1. Foreign Exchange Rate, Hedging and Arbitrage Na Yang

2. Page  2 2 Quiz 1 Which of the following paper currencies has more value? A. US $ 20 B. CNY100 C.they are equal D. It depends.

3. Page  3 3 Foreign exchange rate  A foreign exchange rate is the price of one country's currency in units of another country's currency and it refers to as the value of a country's currency in terms of another country's currency.  Traded currency appear in pairs, the most popular currency pairs are: USD/EUR, USD/JPY, USD/GBP and USD/AUD

4. Page  4 4 Foreign Exchange Rates Quotations  Any two currencies: Direct vs. Indirect ·Direct: HC/FC ·eg. $1.4287/€ is a direct quotation for a US investor ·Indirect: FC/HC ·eg. $1.4287/€ is an indirect quotation for an Irish investor  Dollar: American vs. European ·American: $/FC (e.g. 1.62 $/pound) ·European: FC/$ (e.g. 82 yen/$)

5. Page  5 5 Foreign Exchange Rates Quotations Bid and Ask Quotations –Interbank quotes are given as a bid and ask The bid is the price at which a dealer is willing buy another currency The ask is the price at which a dealer will sell another currency –Example: USD/EUR 1.4286/88 is the bid/ask for Euro. Exchange rate is usually quoted in mid rates ($1.4287/€), which is the average of the bid-ask.

6. Page  6 6 Foreign Exchange Rates Quotations  Spot Exchange Rates: current exchange rate, quotes for spot transactions (actually settled within 1 or 2 business days)  Forward Exchange Rates: – an exchange rate quoted today for settlement at some future date. –Quotes for specified future transactions (3 business days and longer settlement). –Forward exchange rate allows businesses and investors to “lock” in an exchange rate for some future period of time.

7. Page  7 7 Forward exchange rate  Forward exchange rate is calculated from three observable numbers: The (current) spot rate The foreign currency interest rate The home currency interest rate  Forward exchange rate formulas is: F FC/USD =S FC/USD *(1+I FC) /(1+I US )

8. Page  8 8 Foreign Exchange Rates Quotations Cross Rates –Exchange rate is determined through their relationship with third currency –Example: Citibank, Japan quotes ￥ 83.30/C$ Bank of Canada quotes € 0.72 /C$ Cross Rate JPY/EUR = ￥ 83.30/C$/ € 0.72 /C$= ￥ 115.69/€

9. Page  9 9 Triangular Arbitrage Example: Citibank, Japan quotes ￥ 83.30/C$ Bank of Canada quotes € 0.72 /C$ Bank of Finland quotes ￥ 115.45/€ € ￥ C$ € 0.72 /C$ ￥ 83.30/C$ ￥ 115.45/€ Begin:€ 1 million C$ 1.39 M ￥ 115.694 M End:€1.002M

10. Page  10 10 Hedging  Hedging is the practice of taking a position, either through acquiring a cash flow, an asses, or a contract(a forward contract, a future contract), to offset and balance against the value in an existing position  Why Hedging?

11. Page  11 11 Hedging with a Forward Contract  A currency forward contract is an agreement that two parties agree to buy and sell a certain amount of a foreign currency at a specific price and predetermined future date.  Forward contracts are traded in the over-the-counter market  Forward contracts allow businesses and investors to “lock” in an exchange rate for some future period of time.

12. Page  12 12 Hedging with a Forward Contract  USD/GBP Country/CurrencyWed Tues UK pound 1.6231 1.6158 1-mos forward1.62251.6152 3-mos forward1.62111.6138 6-mos forward1.61871.6115

13. Page  13 13 Hedging with a Future Contract  A currency future contract is very similar to a forward contract  Currency future contracts are traded on organized exchanges. Chicago Mercantile Exchange  Currency future contracts are standardized, settled through exchange's clearinghouse and the contracts are marked to market each day according to their market value  Maturities are based on a quarterly cycle of March, June, September and December

14. Page  14 14 Hedging with a Future Contract

15. Page  15 15 Currency Futures and Forward Compared CharacteristicCurrency FuturesCurrency Forward Size of ContractStandard contracts per currency Any size desired PricingOpen outcry process on the exchange floor Prices are determined by bid and ask quotes Margin/CollateralInitial margin is marked to market on a daily basis No explicit collateral, standard banking relationship needed. SettlementRarely delivered upon;settlement normally takes place through purchasing of offsetting position Normally delivered upon Counterpartiesunknown to each otherParties are in direct contact LiquidityLiquid but relatively small in total sales volume and value Liquid but relatively large in total sales volume and value

16. Page  16 16 Hedging with a Currency Option  A currency option contract gives buyers the right, not the obligation, to buy or sell a given amount of foreign currency at a fixed price for a specific time period  Currency options are traded both on organized exchanges and over-the-counter market.  It provides opportunities for buyer to benefit from favorable exchange rate movement and has maximum loss of option premium.

17. Page  17 17 Put Option Contract  Put Option Contract to sell ₤1 million pound in six months  The strike price is $1.62/₤  the premium is 1.7 cent/₤ in the contract. Cost of Option: $17,000 If spot exchange rate at maturity is less than or equal to $1.62/₤ exercise and receive $1.62 million If the spot exchange rate at maturity is more than $1.62/₤, not exercise and sell in the spot market

18. Page  18 18 Hedging with Currency Swap  A currency swap is an agreement between two parties to exchange a given amount of one currency for equivalent amount of another  In a currency swap both the principle and interests are exchanged  Three stages: 1)the principals are exchange at the spot exchange rate 2) interest payments are exchanged on each coupon date 3)the principals are re-exchanged at the swap's maturity

19. Page  19 19 Take-aways  Hedging can reduce uncertainty and risks, but reduce risk doesn't mean add value  Two criteria help a market participant to choose strategy 1.the risk tolerance the participant can assume 2.anticipation for the direction and distance of the exchange rate.

20. Page  20 20 Questions

21. Page  21 21 Reference  5/10/2011, Foreign exchange market, http://en.wikipedia.org/wiki/Foreign_exchange_market  Moffett, Michael, Arthur Stonehill, and David Eiteman.Fundamentals of multinational finance. 2nd. Addison-Wesley, 2005. Print.  5/10/2011, Hedging(Finance), http://en.wikipedia.org/wiki/Hedge_(finance)  4/28/2011, Foreign exchange Forwards and Futures,  http://thismatter.com/money/forex/fx_forwards.htm  5/18/2011, Exchange Rates: New York Closing Snapshot, http://online.wsj.com/mdc/public/page/2_3021-forex- 20110518.html?mod=mdc_pastcalendar  5/10/2011, Currency Futures, http://en.wikipedia.org/wiki/Currency_future  5/18/2011, Currency futures, http://online.wsj.com/mdc/public/page/2_3023-fut_currency-futures-20110518.html?mod=mdc_pastcalendar  5/18/2011, Arbitrage, http://en.wikipedia.org/wiki/Arbitrage  5/18/2011, Foreign exchange rate, http://www.citibank.co.jp/en/index.html  5/18/2011, Daily currency converter, http://www.bankofcanada.ca/rates/exchange/daily-converter/  5/18/2011, Exchange rate, http://www.suomenpankki.fi/en/Pages/default.aspx  5/41/2011, Exchange rate, http:www.xe.com