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Review

Review. Ch 6. Ch 6: Foreign Exchange Markets: Learning Objectives. Examine the what, when, where, and why of currency trading in the global marketplace Understand the definitions and distinctions among spot, forward, swap, and other types of foreign exchange financial instruments

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Review

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  1. Review Ch 6

  2. Ch 6: Foreign Exchange Markets: Learning Objectives Examine the what, when, where, and why of currency trading in the global marketplace Understand the definitions and distinctions among spot, forward, swap, and other types of foreign exchange financial instruments Learn the forms of currency quotations used by currency dealers, financial institutions, and agents of all kinds when conducting foreign exchange transactions Analyze the interaction among changing currency values, cross exchange rates and opportunities arising from intermarket arbitrage

  3. Functions of the FOREX Market The FOREX market is the mechanism by which participants Transfer purchasing power between countries This is necessary as international trade and capital transactions normally involve parties living in countries with different national currencies Obtain or provides credit for international trade transactions Inventories in transit must be financed Minimize exposure to exchange rate risk FOREX markets provide instruments utilized in “hedging” or transferring risk to more willing parties

  4. Transactions in the Interbank Market Transactions within this market can be executed on a spot, forward, or swap basis A spot transaction requires almost immediate delivery of foreign exchange A forward transaction requires delivery of foreign exchange at some future date A swap transaction is the simultaneous exchange of one foreign currency for another

  5. Exhibit 6.8 Bid, Ask, and Mid-Point Quotation

  6. Foreign Exchange Rates & Quotations Expressing Forward Quotations on a Points Basis The yen is quoted only to two decimal points A forward quotation is not a foreign exchange rate, rather the difference between the spot and forward rates Example: Bid Ask Outright spot: ¥118.27 ¥118.37 Plus points (3 months) -1.43 -1.40 Outright forward: ¥116.84 ¥116.97

  7. Exhibit 6.11 Triangular Arbitrage by a Market Trader

  8. Review Ch 7

  9. Ch 7: International Parity Conditions:Learning Objectives Examine how price levels and price level changes (inflation) in countries determine the exchange rate at which their currencies are traded Show how interest rates reflect inflationary forces within each country and currency Explain how forward markets for currencies reflect expectations held by market participants about the future spot exchange rate Analyze how, in equilibrium, the spot and forward currency markets are aligned with interest differentials and differentials in expected inflation

  10. Prices and Exchange Rates Conversely, if the prices were stated in local currencies, and markets were efficient, the exchange rate could be deduced from the relative local product prices ¥ $

  11. Purchasing Power Parity & The Law of One Price If the Law of One Price were true for all goods, the purchasing power parity (PPP) exchange rate could be found from any set of prices Through price comparison, prices of individual products can be determined through the PPP exchange rate This is the absolute theory of purchasing power parity Absolute PPP states that the spot exchange rate is determined by the relative prices of similar basket of goods

  12. The Hamburger Standard The “Big Mac Index,” as it has been christened by The Economist is a prime example of this law of one price: Assuming that the Big Mac is identical in all countries, it serves as a comparison point as to whether or not currencies are trading at market prices Big Mac in China costs Yuan 13.2 (local currency), while the same Big Mac in the US costs $3.73 The actual exchange rate was Yuan 6.78/$ at the time

  13. The Hamburger Standard The price of a Big Mac in Chinese Yuan in U.S. dollar-terms was therefore: The Economist then calculates the implied purchasing power parity rate of exchange using the actual price of the Big Mac in China over the price of the Big Mac in U.S. dollars: Yuan 13.2 Yuan 6.78/$ = $1.95 Yuan 13.2 $3.73 Yuan 3.54/$ =

  14. The Hamburger Standard Now comparing the implied PPP rate of exchange, Yuan 3.54/$, with the actual market rate of exchange at that time, Yuan 6.78/$, the degree to which the Chinese yuan is either undervalued or overvalued versus the U.S. dollar is calculated: Yuan 3.54/$ - Yuan 6.78/$ = -48% Yuan 6.78/$

  15. Exchange Rate Pass-Through Incomplete exchange rate pass-through is one reason that country’s real effective exchange rate index can deviate from it’s PPP equilibrium point The degree to which the prices of imported & exported goods change as a result of exchange rate changes is termed pass-through Example: assume BMW produces a car in Germany and all costs are incurred in euros. When the car is exported to the US, the price of the BMW should be the euro value converted to dollars at the spot rate Where P$ is the BMW price in dollars, P€ is the BMW price in euros and S is the spot rate € €/$

  16. Exchange Rate Pass-Through Incomplete exchange rate pass-through is one reason that a country’s real effective exchange rate index can deviate for lengthy periods from its PPP-equilibrium level If the euro appreciated 20% against the dollar, but the price of the BMW in the US market rose to only $40,000, and not $42,000 as is the case under complete pass-through, the pass-through is partial The degree of pass-through is measured by the proportion of the exchange rate change reflected in dollar prices The degree of pass-through in this case is partial, 14.29% ÷ 20.00% or approximately 0.71. Only 71.0% of the change has been passed through to the US dollar price

  17. Exhibit 7.4 Exchange Rate Pass-Through

  18. Interest Rates and Exchange Rates The international Fisher effect, or Fisher-open, states that the spot exchange rate should change in an amount equal to but in the opposite direction of the difference in interest rates between countries if we were to use the US dollar and the Japanese yen, the expected change in the spot exchange rate between the dollar and yen should be (in approximate form) ¥

  19. Interest Rates and Exchange Rates The Forward Rate A forward rate is an exchange rate quoted today for settlement at some future date The forward exchange agreement between currencies states the rate of exchange at which a foreign currency will be bought or sold forward at a specific date in the future (typically 30, 60, 90, 180, 270 or 360 days) The forward rate is calculated by adjusting the current spot rate by the ratio of euro currency interest rates of the same maturity for the two subject currencies

  20. Interest Rates and Exchange Rates The Forward Rate

  21. Interest Rates and Exchange Rates The Forward Rate example with spot rate of Sfr1.4800/$, a 90-day euro Swiss franc deposit rate of 4.00% p.a. and a 90-day euro-dollar deposit rate of 8.00% p.a.

  22. Interest Rates and Exchange Rates The forward premium or discount is the percentage difference between the spot and forward rates stated in annual percentage terms When stated in indirect terms (foreign currency per home currency units, FC/$) then formula is • For direct quotes ($/FC), then F-S/S should be applied

  23. Exhibit 7.5 Currency Yield Curves and the Forward Premium

  24. Using the previous Sfr example, the forward discount or premium would be as follows: Interest Rates and Exchange Rates The positive sign indicates that the Swiss franc is selling forward at a premium of 3.96% per annum (it takes 3.96% more dollars to get a franc at the 90-day forward rate)

  25. Interest Rate Parity (IRP) Interest rate parity theory provides the linkage between foreign exchange markets and international money markets The theory states that the difference in the national interest rates for securities of similar risk and maturity should be equal to, but opposite sign to, the forward rate discount or premium for the foreign currency, except for transaction costs

  26. Exhibit 7.6 Interest Rate Parity (IRP)

  27. Covered Interest Arbitrage (CIA) Because the spot and forward markets are not always in a state of equilibrium as described by IRP, the opportunity for arbitrage exists The arbitrageur who recognizes this imbalance can invest in the currency that offers the higher return on a covered basis This is known as covered interest arbitrage (CIA) The following slide describes a CIA transaction in much the same way as IRP was transacted

  28. Exhibit 7.7 Covered Interest Arbitrage (CIA)

  29. Covered Interest Arbitrage (CIA) Rule of Thumb: If the difference in interest rates is greater than the forward premium (or expected change in the spot rate), invest in the higher yielding currency. If the difference in interest rates is less than the forward premium (or expected change in the spot rate), invest in the lower yielding currency.

  30. Exhibit 7.8 Uncovered Interest Arbitrage (UIA): The Yen Carry Trade

  31. Review Ch 8

  32. Foreign Currency Derivatives and Swaps: Learning Objectives Explain how foreign currency futures are quoted, valued, and used for speculation purposes Illustrate how foreign currency futures differ from forward contracts Analyze how foreign currency options are quoted, valued, and used for speculation purposes Explain how foreign currency options are valued Define interest rate risk, and examine how can it be managed

  33. Foreign Currency Derivatives and Swaps: Learning Objectives Explain interest rate swaps and how they can be used to manage interest rate risk Analyze how interest rate swaps and cross currency swaps can be used to manage both foreign exchange risk and interest rate risk simultaneously

  34. Using Foreign Currency Futures Any investor wishing to speculate on the movement of a currency can pursue one of the following strategies Short position – selling a futures contract based on view that currency will fall in value Long position – purchase a futures contract based on view that currency will rise in value Example: Amber McClain believes that Mexican peso will fall in value against the US dollar, she looks at quotes in the WSJ for Mexican peso futures

  35. Exhibit 8.1 Mexican Peso (CME)--MXN 500,000; $ per 10MXN

  36. Using Foreign Currency Futures Example (cont.): Amber believes that the value of the peso will fall, so she sells a March futures contract By taking a short position on the Mexican peso, Amber locks-in the right to sell 500,000 Mexican pesos at maturity at a set price above their current spot price Using the quotes from the table, Amber sells one March contract for 500,000 pesos at the settle price: $.10958/Ps Value at maturity (Short position) = -Notional principal x (Spot – Forward)

  37. Using Foreign Currency Futures To calculate the value of Amber’s position we use the following formula Using the settle price from the table and assuming a spot rate of $.09500/Ps at maturity, Amber’s profit is Value at maturity (Short position) = -Notional principal  (Spot – Forward) Value = -Ps 500,000  ($0.09500/ Ps - $.10958/ Ps) = $7,290

  38. Using Foreign Currency Futures If Amber believed that the Mexican peso would rise in value, she would take a long position on the peso Using the settle price from the table and assuming a spot rate of $.11000/Ps at maturity, Amber’s profit is Value at maturity (Long position) = Notional principal  (Spot – Forward) Value = Ps 500,000  ($0.11000/ Ps - $.10958/ Ps) = $210

  39. Currency Futures and Forwards Compared

  40. Currency Options A foreign currency option is a contract giving the purchaser of the option the right to buy or sell a given amount of currency at a fixed price per unit for a specified time period The most important part of clause is the “right, but not the obligation” to take an action Two basic types of options, calls and puts Call – buyer has right to purchase currency Put – buyer has right to sell currency The buyer of the option is the holder and the seller of the option is termed the writer

  41. Foreign Currency Options Every option has three different price elements The strike or exercise price is the exchange rate at which the foreign currency can be purchased or sold The premium, the cost, price or value of the option itself paid at time option is purchased The underlying or actual spot rate in the market There are two types of option maturities American options may be exercised at any time during the life of the option European options may not be exercised until the specified maturity date

  42. Foreign Currency Options Options may also be classified as per their payouts At-the-money (ATM) options have an exercise price equal to the spot rate of the underlying currency In-the-money (ITM) options may be profitable, excluding premium costs , if exercised immediately Out-of-the-money (OTM) options would not be profitable, excluding the premium costs, if exercised

  43. Foreign Currency Options Markets The increased use of currency options has lead the creation of several markets where financial managers can access these derivative instruments Over-the-Counter (OTC) Market – OTC options are most frequently written by banks for US dollars against British pounds, Swiss francs, Japanese yen, Canadian dollars and the euro Main advantage is that they are tailored to purchaser Counterparty risk exists Mostly used by individuals and banks

  44. Exhibit 8.2 Swiss Franc Option Quotations (U.S. Cents/SF)

  45. Foreign Currency Options Markets The spot rate means that 58.51 cents, or $0.5851 was the price of one Swiss franc The strike price means the price per franc that must be paid for the option. The August call option of 58 ½ means $0.5850/Sfr The premium, or cost, of the August 58 ½ option was 0.50 per franc, or $0.0050/Sfr For a call option on 62,500 Swiss francs, the total cost would be Sfr62,500 x $0.0050/Sfr = $312.50

  46. Foreign Currency Speculation Speculating in the spot market Hans Schmidt is a currency speculator. He is willing to risk his money based on his view of currencies and he may do so in the spot, forward or options market Assume Hans has $100,000 and he believes that the six month spot for Swiss francs will be $0.6000/Sfr. Speculation in the spot market requires that view is currency appreciation

  47. Foreign Currency Speculation Speculating in the spot market Hans should take the following steps Use the $100,000 to purchase Sfr170,910.96 today at a spot rate of $0.5851/Sfr Hold the francs indefinitely, because Hans is in the spot market he is not committed to the six month target When target exchange rate is reached, sell the Sfr170,910.96 at new spot rate of $0.6000/Sfr, receiving Sfr170,910.96 x $0.6000/Sfr = $102,546.57 This results in a profit of $2,546.57 or 2.5% ignoring cost of interest income and opportunity costs

  48. Foreign Currency Speculation Speculating in the forward market If Hans were to speculate in the forward market, his viewpoint would be that the future spot rate will differ from the forward rate Today, Hans should purchase Sfr173,611.11 forward six months at the forward quote of $0.5760/Sfr. This step requires no cash outlay In six months, fulfill the contract receiving Sfr173,611.11 at $0.5760/Sfr at a cost of $100,000 Simultaneously sell the Sfr173,611.11 in the spot market at Hans’ expected spot rate of $0.6000/Sfr, receiving Sfr173,611.11 x $0.6000/Sfr = $104,166.67 This results in a profit of $4,166.67 with no investment required

  49. Foreign Currency Speculation Speculating in the options market If Hans were to speculate in the options market, his viewpoint would determine what type of option to buy or sell As a buyer of a call option, Hans purchases the August call on francs at a strike price of 58 ½ ($0.5850/Sfr) and a premium of 0.50 or $0.0050/Sfr At spot rates below the strike price, Hans would not exercise his option because he could purchase francs cheaper on the spot market than via his call option

  50. Foreign Currency Speculation Speculating in the options market Hans’ only loss would be limited to the cost of the option, or the premium ($0.0050/Sfr) At all spot rates above the strike of 58 ½ Hans would exercise the option, paying only the strike price for each Swiss franc If the franc were at 59 ½, Hans would exercise his options buying Swiss francs at 58 ½ instead of 59 ½

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