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Chapter 31

Chapter 31. THE MARKET FOR FOREIGN EXCHANGE RATE RISK CONTROL INSTRUMENTS. Foreign Exchange Rates. The amount of one currency that can be exchanged for a unit of another currency Exchange Rate Quotation Conventions Direct quote Indirect quote. Foreign Exchange Risk.

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Chapter 31

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  1. Chapter 31 THE MARKET FOR FOREIGN EXCHANGE RATE RISK CONTROL INSTRUMENTS

  2. Foreign Exchange Rates • The amount of one currency that can be exchanged for a unit of another currency • Exchange Rate Quotation Conventions • Direct quote • Indirect quote

  3. Foreign Exchange Risk • Foreign exchange risk refers to the risk of adverse movements in the exchange rate. • Assets denominated in a foreign currency expose investors to exchange rate risk. • Liabilities denominated in foreign currency expose borrowers to exchange rate risk.

  4. Spot Market • The market for the settlement of foreign exchange transactions within two business days. • Appreciation • Depreciation • American terms • European terms

  5. Spot Exchange Rates • Foreign exchange rates between major currencies are free to float, with market forces determining the relative value of a currency. • Spot exchange rates adjust to compensate for the relative inflation rate between two countries.

  6. Cross rates • The exchange rate between two countries except the U.S. Dollar price of currency X Dollar price of currency Y • Cross rate mispricing leads to triangular arbitrage • it involves positions in three currencies

  7. Foreign Exchange Dealers • Large international banks act as dealers in the foreign exchange market • Dealers are linked by telephone and cable and various information transfer services • Revenue sources: • Bid-ask spread • Commissions • Trading profits

  8. The Euro • European Union • 15 European member countries • Treaty on European Union (1992) • established monetary union • Maastricht Treaty • single currency and monetary policy • European Central Bank (ECB) • Economic and Monetary Union (EMU)

  9. Entry Requirements • The annual fiscal deficit not to exceed 3% of GDP. • Cumulative public debt not to exceed 60% of GDP. • Other economic, political, and social requirements • Approval by voters of a country seeking membership

  10. The Euro • Adopted on January 1, 1999 • fixed conversion rate against member country’s national currencies and relative to euro • free to fluctuate against all other currencies • January 1, 2002 • physical replacement of member countries’ currencies with euro

  11. OutcomesSince Birth of Euro • The euro has been viable and fairly stable. • It has developed a very large public and cooperate capital market denominated in euros. • Since its inception at $1.17, the euro has weakened considerably, reaching a low of $0.8229 on October 27, 2000. • Potential participants include the U.K. and Sweden; Denmark voted against joining the EMU on September 28, 2000.

  12. Instruments for Hedging Foreign Exchange Risk • Currency Forward Contracts • Currency Futures Contracts • Currency Options • Currency Swaps

  13. Currency Forward Contracts • Forward Contract Maturities • maturity of less than two years • longer dated forward contracts have large bid-ask spreads

  14. Pricing Currency Forward Contracts • The forward exchange rate is determined from the spot exchange rate and the interest rates in the two countries. • Interest rate parity implies that, by hedging in the forward market, an investor will receive the same domestic return whether investing domestically or in a foreign country.

  15. Interest Rate Parity • Relationship between the spot exchange rate, the interest rates in two countries, and the forward rate. • The arbitrage process which forces interest rate parity is called covered interest arbitrage.

  16. Currency Futures Contracts • Trading Locations • Underlying Currencies • Contract Size • Contract Maturity

  17. Currency Option Contracts • Underlying Currencies • spot currency • currency futures • Currency Options Trading • organized exchange • over-the-counter • Trading Locations • Contract Specifications

  18. Currency Swaps • A package of currency forward contracts. • Allows hedging of long-dated foreign exchange risk. • More traditionally efficient than futures or forward contracts. • Used to arbitrage opportunities in global financial markets for raising funds at lower cost than in the domestic market.

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