You are on page 1of 53

CHAPTER

16

Foreign
Exchange
Derivative
Market

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

Copyright 2002 Thomson Publishing. All rights reserved.

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

Copyright 2002 Thomson Publishing. All rights reserved.

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
Copyright 2002 Thomson Publishing. All rights reserved.

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

Copyright 2002 Thomson Publishing. All rights reserved.

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. dollarse.g. $.70 U.S. per Canadian Dollar
1 U.S. dollars 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.
Copyright 2002 Thomson Publishing. All rights reserved.

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
Copyright 2002 Thomson Publishing. All rights reserved.

Background on Foreign Exchange


Markets

Currency terminology
Appreciation

means a currencys value increases


relative to another currency
Depreciation means a currencys value decreases
relative to another currency

Supply and demand influences the values of


currencies
Many factors can simultaneously affect supply
and demand

Copyright 2002 Thomson Publishing. All rights reserved.

Background on Foreign Exchange


Markets
Background on Foreign Exchange Markets

19441971 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
Copyright 2002 Thomson Publishing. All rights reserved.

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
Copyright 2002 Thomson Publishing. All rights reserved.

Classification of Exchange Rate


Arrangement

There is a wide variation in how countries


approach managing or influencing their
currencys 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
Copyright 2002 Thomson Publishing. All rights reserved.

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 differentialinfluence from real
sector of economy
Currency of the higher inflation country (euro)
depreciates compared to the lower inflation
country ($)

Copyright 2002 Thomson Publishing. All rights reserved.

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

Copyright 2002 Thomson Publishing. All rights reserved.

Factors Affecting Exchange Rates


Direct intervention occurs when a countrys
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


currencys value drops relative to the one
purchased
Market forces of supply and demand can
overwhelm the intervention
Copyright 2002 Thomson Publishing. All rights reserved.

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
Copyright 2002 Thomson Publishing. All rights reserved.

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

Copyright 2002 Thomson Publishing. All rights reserved.

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


Copyright 2002 Thomson Publishing. All rights reserved.

Forecasting Techniques

Market-based
Forecasting
Technical Forecasting

Fundamental Forecasting

Mixed Forecasting

Copyright 2002 Thomson Publishing. All rights reserved.

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 patternsdepends on orderly cycles
If price movements are random, this method
wont work
Models may work well some of the time and
not work other times

Copyright 2002 Thomson Publishing. All rights reserved.

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

Copyright 2002 Thomson Publishing. All rights reserved.

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

Copyright 2002 Thomson Publishing. All rights reserved.

Forecasting Exchange Rates: MarketBased


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
currencys value in the near future
Forward rate: used as the best estimate of the
future spot rate based on the expectations of
market participants

Copyright 2002 Thomson Publishing. All rights reserved.

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

Copyright 2002 Thomson Publishing. All rights reserved.

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

Copyright 2002 Thomson Publishing. All rights reserved.

Forecasting Exchange Rate Volatility

Methods Used To Forecast Volatility


Volatility of historical data
Use a times series of volatility patterns in
previous periods
Derive the exchange rates implied standard
deviation from the currency option pricing
model

Copyright 2002 Thomson Publishing. All rights reserved.

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
Copyright 2002 Thomson Publishing. All rights reserved.

Foreign Exchange Derivative Contracts


Forward Contracts

Currency Swaps

Hedge or Speculate

Currency
Currency Futures
Futures

Currency Options
Copyright 2002 Thomson Publishing. All rights reserved.

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

Copyright 2002 Thomson Publishing. All rights reserved.

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
Copyright 2002 Thomson Publishing. All rights reserved.

Foreign Exchange Derivatives

Forward rate premium or discount


p =

FR - S

Where:

360
n

P = % annualized premium or discount


FR = Forward exchange rate
S = Spot exchange rate
n = number of days forward

Copyright 2002 Thomson Publishing. All rights reserved.

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

Copyright 2002 Thomson Publishing. All rights reserved.

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
Copyright 2002 Thomson Publishing. All rights reserved.

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 optionsif
CD depreciates against U.S., gain will offset spot loss

Copyright 2002 Thomson Publishing. All rights reserved.

Foreign Exchange Derivatives-Speculate


Business or person has no spot interest in
underlying assettakes 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

Copyright 2002 Thomson Publishing. All rights reserved.

Foreign Exchange DerivativesSpeculation


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

Copyright 2002 Thomson Publishing. All rights reserved.

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

Copyright 2002 Thomson Publishing. All rights reserved.

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
Copyright 2002 Thomson Publishing. All rights reserved.

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

Copyright 2002 Thomson Publishing. All rights reserved.

International Arbitrage

Equation for covered interest arbitrage


P =

Where:

( 1 + ih)
(1 + if )

P = Forward premium or discount


ih = Home country interest rate
if = Foreign interest rate

Copyright 2002 Thomson Publishing. All rights reserved.

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

Copyright 2002 Thomson Publishing. All rights reserved.

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

Copyright 2002 Thomson Publishing. All rights reserved.

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
Copyright 2002 Thomson Publishing. All rights reserved.

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
Copyright 2002 Thomson Publishing. All rights reserved.

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

Copyright 2002 Thomson Publishing. All rights reserved.

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

Copyright 2002 Thomson Publishing. All rights reserved.

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!!!

Copyright 2002 Thomson Publishing. All rights reserved.

Forecasting Foreign Exchange Rates


Technical forecasting
Fundamental forecasting
Market-based forecasting
Mixed forecasting

Copyright 2002 Thomson Publishing. All rights reserved.

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

Copyright 2002 Thomson Publishing. All rights reserved.

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??

Copyright 2002 Thomson Publishing. All rights reserved.

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

Copyright 2002 Thomson Publishing. All rights reserved.

Other Forex Derivatives


Currency futures contracts
Currency swaps
Currency option contracts

Copyright 2002 Thomson Publishing. All rights reserved.

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

Copyright 2002 Thomson Publishing. All rights reserved.

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)

Copyright 2002 Thomson Publishing. All rights reserved.