Foreign Exchange Theory

1. Foreign Exchange Theory Session 2 Introduction to Derivatives II

2. Derivatives an Evil? • Creates excessive volatility in the underlying market. • Derivatives are too risky. • Many firms face large losses as a result of derivatives. N. Takezawa (ICU)

3. Corporate Losses (examples) • California’ Orange County ($1.64 billion,Repo & bonds,1994) • Baring Bank (Mr. Leeson)($1.3 billion, Nikkei futures/options 1995) • Metallgesellshaft ($1.3 billion, oil futures, 1993) • Showa Shell Sekiyu ($1.6 billion, FX forwards, 1994) • Kashima Oil ($1.5 billion, FX forwards,1994) • Yakult (commodity futures, 1998) N. Takezawa (ICU)

4. Volatility Introducing derivatives increase volatility of the underlying asset? Bacha and Fremault Vila (1994) Examine whether the introduction of the Nikkei index futures increase volatility of the underlying spot index. The Nikkei index futures are traded on SIMEX, OSE, CME. They find little evidence of increased volatility after introduction of futures. N. Takezawa (ICU)

5. Conrad (1989) Looks at the introduction of options on individual stockon an organized exchange [CBOE and American Option Exchange]. Examines its impact on the underlying stock price. Specifically, looks at the cumulative residuals (abnormal returns). Finds increase in excess returns around listing date. Is this evidence for improved welfare? Risk? Beta from the market model is used to measure systematic risk. Beta is not statistically different between the pre and post listing periods. Volatility? Volatility as measured by variance (stand. dev. returns) decreases. N. Takezawa (ICU)

6. Usage by non-financial firms • 1995 survey. 350 firms responded for US survey (16%) and 493 firms responded for Japanese survey (24%). • US=59% use derivatives, Japan=52% • By instrument (Japan): Forward contracts (79%), Swaps (59%), Options (29%), and Futures (12%). Nissay Research (1996) and Wharton-CIBC Wood Gundy (1996) N. Takezawa (ICU)

7. Non-financial Firms: Derivatives Usage 利用状況 41％ 利用している、７％ 以前利用した事がある、 ５２％ 利用した事はない 規模別 小型企業 １８％、中型企業 ３７％、大型企業 55％、 超大型企業 86％ デリバティブ利用のタイプ別 先渡契約 79％、スワップ 59％、オプション 29％、先物 １２％ 原資産 為替関連 87％、金利関連 60％ ニッセイ基礎研究所（１９９６） N. Takezawa (ICU)

8. Forward Rates • Spot Market vs Forward Market • Spot market: transaction involving an agreement on a price today with settlement in two business days. (immediate transaction) • Forward market: transaction involving an agreement on price today for settlement at a future date (+2 business days). (future transaction) N. Takezawa (ICU)

9. Forward and Spot Forward Rate (rate set today) （先渡契約） Use rate set one month earlier Spot rate Today One Month Later The forward rate (one month) is set today, for example at 107 yen/dollar. This means you can use the 107 yen/dollar rate one month later to buy/sell yen. Whereas the spot rate is the rate you buy/sell yen today (+2 business days). N. Takezawa (ICU)

10. Hedging Price Risk Forward Contract: an agreement to buy or sell an asset for pre-specified price at a given time in the future. 100yen/$ 110yen/$ 120yen/$ 110 yen/$ ? 1 Month Later Today You are based in Japan and export goods to the market in US dollars. You wish to convert your dollar earnings back into Japanese yen. Payment to you in dollars is made one month later (agreement made today- price is $1 per unit). N. Takezawa (ICU)

11. Dollar holdings in terms of yen Gain/Loss spot position + Gain relative to 110yen/$ 0 spot rate in 1 month 110 - forward: contract to sell 1$ at 110yen/$ Spot position cancels with forward position N. Takezawa (ICU)

12. Covered Interest Parity金利パリティ F(t,T) is the forward rate (yen/$) at time t which matures at time T, S(t) is the spot exchange rate (yen/$) at time t, and I is the the Eurorate (interest rate). The interest rate is adjusted by time to maturity T-t based on a 360 day year. N. Takezawa (ICU)

13. N. Takezawa (ICU)

14. Eurocurrency (Euromarket) • In general, a eurocurrency is a foreign currency denominated deposit in bank located outside of the country where the currency is issued as legal tender (Eurobank). • For example, a dollar deposit in Japan would be a Eurodollar deposit. It does not matter whether it is a Japanese or US bank. Generally speaking, location matters. • Deposit rates: IBOR - interbank offered rates • Typically, deposits under one year (30 or 90 day deposits). N. Takezawa (ICU)

15. Reference Rates • IBOR or interbank offered rates • LIBOR (London) • BIBOR (Bahrain) • TIBOR (Tokyo) • SIBOR (Singapore), etc. • LIMEAN = mean of bid and ask • LIBID=London interbank bid rate • Most Eurocurrencies are adjusted by a 360 day year. 365 day year for British Pound and Australian dollar. N. Takezawa (ICU)

16. The empirical evidence • Most studies show that CIP holds when investigating major currencies and using eurorates. • CIP will not always hold when there are institutional constraints and/or when non-offshore rates are used. • Issues in testing CIP: high frequency data, synchronous data (same trading time), etc. • Should we always expect CIP to hold? Or just on average? • Refer to Mark Taylor, Covered interest parity: a high frequency, high quality data study, Economica, 1987 as an example. N. Takezawa (ICU)

17. N. Takezawa (ICU)

18. Cont. • Borrow funds in US dollars at the Euro-rate. This is a large and liquid market. These funds are then converted to Canadian dollars. • Invest in Canadian domestic t-bills. • You must return the amount you borrowed. • So, the borrowed funds (covered) must be greater than or equal to your investment. N. Takezawa (ICU)

19. N. Takezawa (ICU)

20. N. Takezawa (ICU)

21. Unbiased Expectations S(t) F(t,T) E(S(T)) T t N. Takezawa (ICU)

22. N. Takezawa (ICU)