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CHAPTER 16 Foreign Exchange Derivative Market. Chapter Objectives n Explain how various factors affect exchange rates n Describe how foreign exchange.

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Presentation on theme: "CHAPTER 16 Foreign Exchange Derivative Market. Chapter Objectives n Explain how various factors affect exchange rates n Describe how foreign exchange."— Presentation transcript:

1 CHAPTER 16 Foreign Exchange Derivative Market

2 Chapter Objectives n Explain how various factors affect exchange rates n Describe how foreign exchange risk can be hedged with foreign exchange derivatives n Describe how to use foreign exchange derivatives to capitalize (speculate) on expected exchange rate movements

3 Background On Foreign Exchange Markets n Exchanging currencies is needed when: l Trade (real) prompts need for forex l Capital flows (financial) prompts need for forex n Foreign exchange trading l Via global telecommunications network between mostly large banks l Bid/ask spread

4 Foreign Exchange Rates n Quoted two ways: l Foreign currency per U.S. dollar l Dollar cost of unit of foreign exchange n Appreciation/depreciation of currency l Appreciation = more forex to buy $ l Purchase more forex with $ l Depreciation = foreign goods cost more $ l Total return to foreign investor decreases

5 Background on Foreign Exchange Markets n Exchange rate quotations are available in the financial press and on the Internet with spot exchange rate quotes for immediate delivery n Forward exchange rate is for delivery at some specified future point in time n Forward premium is the percent annualized appreciation of a currency n Forward discount is the percent annualized depreciation of a currency

6 Background on Foreign Exchange Markets n Exchange rates involve different kinds of quotes for comparing the value of the U.S. dollar to various foreign currencies l 1 unit of foreign currency worth some amount of U.S. dollars—e.g. $.70 U.S. per Canadian Dollar l 1 U.S. dollar’s value in terms of some amount of foreign currency– e.g. CD$1.43 per U.S. dollar l Note reciprocal relationship n Cross-exchange rates express relative values of two different foreign currencies per $1 U.S.

7 Background on Foreign Exchange Markets n Cross-exchange rates are foreign exchange rates of two currencies relative to a currency. n Value of one unit of currency A in units of currency B = value of currency A in $ divided by value of currency B in $ n British Pound = $1.4555; Euro = $.8983 n Value of Pound in Euros = $1.4555/$.8983 or… l 1.62 Pounds per Euro using the forex rates per U.S. dollar

8 Background on Foreign Exchange Markets n Currency terminology l Appreciation means a currency’s value increases relative to another currency l Depreciation means a currency’s value decreases relative to another currency n Supply and demand influences the values of currencies n Many factors can simultaneously affect supply and demand

9 Background on Foreign Exchange Markets n 1944–1971 known as the Bretton Woods Era l Government maintained exchange rates within a 1% range l Required government intervention and control n By 1971 the U.S. dollar was clearly overvalued Background on Foreign Exchange Markets

10 n Smithsonian Agreement (1971) among major countries allowed dollar devaluation and widened boundaries around set values for each currency n No formal agreements since 1973 to fix exchange rates for major currencies l Freely floating exchange rates involve values set by the market without government intervention l Dirty float involves some government intervention

11 Classification of Exchange Rate Arrangement n There is a wide variation in how countries approach managing or influencing their currency’s value l Float with periodic intervention l Pegged to the dollar or some kind of composite l Some countries have both controlled and floating rates l Some arrangements are temporary and others more permanent

12 Factors Affecting Exchange Rates: Real Sector n Differential country inflation rates affect the exchange rate for euros and dollars if inflation is suddenly higher in Europe n Theory of Purchasing Power Parity suggests the exchange rate will change to reflect the inflation differential—influence from real sector of economy n Currency of the higher inflation country (euro) depreciates compared to the lower inflation country ($)

13 Factors Affecting Exchange Rates: Financial Sector n Differential interest rates affect exchange rates by influencing capital flows between countries n For example, the interest rates are suddenly higher in the United States than in Europe n Investors want to buy dollar-denominated securities and sell European securities n Euros are sold, dollars bought to buy U.S. securities n Downward pressure on the euro, appreciation of the dollar

14 Factors Affecting Exchange Rates n Direct intervention occurs when a country’s central bank buys/sells currency reserves n For example, the U.S. central bank, the Federal Reserve sells one currency and buys another l Sale by central bank creates excess supply and that currency’s value drops relative to the one purchased l Market forces of supply and demand can overwhelm the intervention

15 Factors Affecting Exchange Rates n Indirect intervention involves influencing the factors that affect exchange rates rather than central bank purchases or sales of currencies n Interest rates, money supply and inflationary expectations affect exchange rates n Historical perspective on indirect intervention l Peso crisis in 1994 l Asian crisis in 1997 l Russian crisis in 1998

16 Factors Affecting Exchange Rates n Some countries use foreign exchange controls as a form of indirect intervention to maintain their exchange rates n Place restrictions on the exchange of currency n May change based on market pressures on the currency n Venezuela in mid-1990s illustrates the issues involved in controlling rates via intervention and the affect of market forces

17 Movements in Exchange Rates n Foreign exchange rate changes can have an important effect on the performance of multinational firms and economic conditions n Many market participants forecast rates l Market participants take positions in derivatives based on their expectations of future rates l Speculators attempt to anticipate the direction of exchange rates n There are several forecasting techniques

18 Forecasting Techniques Technical Forecasting Fundamental Forecasting Market-based Forecasting Mixed Forecasting

19 Forecasting Exchange Rates: Technical n Technical forecasting is a technique that uses historical exchange rate data to predict the future n Uses statistics and develops rules about the price patterns—depends on orderly cycles n If price movements are random, this method won’t work n Models may work well some of the time and not work other times

20 Forecasting Exchange Rates: Fundamental n Fundamental forecasting is based on fundamental relationships between economic variables and exchange rates n May be statistical and based on quantitative models or be based on subjective judgement n Regression used to forecast if values of influential factors have a lagged impact n Not all factors are known and some have an instant impact so sensitivity analysis is used to deal with uncertainty

21 Forecasting Exchange Rates: Fundamental n Limitation of fundamental forecasting methods: l Some factors that are important to determining exchange rates are not easily quantifiable l Random events can and do affect exchange rates l Predictor models may not account for these unexpected events

22 Forecasting Exchange Rates: Market- Based n Market-based forecasting uses market indicators like the spot and forward rates to develop a forecast n Spot rate: recognizes the current value of the spot rate as based on expectations of currency’s value in the near future n Forward rate: used as the best estimate of the future spot rate based on the expectations of market participants

23 Forecasting Exchange Rates: Mixed n Mixed forecasting is used because no one method has been found superior to another n Multinational corporations use a combination of methods n Assign a weight to each technique and the forecast is a weighted average n Perhaps a weighted combination of technical, fundamental, and market-based forecasting

24 Forecasting Exchange Rate Volatility n Market participants forecast not only exchange rates but also volatility n Volatility forecast l Recognizes how difficult it is to forecast the actual rate l Provides a range around the forecast

25 Forecasting Exchange Rate Volatility n Volatility of historical data n Use a times series of volatility patterns in previous periods n Derive the exchange rate’s implied standard deviation from the currency option pricing model Methods Used To Forecast Volatility

26 Speculation in Foreign Exchange Markets n For example, a dealer takes a short position in a foreign currency to profit from expected depreciation n Dealer forecasts currency 1 to depreciate relative to foreign currency 2 so the first step is to borrow currency 1 and then exchange currency 1 for currency 2 l Invest in currency 2 and receive the investment returns at maturity l Convert back to foreign currency 1 and pay back loan denominated in currency 1

27 Foreign Exchange Derivative Contracts Currency Futures Currency Futures Hedge or Speculate Forward Contracts Currency Swaps Currency Options

28 Foreign Exchange Derivatives-Hedge n Forward contracts l Negotiated with a counterparty l Specify a maturity date, amount and which currency to buy or sell l Negotiated in over-the-counter market l Used to lock in the price paid or price received for a future currency transaction l Classic hedging contract

29 Foreign Exchange Derivatives-Hedge n Forward contracts can be used to hedge if a corporation must pay a foreign currency invoice in the future l Purchase foreign currency for amount/date of invoice l Locks in cost of invoice l Hedges foreign exchange risk of transaction n Forward contracts are also used by hedgers who have a foreign currency inflow on some future date

30 Foreign Exchange Derivatives n Forward rate premium or discount P = % annualized premium or discount FR = Forward exchange rate S = Spot exchange rate n = number of days forward Where: x FR - S S 360 n p =

31 Foreign Exchange Derivatives-Hedge n Currency futures contracts trade on exchanges, are standardized in terms of the maturity and amount n Currency swaps allow one currency to be periodically swapped for another at a specified exchange rate n Currency options contracts offer one-way insurance to buy (call) or sell (put) a currency

32 Foreign Exchange Derivatives-Hedge n Buying a call option on a foreign currency is the right to purchase a specified amount of currency at the strike price within the specified time period l Exercise the option if the spot rate rises above the strike price l Do not exercise if the spot rate does not reach or exceed the strike price l U.S. business that owes Canadian in 60 days buys currency call options to hedge spot forex risk

33 Foreign Exchange Derivatives-Hedge n Buying a put option on a foreign currency is the right to sell a specified amount of currency at the strike price within the specified time period l Exercise the option if the spot rate falls below the strike price l Do not exercise if the spot rate does not decline below the strike price l U.S. business hedges Canadian dollar payment it will receive in 30 days by buying CD currency put options—if CD depreciates against U.S., gain will offset spot loss

34 Foreign Exchange Derivatives-Speculate n Business or person has no spot interest in underlying asset—takes position based on forecast of currency movements n Forward contracts l Buy/sell foreign currency forward l When received, sell in the spot market n Purchase/sell futures contracts n Purchase call/put options

35 Foreign Exchange Derivatives- Speculation n For example, what position in derivates would a speculator take if he/she anticipates a depreciation in a currency? n Forward contracts l Sell foreign currency forward l At maturity, buy in the spot market n Sell futures contracts n Purchase put options

36 International Arbitrage n Arbitrage takes advantage of a temporary price difference in two locations to make profits buying at a lower price than you can receive via the simultaneous sale of an asset, financial instrument or currency n Risk free because the purchase and sale price are locked in simultaneously n As arbitrage occurs, prices in both locations change until equilibrium (one price) returns

37 International Arbitrage n Covered interest arbitrage activity creates a relationships between spot rates, interest rates and forward rates n Borrow in country 1 n Convert the funds to currency for country 2 using the spot rate; buy forward contract for return n Invest in country 2 and earn an investment rate of return n Convert back to country 1 currency using forward contract, repay loan

38 International Arbitrage n Covered interest arbitrage activity makes forward premium approximately equal to the differential in interest rates between two countries n If forward premium does not equal the interest rate differential, covered interest arbitrage is possible n If the forward premium or discount equals the interest rate differential, there are no opportunities for arbitrage

39 International Arbitrage n Equation for covered interest arbitrage P = Forward premium or discount i h = Home country interest rate i f = Foreign interest rate Where: – ( 1 + i h ) (1 + i f ) 1P=

40 Explaining Price Movements of Foreign Exchange Derivatives n Indicators of foreign exchange derivatives are closely monitored by market participants n Hedgers and speculators continuously forecast direction and degree of movement and monitor l Inflation rates between countries l Interest rates l Economic indicators

41 Foreign Exchange Markets n Exchanging Currencies Is Needed When: l Trade (real) prompts need For forex l Capital flows (financial) prompts need for forex n Foreign Exchange Trading l Via global telecommunications network between mostly large banks l Bid/ask spread

42 Foreign Exchange Rates n Quoted Two Ways: l Foreign currency per U.S. Dollar l Dollar cost Of unit Of foreign exchange n Appreciation/Depreciation of Currency l Appreciation = more forex To buy $ l Purchase more forex with $ l Depreciation = foreign goods cost more $ l Return To foreign investor decreases

43 Exchange Rate Systems n Bretton Woods Era ( ) l Fixed Or pegged forex rates l Central bank maintained rates l Could not adjust To major economic change n Smithsonian Agreement (1971) l Devalued dollar l Widened trading range Of forex l First Step Toward Market-Determined Forex

44 Exchange Rate Systems n Market-Determined Rates (1973) l Dirty Float l Exchange Rate Mechanisms: u Currencies pegged to another u European currency unit (ECU) u Central Bank involvement u ERM problems

45 Major Factors Affecting Forex n Differential inflation rates between countries l Goods and services impact demand/supply for foreign exchange l Inflating currency declines to provide…. l Purchasing power parity

46 Major Factors Affecting Forex n Differential interest rates between countries l Reflect expected differential inflation rates l Global Fisher Effect n Governmental Intervention l Domestic Economic Policy l Direct Intervention, e.g., Forex Controls l Market Forces Reign!!!

47 Forecasting Foreign Exchange Rates n Technical forecasting n Fundamental forecasting n Market-based forecasting n Mixed forecasting

48 Forecasting Forex Volatility n Forex prices difficult to forecast n Forecasting volatility creates range of probable forex rates n Use best- and worst-case scenarios in planning l Define future period l Consider historical volatility l Time series of previous volatility

49 Speculation In Forex Market n Take position based on forex expectations n Expect To appreciate l Take long position (buy) l Forward contract to buy l Buy forex currency futures contract l Buy forex call options n Action taken if depreciation expected??

50 Foreign Exchange Derivatives n Speculate vs. Hedging n Forward contracts l Contract To buy/sell forex at specified price on specified date l OTC market characteristics l Reflects expected future spot rate l Premium vs. Discount from spot l Interest rate parity concept

51 Other Forex Derivatives n Currency futures contracts n Currency swaps n Currency option contracts

52 International Arbitrage n Arbitrage defined n Locational arbitrage n Covered interest arbitrage l Maintains interest rate parity l Forward/spot differential = u Differential inflation rates u Interest rate differentials u Expected future spot rate

53 Institutional Use Of Forex Market n Intermediary or dealer of forwards or other derivative contracts n Speculating/hedging l Future investment flows (loans, interest) l Future financing flows (principal and interest)


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