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Chapter 16

Foreign ExchangeDerivative Markets

Financial Markets and Institutions, 7e, Jeff MaduraCopyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.

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Chapter Outline

Background on foreign exchange markets Factors affecting exchange rates Movements in exchange rates

Forecasting exchange rates Forecasting exchange rate volatility Speculation in foreign exchange markets Foreign exchange derivatives

International arbitrage Explaining price movements of foreign exchange

derivatives

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Background on Foreign Exchange

Markets Foreign exchange markets consist of a global

telecommunications network among large commercialbanks that serve as financial intermediaries

Banks are located in New York, Tokyo, Hong King, Singapore,Frankfurt, Zurich, and London

The bid price is always lower than the ask price

Institutional use of foreign exchange markets The degree of international investment by financial institutions is

influenced by potential return, risk, and government regulations Institutions are increasing their use of the foreign exchange

markets because of reduced information and transaction costs

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Markets (cont’d) Financial

Institution

Participation in Foreign Exchange Market

Commercialbanks

Serve as financial intermediaries in the foreign exchange market bybuying or selling currenciesSpeculate on foreign currency movements by taking long positionsin some currencies and short positions in othersProvide forward contracts to customersOffer currency options to customers, which can be tailored to acustomer’s specific needs

International

mutual funds

Use foreign exchange markets to exchange currencies when

reconstructing their portfoliosUse foreign exchange derivatives to hedge a portion of their exposure

Brokerage firmsand investmentbanking firms

Engage in foreign security transactions for their customers or for their own accounts

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Markets (cont’d) Financial

Institution

Participation in Swap Market

Insurancecompanies

Use foreign exchange markets when exchanging currencies for their international operations

Use foreign exchange markets when purchasing foreign securitiesfor their investment portfolios or when selling foreign securitiesUse foreign exchange derivatives to hedge a portion of their exposure

Pension funds Require foreign exchange of currencies when investing in foreignsecurities for their stock or bond portfolios

Use foreign exchange derivatives to hedge a portion of their exposure

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Markets (cont’d) Exchange rate quotations

The spot exchange rate is for immediate

deliveryForward rates indicate the rate at which a

currency can be exchanged in the future

Cross-exchange rates Some quotations express the exchange rate

between two non-dollar currencies

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Computing A Cross-Exchange

Rate

The euro is worth $1.15, and the Canadian dollar is worth $0.60. What is the value of the euro inCanadian dollars?

92.1$C60.0$/15.1$C$ineuroof Value

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Markets (cont’d) Types of exchange rate systems

1944 to 1971: the exchange rate at which onecurrency could be exchanged for another was

maintained within 1 percent of a specified rate (theBretton Woods era) 1971: an agreement among major countries

(Smithsonian Agreement) allowed for devaluation of the dollar and a widening of the boundaries to 2.25%

1973: boundaries were eliminated and exchangerates of major countries were allowed to float Dirty float

Freely floating system

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Markets (cont’d) Types of exchange rate systems (cont’d)

Pegged exchange rate systems

Some currencies may be pegged to another currency or a unit of account and maintained withinspecified boundaries ERM until 1999

Hong Kong since 1983 Argentina from 1991 until 2002

A country that pegs its currency does not havecomplete control over its local interest rates

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Markets (cont’d) Types of exchange rate systems (cont’d)

Classification of exchange rate arrangements

Many countries allow the value of their currency tofloat against others, but governments interveneperiodically to influence its value

Many governments attempt to impose exchange

controls to prevent their exchange rate fromfluctuating When controls are removed, the exchange rate abruptly

adjust to a new market-determined level

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Factors Affecting Exchange Rates

The value of a currency adjusts to changes indemand and supply In equilibrium, there is no excess or deficiency of that

currency If a currency increases in value, it appreciates

If a currency decreases in value, it depreciates

Exchange rates are influenced by:

Differential inflation rates Differential interest rates

Government intervention

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(cont’d) Differential inflation rates

Purchasing power parity (PPP) suggests that the exchange ratewill change by a percentage that reflects the inflation differentialbetween the two countries of concern

Differential interest rates Interest rate movements affect exchanges rates by influencing

the capital flows between countries

Central bank intervention Central banks attempt to adjust a currency’s value to influence

economic conditions Direct intervention occurs when a country’s central bank sells

some of its currency reserves for a different currency

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(cont’d) Indirect intervention

The Fed can affect the dollar’s value indirectly by influencing thefactors that determine its value e.g., the Fed can attempt to lower interest rates by increasing the

money supply, which puts downward pressure on the dollar Indirect intervention during the Peso Crisis

The central bank increased interest rates to discourage foreigninvestors from withdrawing their investments in Mexico’s debtsecurities

Indirect intervention during the Asian Crisis

Some Asian countries increased their interest rates to encourageinvestors to leave their funds in Asia

Indirect intervention during the Russian crisis The Russian central bank attempted to prevent outflows by tripling

interest rates

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(cont’d) Foreign exchange controlsControls, such as restrictions on the

exchange of a currency, can be used as aform of indirect intervention e.g., Venezuela imposed foreign exchange

controls in the mid-1990s

Under severe pressure, governments tend tolet the currency float temporarily toward itsmarket-determined level

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Forecasting Exchange Rates

Market participants take derivative positions based ontheir expectations of future exchange rates

Technical forecasting involves the use of historical

exchange rate data to predict future values e.g., time-series models that examine moving averages and

allow the forecaster to develop some rule

Fundamental forecasting is based on fundamentalrelationships between economic variables and exchange

rates e.g., high inflation in a country can lead to depreciation in its

currency

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(cont’d) Market-based forecasting is the process of

developing forecasts based on the spot rate or the forward rate

Use of the spot rate Corporations can use the spot rate to forecast, since it

represents the market’s expectation of the spot rate in thenear future

Use of the forward rate

Speculators would take positions if there was a largediscrepancy between the forward rate and expectations of the future spot rate e.g., if the forward rate for the pound was $1.40 and the spot

rate was expected to be $1.45, everyone would buy poundsforward and sell them at the future spot rate

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(cont’d) Mixed forecasting involves using a combination

of forecasting techniques

No single technique has been found to beconsistently superior

Each of the techniques is assigned a weight, and themore reliable techniques receive a higher weight

The actual forecast used by an MNC is a weightedaverage of the various forecasts developed

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Forecasting Exchange Rate

Volatility Participants forecast exchange rate

volatility to develop a range surrounding

their forecast To develop a volatility forecast:

Determine the relevant period of concern

Decide on a method to forecast volatility e.g., historical exchange rate volatility, time series

of volatility patterns, implied standard deviations

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Speculation in Foreign Exchange

Markets Commercial banks take positions in

currencies to capitalize on expected

exchange rate movements

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Speculating on Expected

Exchange Rate Movements

Zena Bank expects the euro to depreciate against the dollar and plansto take a short position in euros and a long position in dollars.

Assume the following:1. Interest rate on borrowed euros is 5 percent annualized

2. Interest rate on dollars loaned out is 6 percent annualized

3. Spot rate is €0.90 per dollar

4. Expected spot rate in ten days is €0.95 per dollar

5. Zena Bank can borrow €10 million

Describe the steps Zena should take to profit from shorting euros andgoing long on dollars.

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Speculating on Expected

Exchange Rate Movements(cont’d) Zena Bank should take the following steps:

1. Borrow €10 million and convert to $11,111,111

2. Invest the $11,111,111 million for ten days at 6 percent annualized(or .1667 percent over ten days), which will generate $11,129,630

3. After ten days, convert the $11,129,630 into euros at the existingspot rate, which converts to €10,573,148

4. Pay back the loan of €10 million plus interest of 5 percent annualized

(.1389 percent over ten days), which equals €10,013,889

Thus, Zena earns €559,259 over a ten-day period.

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Foreign Exchange Derivatives

Foreign exchange derivatives can be used to:

Speculate on future exchange rate movements

Hedge anticipated cash inflows or outflows in a givenforeign currency

Institutional investors have increased their international investments, which has increased

their exposure to exchange rate risk

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(cont’d) Forward contracts

Forward contracts are contracts typically negotiated with acommercial bank that allow the purchase or sale of a specifiedamount of a particular foreign currency at a specified exchangerate on a specified future date

The forward market facilitates the trading of forward contracts Commercial banks profit from the difference between the bid price

and the ask price and are exposed to exchange rate risk if their purchases do not match their sales of a foreign currency

Forward purchases can hedge the corporation’s risk that thecurrency’s value may appreciate

Forward sales can hedge the corporation’s risk that thecurrency’s value may depreciate

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(cont’d) Forward contracts (cont’d)

The forward rate may sometimes exhibit a premium

or discount relative to the existing spot rate:

The forward premium reflects the percentage bywhich the forward rate exceeds the spot rate on anannualized basis

nS

S FR 360premiumrateForward

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Computing A Forward Rate

Premium or Discount

Assume that the spot rate for the euro is $1.20,

while the 180-day forward rate for the euro is$1.22. What is the forward rate premium?

%33.3180

360

20.1$

20.1$22.1$

360

premiumrateForward

nS

S FR

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(cont’d) Currency futures contracts

A currency futures contract is a standardized contract thatspecifies an amount of a particular currency to be exchangedon a specified date and at a specified exchange rate Firms purchase futures to hedge payables

Firms sell futures to hedge receivables

Futures contracts have specified settlement dates

Currency swaps

A currency swap is an agreement that allows one currency tobe periodically swapped for another at specified exchangerates Essentially a series of forward contracts

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(cont’d) Currency options contracts

A currency call option provides the right to purchase aparticular currency at a specified price (the exercise price)within a specified period Used to hedge payables in a foreign currency

The option will not be exercised if the spot rate remains belowthe exercise price

A currency put option provides the right to sell a particular currency at the exercise price within a specified period

Used to hedge receivables in a foreign currency The option will not be exercised if the spot rate remains above

the exercise price

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(cont’d) Currency options contracts (cont’d)

Conditional currency options The premium is conditioned on the actual movement in the

currency’s value over the period of concern

The choice of a basic option versus a conditional option isdependent on the firm’s expectations of the currency’sexchange rate over the period of concern

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(cont’d) Use of foreign exchange derivatives for

speculating

Speculators who expect the euro to appreciatecould: Purchase euros forward and sell them in the spot market

when received

Purchase futures contracts on euros and sell euros in the

spot market when received Purchase call options on euros and sell the euros in the

spot market if the option is exercised

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(cont’d) Use of foreign exchange derivatives for

speculating (cont’d)

Speculators who expect the euro to depreciatecould: Sell euros forward and purchase them in the spot market

to fulfill the obligation

Sell futures contracts on euros and purchase euros in the

spot market by the settlement date Purchase put options on euros and purchase the euros in

the spot market if the option is exercised

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Speculating with Currency

Futures

Assume the following:

1. The spot rate for the euro is $1.15

2. The price of a futures contract is $1.17

3. Expectation of euro’s spot rate as of the settlement date is $1.20

What could you do to profit from your expectations?

You could buy euro futures. You would receive euros on the settlementdate for $1.17 and could sell euros at $1.20 if your expectationswere correct. To account for uncertainty, you could also develop aprobability distribution for the future spot rate.

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Speculating with Currency

Options

Assume the following:

1. The spot rate for the euro is $1.15

2. A call option is available with an exercise price of $1.17 and apremium of $0.02 per unit.

3. Expectation of euro’s spot rate as of the settlement date is $1.20

What could you do to profit from your expectations?

You could euro call options. If your expectations are correct, you willnet $1.20 – $1.17 – $0.02 = $0.01 per unit.

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International Arbitrage

If exchange rates become misaligned, arbitrage willoccur, forcing realignment

Locational arbitrage is the act of capitalizing on a

discrepancy between the spot rate at two differentlocations by purchasing the currency where it is pricedlow and selling it where it is priced high Some financial institutions watch for locational arbitrage

opportunities, so any discrepancy in exchange rates is quicklycorrected

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Conducting Locational Arbitrage

Assume the following information:

What actions could an arbitrageur take to benefit from these quotes?

An arbitrageur could conduct locational arbitrage by purchasing eurosfrom Blythe Bank for $1.19 and selling them to Slythe Bank for $1.20.

Bid Rate on Euros Ask Rate on Euros

Blythe Bank $1.18 $1.19

Slythe Bank $1.20 $1.21

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International Arbitrage (cont’d)

Covered interest arbitrage Interest rate parity refers to the relationship between a

forward rate premium and the interest rate differential of twocountries:

If the interest rate is lower in the foreign country than in the homecountry, the forward rate of the foreign currency should exhibit a

premium The forward rate premium or discount should be about equal to

the differential in interest rates between the countries of concern

1)1()1(

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Computing A Forward Premium

Using Interest Rate Parity

Assume that the spot rate of the British pound is $1.50, the one-year U.S.interest rate is 7 percent, and the one-year British interest rate is 8

percent. What should the forward rate premium or discount of the Britishpound be?

The forward rate reflects a 0.93% discount below the spot rate, or $1.49.

%93.0108.1

07.1

1)1(

)1(

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i p

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International Arbitrage (cont’d)

Covered interest arbitrage (cont’d) If interest rate parity does not hold, covered interest

arbitrage is possible E.g., if the spot rate and forward rate for a foreign currency are

equal and the foreign interest rate is higher, arbitrageurs wouldbuy the currency now, invest in the foreign country, and sell thecurrency forward

Interest rate parity prevents investors from earning higher returns from covered interest arbitrage than can be earned in

the U.S. Impact of the September 11 Crisis

The interest rate differential between the U.S. and other countries increased, resulting in increased forward rate discounts

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Explaining Price Movements of

Foreign Exchange Derivatives Indicators of foreign exchange derivative prices

The spot rate influences the forward rate andcurrency futures

Indicators that may signal a change in economicconditions that will affect the supply and demand for aparticular currency and the spot rate are monitored: Relative inflation

Relative interest rates

Economic growth indicators

Relative budget deficits

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