Foreign Exchange Derivative Market

1. Foreign Exchange Derivative Market 16

2. 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

3. 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

4. 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

5. 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

6. 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. dollars—e.g. $.70 U.S. per Canadian Dollar • 1 U.S. dollar’s 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.

7. 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

8. Background on Foreign Exchange Markets • Currency terminology • Appreciation means a currency’s value increases relative to another currency • Depreciation means a currency’s value decreases relative to another currency • Supply and demand influences the values of currencies • Many factors can simultaneously affect supply and demand

9. Background on Foreign Exchange Markets • 1944–1971 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 Background on Foreign Exchange Markets

10. 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

11. Classification of Exchange Rate Arrangement • There is a wide variation in how countries approach managing or influencing their currency’s 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

12. 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 differential—influence from real sector of economy • Currency of the higher inflation country (euro) depreciates compared to the lower inflation country ($)

13. 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

14. Factors Affecting Exchange Rates • Direct intervention occurs when a country’s 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 currency’s value drops relative to the one purchased • Market forces of supply and demand can overwhelm the intervention

15. 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

16. 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

17. 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

18. Forecasting Techniques Market-based Forecasting Technical Forecasting Fundamental Forecasting Mixed Forecasting

19. 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 patterns—depends on orderly cycles • If price movements are random, this method won’t work • Models may work well some of the time and not work other times

20. 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

21. 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

22. Forecasting Exchange Rates: Market-Based • 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 currency’s value in the near future • Forward rate: used as the best estimate of the future spot rate based on the expectations of market participants

23. 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

24. 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

25. Forecasting Exchange Rate Volatility • Volatility of historical data • Use a times series of volatility patterns in previous periods • Derive the exchange rate’s implied standard deviation from the currency option pricing model Methods Used To Forecast Volatility

26. 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

27. Foreign Exchange Derivative Contracts Currency Swaps Forward Contracts Hedge or Speculate Currency Futures Currency Options

28. 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

29. 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

30. FR - S 360 p = x S n Foreign Exchange Derivatives • Forward rate premium or discount Where: P = % annualized premium or discount FR = Forward exchange rate S = Spot exchange rate n = number of days forward

31. 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

32. 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

33. 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 options—if CD depreciates against U.S., gain will offset spot loss

34. Foreign Exchange Derivatives-Speculate • Business or person has no spot interest in underlying asset—takes 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

35. Foreign Exchange Derivatives-Speculation • 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

36. 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

37. 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

38. 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

39. ( 1 + ih) P = – 1 (1 + if ) International Arbitrage • Equation for covered interest arbitrage Where: P = Forward premium or discount ih = Home country interest rate if = Foreign interest rate

40. 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

41. 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

42. 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

43. 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

44. 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

45. 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

46. 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!!!

47. Forecasting Foreign Exchange Rates • Technical forecasting • Fundamental forecasting • Market-based forecasting • Mixed forecasting

48. 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

49. 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??

50. 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