Foreign Exchange Derivative Market 16

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

International Arbitrage Equation for covered interest arbitrage – ( 1 + ih) (1 + if ) 1 P = Where: P = Forward premium or discount ih = Home country interest rate if = Foreign interest rate

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

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

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

Exchange Rate Systems Bretton Woods Era (1944-1971) Fixed Or pegged forex rates Central bank maintained rates Could not adjust To major economic change Smithsonian Agreement (1971) Devalued dollar Widened trading range Of forex First Step Toward Market-Determined Forex

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

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

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

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

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

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

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

Other Forex Derivatives Currency futures contracts Currency swaps Currency option contracts

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

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