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Currency Exchange Rates, Hedging, and Arbitrage

Currency Exchange Rates, Hedging, and Arbitrage. Jennie Morse BA 543 Evening Section. Agenda. Intro Exchange Rates Forex Market Hedging vs. Arbitrage Currency Derivatives Forward Contracts Futures Contracts Options Swaps Conclusion and Questions. Introduction.

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Currency Exchange Rates, Hedging, and Arbitrage

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  1. Currency Exchange Rates, Hedging, and Arbitrage Jennie Morse BA 543 Evening Section

  2. Agenda • Intro • Exchange Rates • Forex Market • Hedging vs. Arbitrage • Currency Derivatives • Forward Contracts • Futures Contracts • Options • Swaps • Conclusion and Questions

  3. Introduction • Exchange rates becoming increasingly important due to: • Globalization • Technology • Importance of exchange risk to • Investors • Borrowers

  4. Exchange Rates • Exchange Rate: the price of one currency in terms of another Examples: • Yahoo Finance

  5. Quoting Exchange Rates • Direct vs. Indirect From US Perspective: Direct: $$$$ € Indirect: €€€€ $ American vs. European European: • USD is base currency American: • USD is counter currency Quoting order: EUR, GBP, AUD, NZD, USD

  6. Foreign Exchange Market • Decentralized OTC market • Top 3 exchange locations: London, US, Japan • Very liquid market • Spot transactions (2 days) • Pegged vs. Floating rates • 3 factors that cause flucuation: • Economic conditions • Political events • Market Psychology

  7. Hedging & Arbitrage • Hedging • Used to offset potential losses and evade potential losses, but is not risk-free • Ex: SW airlines fuel • Arbitrage • Risk-free strategy used to capitalize on mispriced assets • Ex: Triangular Arbitrage

  8. Triangular Arbitrage

  9. Currency Derivatives • Four Instruments used for mitigating exchange rate risk: • Forward Contracts • Futures Contracts • Options • Currency Swaps

  10. Forward Contracts • Most common way to alleviate exchange rate risk • Traded in OTC markets • Locks in future rate: • Eliminate risk of adverse rate swings • Relinquish opportunity to benefit from advantageous price changes • Not good for LT use

  11. Futures Contracts • Standardized • Traded on exchanges • Only for major national currencies • 1 year maximum; does not protect against LT risk

  12. Currency Options • Major currencies traded on exchanges • Customized options traded in OTC market • 2 types: • Regular option where underlying is a currency and strike price is an exchange rate • Futures Options

  13. Currency Swaps • Transactionally efficient vehicle to protect against LT risk • Also used to capitalize on arbitrage opportunities where a borrower could raise funds at a lower rate than what is available domestically

  14. Currency Swaps • Two companies issue bonds in the other’s bond market • Swap money raised from bond sale • Make coupon payments to each other to cover the other’s debt • Swap par value of bonds on maturity date

  15. Conclusion • Take-aways: • Definition of exchange rate • How rates are quoted • What exchange rate risk is • Key facts about Forex market: • Decentralized OTC market; floating rates • Spot Transactions completed in 2 days • 4 methods to protect against exchange risk • Forwards, Futures, Options, Swaps

  16. Questions

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