1. Foreign Exchange Derivative Market16

2. 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

3. 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

4. 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

5. 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

6. 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.

7. 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

8. 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

9. 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

10. 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

11. 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

12. 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 ($)

13. 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

14. 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

15. 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

16. 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

17. 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

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

19. 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

20. 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

21. 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

22. 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

23. 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

24. 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

25. 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

26. 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

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

28. 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

29. 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

30. 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

31. 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

32. 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

33. 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

34. 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

35. 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

36. 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

37. 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

38. 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

39. 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

40. 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

41. 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

42. 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

43. 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

44. 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

45. 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

46. 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!!!

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

48. 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

49. 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??

50. 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

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

52. 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

53. 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)