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CHAPTER 11 Foreign Exchange Futures

CHAPTER 11 Foreign Exchange Futures. In this chapter, we discuss foreign exchange futures. This chapter is organized as follows: Price Quotations Geographical and Cross-Rate Arbitrage Forward and Futures Market Characteristics Determinants of Foreign Exchange Rates

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CHAPTER 11 Foreign Exchange Futures

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  1. CHAPTER 11Foreign Exchange Futures • In this chapter, we discuss foreign exchange futures. This chapter is organized as follows: • Price Quotations • Geographical and Cross-Rate Arbitrage • Forward and Futures Market Characteristics • Determinants of Foreign Exchange Rates • Futures Price Parity Relationships • Speculation in Foreign Exchange Futures • Hedging with Foreign Exchange Futures Chapter 11

  2. Price Quotation • In the foreign exchange market, every price is a relative price. That is, there is a reciprocal rate. • Example: • To say that $1 = € 2.5 (2.5 euros) implies that € 2.5 will buy $1 • Or • € 1 = $0.40 • Figure 11.1 shows foreign exchange rate quotations as they appear in the Wall Street Journal. Chapter 11

  3. Price Quotation • Insert Figure 11.1 here Chapter 11

  4. Price Quotation • Forward rates are the rates that you can contract today for the currency. • If you buy a forward rate, you agree to pay the forward rate in 30 days to receive the currency in question. • If you sell a forward rate, you agree to deliver the currency in question in receipt of the forward rate. • The transactions are in the interbank market. The transactions are for $1,000,000 or more. • One rate is the inverse of the other (e.g., $/€ reverse of €/$). • Using the previous example $1 = €2.5 Chapter 11

  5. CME’s Euro FX FuturesProduct Profile Chapter 11

  6. Geographical and Cross-Rate Arbitrage • Pricing relationships exist in the foreign exchange market. This sections explores two of these relationships and associated arbitrage opportunities: • Geographical Arbitrage • Cross-Rate Arbitrage Chapter 11

  7. Geographical Arbitrage • Geographical arbitrage occurs when one currency sells for a different prices in two different markets. • Example • Suppose that the following exchange rates exist between German marks and U.S. dollars as quoted in New York and Frankfurt for 90-day forward rates: • New York $/€ 0.42 • Frankfurt €/$ 2.35 • To identify the opportunity for an arbitrage we can compute the inverse. From the price in New York, we can compute the appropriate exchange rate in Frankfurt. Chapter 11

  8. Geographical Arbitrage • If the transpose is equal to the price of the currency in another market, there is no opportunity for a geographic arbitrage. • If the transpose is not equal to the price of the currency in another market, the opportunity for a geographic arbitrage exists. In this case: In New York, the €/$ rate is 2.381, but in Frankfurt it is 2.35. Thus, an arbitrage opportunity exists. Table 11.1 shows how to exploit this pricing discrepancy. Chapter 11

  9. Geographical Arbitrage Chapter 11

  10. Cross-Rate Arbitrage US$ € (Euro) US$ ₤ (B. Pound) Cross-Rate Arbitrage • Cross-rate arbitrage, if present, allows you to exploit misalignments in cross rates. A cross-rate is the exchange rate between two currencies that is implied by the exchange on other currencies. • Example • In New York, there is a rate quoted for the U.S. dollar versus the euro. There is also a rate quoted for the U.S. dollar versus the British pound. Together these two rates imply a rate that should exist between the euro and the British pound that do not involve the dollar. This implied exchange rate is called the cross rate. Cross rates are reported in the Wall Street Journal. Figure 11.2 shows quotations for cross rates from the Wall Street Journal. Chapter 11

  11. Cross-Rate Arbitrage • Insert Figure 11.2 here Chapter 11

  12. Cross-Rate Arbitrage • If the direct rate quoted somewhere does not match the cross rate, an arbitrage opportunity exists. • Suppose that we have the following 90-day forward rates. FS indicates the Swiss franc (FS): • New York $/€ 0.42 • $/SF 0.49 • Frankfurt €/SF 1.20 • The exchange rates quoted in New York imply the following cross rate in New York for the €/SF: Chapter 11

  13. Cross-Rate Arbitrage • Because the rate directly quoted in Frankfurt differs from the cross rate in New York, an arbitrage opportunity is present. • Table 11.2 shows the transactions required to conduct the arbitrage. Chapter 11

  14. Forward and Futures Market Characteristics • The institutional structure of the foreign exchange futures market resembles that of the forward market, with a number of notable exceptions as shown in Table 11.3. Chapter 11

  15. Determinants of Foreign Exchange Rates • This section explores the following determinants of foreign exchange rates: • Balance of Payments • Fixed Exchange Rates • Other Exchange Rate Systems • Freely Floating • Managed Float or Dirty Float Policy • Pegged Exchange Rate System • Joint Float Chapter 11

  16. Balance of Payments • Balance of payments is the flow of payments between residents of one country and the rest of the world. This flow of payments affects exchange rates. • The balance of payments encompasses all kinds of flows of goods and services among nations, including: • The movement of real goods • Services • International investment • All types of financial flows • Deficit Balance of Payment • Expenditures by a particular country exceed receipts. A constant balance of payments deficit will cause the value of the country’s currency to fall. • Surplus Balance of Payment • Receipts by particular country exceed expenditures. Chapter 11

  17. Fixed Exchange Rates • Fixed Exchange Rates • A fixed exchange rate is a stated exchange rate between two currencies at which anyone may transact. • For a particular country, a continual excess of imports over exports puts pressure on the value of its currency as its world supply continues to grow. • Eventually, the fixed exchange rate between the country’s currency and that of other nations must be adjusted either by devaluating or revaluating. • Devaluation: the value of the currency will fall relative to other countries. • Revaluation: the value of the currencies will increase relative to other countries. • Exchange Risk • The risk that the value of a currency will change relative to other currencies. • Today a free market system of exchange rates prevails. Daily fluctuations exists in the exchange rates market. Chapter 11

  18. Other Exchange Rates Systems • Freely Floating • A currency has no system of fixed exchange rates. The country's central bank does not influence the value of the currency by trading in the foreign exchange market. • Managed Float or Dirty Float Policy • The central bank of a country influences the exchange value of its currency, but the rate is basically a floating rate. • Pegged Exchange Rate System • The value of one currency might be pegged to the value of another currency, that itself floats. • Joint Float • In a joint float, currencies participating in the joint float have fixed exchange values relative to other currencies in the joint float, but the group of currencies floats relative to other currencies that do not participate in the joint float. This is particularly important for the foreign exchange futures market. Chapter 11

  19. Future Price Parity Relationships • In this section, other price relationships will be examined, including: • Interest Rate Parity Theorem (IRP) • Purchasing Power Parity Theorem (PPP) Chapter 11

  20. Interest Rate Parity Theorem • The Interest Rate Parity Theorem states that interest rates and exchange rates form one system. • Foreign exchange rates will adjust to ensure that a trader earns the same return by investing in risk-free instruments of any currency, assuming that the proceeds from investment are converted into the home currency by a forward contract initiated at the beginning of the holding period. • To illustrate the interest rate parity, consider Table 11.4. Chapter 11

  21. Interest Rate Parity Theorem • If interest rate parity holds, you should earn exactly the same return by following either of two strategies: • Strategy 1: • Invest in the U.S. for 180 days with a current rate of 20% • Strategy 2: • Sell $ for euros (€) at the current rate (spot rate) of 0.42. • Invest € proceeds for 180 days in Germany with a current rate of 32.3 percent. • Receive the proceeds of the German investment receiving (€ 2.7386 in 180 days). • Sell the proceeds of the German Investment for dollars through a 180-day forward contract initiated at the outset of the investment horizon for a rate of 0.40. Chapter 11

  22. Interest Rate Parity Theorem • Strategy 1 • Invest in the U.S. for 180 days. You will have the following in 6 months: • FV = PV(1+i)N • Alternative notation: • FV = DC (1+RDC) • FV = $1(1+.20)0.5 • FV = $1.095 Chapter 11

  23. Interest Rate Parity Theorem • Strategy 2: • Sell $ for euros (€) at the current rate (spot rate) or 0.42. You will receive: • Invest euro proceeds for 180 days in Germany with a current rate of 32.3 percent. • FV = PV(1+i)N or FV = DC (1+RDC) • = 2.381(1+.323)0.5 • = €2.7386 • c) Receive the proceeds of the German Investment(receiving € 2.7386 in 180 days). Take your euros out of bank. Chapter 11

  24. Interest Rate Parity Theorem • Strategy 2: • d) Sell the proceeds of the German investment for dollars through a 180-day forward contract initiated at the outset of the investment horizon for a rate of 0.40. • $U.S. = €($/€) • $U.S. = 2.7386 (0.40) or $U.S. = $1.09544 • This amount can be stated as: DC/FC = the rate at which the domestic currency can be converted to the foreign currency today. rFC = the rate that can be earned over the time period of interest on the foreign currency. F0,t = the forward or futures contract rate for conversion of the foreign currency into the domestic currency. Chapter 11

  25. Interest Rate Parity Theorem • The two strategies produce the same return, so there is no arbitrage opportunity available. If the two produced different returns, an arbitrage strategy would be present. Chapter 11

  26. Interest Rates Parity Theorem • The equality between the two strategies can also be stated as: • DC(1 + rDC) = (DC/FC)(1 + rFC)F0,t • Where • DC = the dollar amount of the domestic currency • rDC = the rate that can be earned over the time period of interest on the domestic currency • DC/FC = the rate at which the domestic currency can be converted to the foreign currency today • rFC = the rate that can be earned over the time period of interest on the foreign currency • Fo,t = the forward or futures contract rate for conversion of the foreign currency into the domestic currency Chapter 11

  27. Interest Rates Parity Theorem Using the previous example: We can manipulate the equality to solve for other variables: • The above equation says that, for a unit of foreign currency, the futures price equals the spot price of the foreign currency times the quantity: This quantity is the ratio of the interest factor for the domestic currency to the interest factor for the foreign currency. Chapter 11

  28. Interest Rates Parity Theorem • We can compare the last equation to the Cost-of-Carry Model in perfect markets with unrestricted short selling, we obtain: The cost of carry approximately equals the difference between the domestic and foreign interest rates for the period from t = 0 to the futures expiration. Applying this equation for the 180-day horizon using the rates from Table 11.4. F0,t = .40 S0 = .42 rDC = .095445 for the half-year rFC = .150217 for the half-year The result is: Chapter 11

  29. Exploiting Deviations from Interest Rate Parity • In the event that the two rates are not equal, the arbitrage that would be undertaken is referred to as covered interest arbitrage. Where we would borrow the $1 needed to undertake Strategy 2 above. If the rate earned on the investment is higher than the cost of borrowing the $1, an arbitrage profit can be earned. This is equivalent to cash-and-carry arbitrage. • This cash-and-carry strategy is known as the covered interest arbitrage in the foreign exchange market. Chapter 11

  30. Covered Interest Arbitrage 0 1 1. Borrow DC @ RDC 5. Receive DC/FC plus accrued RFC 2. Sell FC forward/futures 6. Deliver FC at RFC 3. Exchange & receive DC/FC 7. Receive DC 4. Invest FC @ RFC 8. Pay loan (DC +RDC) DC = Domestic fund/currencyFC = Foreign currency/fundsRDC = Domestic interest rateRFC = Foreign interest rate Exploiting Deviations from Interest Rate Parity If Interest Rate Parity (IRP), the exchange rate equivalent of the Cost-of-Carry Model, holds the trader must be left with zero funds. Otherwise an arbitrage opportunity exists. Chapter 11

  31. Exploiting Deviations from Interest Rate Parity • Using the data from our previous example, Table 11.5 shows the transactions that will exploit this discrepancy. Chapter 11

  32. Purchasing Power Parity Theorem • The Purchasing Power Parity Theorem (PPP) asserts that the exchange rates between two currencies must be proportional to the price level of traded goods in the two currencies. Violations of PPP can lead to arbitrage opportunities, such as the example of “Tortilla Arbitrage” shown in Table 11.6. • Assume that transportation and transaction costs are zero and that there are no trade barriers. The spot value of Mexican Peso (MP) is $.10. Chapter 11

  33. Purchasing Power Parity Theorem • Over time, exchange rates must conform to PPP. Table 11.7 presents prices and exchange rates at two different times (PPP at t = 0, PPP at t = 1). Chapter 11

  34. Speculation in Foreign Exchange Speculating with an Outright Position • Assume that today, April 7, a speculator has the following information about the exchange rates between the U.S. and the euro. Table 11.10 shows the exchange rates. • Based on the exchange rate information, the market believes the euro will rise relative to the dollar. The speculator disagrees. The speculator believes that the price of the euro, in terms of dollars, will actually fall over the rest of the year. Chapter 11

  35. Speculation in Foreign Exchange Speculating with an Outright Position • Table 11.11 shows the speculative transactions that the speculator enters to take advantage of her/his belief. The speculator’s hunch was correct, and thus made a profit. Chapter 11

  36. Speculation in Foreign Exchange Speculating with Spreads • Spread strategies include intra-commodity and inter-commodity. Assume that a speculator believes that the Swiss franc will gain in value relative to the euro but is also uncertain about the future value of the dollar relative to either of these currencies. • The speculator gathers market prices for June 24 $/C and $/SF spot and future exchange rates. Table 11.12 summarizes the information. Chapter 11

  37. Speculation in Foreign Exchange Speculating with Spreads • Table 11.13 shows the transactions that the speculator enters to exploit his/her belief that the December cross rate is too low. Chapter 11

  38. Speculation in Foreign Exchange Speculating with Spreads • Assume that a speculator observes the spot and futures prices as shown in Table 11.14. The speculator observes that the prices are relatively constant, but believes that the British economy is even worse than generally appreciated. She anticipates that the British inflation rate will exceed the U.S. rate. Therefore, the trader expects the pound to fall relative to the dollar. Because the speculator is risk averse, she decides to trade a spread instead of an outright position. Chapter 11

  39. Speculation in Foreign Exchange Speculating with Spreads • Table 11.15 shows the transactions that the speculator enters to exploit her belief. As a result of her conservatism, the profit is only $150. Had the trader taken an outright position by selling the MAR contract, the profit would have been $517.50. Chapter 11

  40. Hedging with Foreign Exchange FuturesHedging Transaction Exposure • You are planning a six-month trip to Switzerland. You plan to spend a considerable sum during this trip. You gather the information in Table 11.6. After analyzing the data, you fear that spot rates may rise even higher, so you decide to lock-in the existing rates by buying Swiss franc futures. Chapter 11

  41. Hedging with Foreign Exchange FuturesHedging Transaction Exposure • Table 11.17 shows that transaction that you enter in order to lock in your exchange rate. In this example, you had a pre-existing risk in the foreign exchange market, since it was already determined that you would acquire the Swiss francs. By trading futures, you guaranteed a price of $.5134 per franc. Chapter 11

  42. Hedging with Foreign Exchange FuturesHedging Import/Export Transaction • You, the owner of a import/export business, just finished negotiating a large purchase of 15,000 Japanese watches from a firm in Japan. The Japanese company requires your payment in yens upon delivery. Delivery will take place in 6 months. The price of the watches is set to Yen 2850 per watch (today’s yen exchange rate). Thus, you will have to pay Yen 42,750,000 in about seven months. • You gather the information shown in Table 11.18. After analyzing the information, you fear that dollar may lose ground against the yen. Chapter 11

  43. Hedging with Foreign Exchange FuturesHedging Import/Export Transaction • To avoid any worsening of your exchange position, you decide to hedge the transaction by trading foreign exchange futures. Table 11.19 shows the transactions. Notice that because you were not able to fully hedge your position, you still had a loss. Chapter 11

  44. Hedging with Foreign Exchange FuturesHedging Translation Exposure • Many global corporations have subsidiaries that earn revenue in foreign currencies and remit their profits to a U.S. parent company. The U.S. parent reports its income in dollars, so the parent's reported earnings fluctuate with the exchange rate between the dollar and the currency of the foreign country in which the subsidiary operates. This necessity to restate foreign currency earnings in the domestic currency is called translation exposure. Chapter 11

  45. Hedging with Foreign Exchange FuturesHedging Translation Exposure • The Schropp Trading Company of Neckarsulm, a subsidiary of an American firm, expects to earn 4.3 million this year and plans to remit those funds to its American parent. The company gathers information about the euro exchange rates for January 2 and December 15 as shown in Table 11.20. • With the DEC futures trading at .4211 dollars per euro on January 2, the expected dollar value of those earnings is $1,810,730. If the euro falls, however, the actual dollar contribution to the earnings of the parent will be lower. Chapter 11

  46. Hedging with Foreign Exchange FuturesHedging Translation Exposure • The firm can either hedge or leave unhedged the value of the earnings in euros, as Table 11.21 shows. Chapter 11

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