spot rate is $US/£UK and the (one year) forward exchange rate is $US/£UK?

19 Comparing the Two Strategies Domestic risk-free investment: 1. Buy US Treasury Bills Strategy t = 0 t = 1 CF ($US) CF (£UK) CF ($US) CF (£UK) Buy T-Bills (5.00%)-100, ,000 Total-100, ,0000

20 Comparing the Two Strategies Foreign risk-free investment: 1. Convert $US for foreign currency 2. Buy foreign risk-free bonds for 1 year 3. Convert the foreign currency back to $US (forward contract) Strategy t = 0 t = 1 CF ($US) CF (£UK) CF ($US) CF (£UK) Convert $US to £UK (spot rate ) - 100, ,701 Buy UK risk-free bonds (5.20%) - 59, ,806 Convert £UK to $US (forward rate ) +103, ,806 Total-100, ,6300

21 Arbitrage Strategy Buy Cheap: Domestic risk-free investment Buy US Treasury Bills Buy US Treasury Bills  get 5% dollar denominated risk free rate Sell Expensive: Foreign risk-free investment Convert £UK to $US Short sell UK risk-free bonds for 1 year Convert $US back to £UK (forward contract)  pay 3.63% dollar denominated risk free rate

22 Covered Interest Arbitrage Strategy t = 0 t = 1 CF ($US) CF (£UK) CF ($US) CF (£UK) Buy US T-Bills (5.00%)-100, ,000 Convert £UK to $US (spot rate ) +100,000-59,701 Sell UK risk-free bonds (5.20%)+59,701-62,806 Convert $US to £UK (forward rate ) -105,000+63,636 Total

23 Covered Interest Arbitrage What is the no-arbitrage UK risk free rate? (r = %) Strategy t = 0 t = 1 CF ($US) CF (£UK) CF ($US) CF (£UK) Buy US T-Bills (5.00%)-100, ,000 Convert £UK to $US (spot rate ) +100,000-59,701 Sell UK risk-free bonds (5.20%)+59,701-59,701(1+r) Convert $US to £UK (forward rate ) -105,000+63,636 Total000 =0 +803

24 Interest Rate Parity (Covered Interest Arbitrage) Intuition: If two investments are risk-free they must have the same rate of return. Therefore, any difference in the domestic and foreign risk-free rates must be offset by a difference in the spot and forward exchange rates. Formula:

25 Interest Rate Parity (Covered Interest Arbitrage) Notation: E 0 = spot exchange rate ($US/£UK) or (£UK/$US) F 0 = forward exchange rate ($US/£UK) or (£UK/$US) * Note that if you use the £UK/$US (indirect) exchange rate you will also have to reverse the ratio of interest rates. Formula:

26 Practice Problems Practice Problem #1 The annual risk-free rate in the US is 5.00% while in Japan it is 3.20%. What should be the spot J¥/ $US exchange rate, if the (one year) forward J¥/ $US exchange rate is ? Answer: E 0 ( J¥/ $US) =

27 Practice Problems Practice Problem #2 The annual risk-free rate in the US is 4.60% while in Japan it is 3.50%. The spot J¥/£UK exchange rate is , the spot $US/£UK exchange rate is , the (one year) forward J¥/£UK exchange rate is and the forward $US/£UK exchange rate is Describe an arbitrage transaction. Write down the same stages and use the table format presented in the lecture notes.

28 Practice Problems BKM Ch. 23: 10, Practice problems: Forward and futures contracts 1-5; Currency exchange rates 6-9.


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