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Speculation (Direction)
Spot Market & FX Options
• Speculation: holding an uncovered position
• Choice of Investment depends upon Speculator’s
Expectations:
• Foreign currency appreciation
Desire a Long Exposure
Buy foreign currency
Long FX forward / futures
Buy FX call option
• Foreign currency depreciation
Desire a Short Exposure
Sell foreign currency
Sell FX forward / futures
Buy a FX put option
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4 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Currency Call Options
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Currency Call Options
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6 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Currency Put Options
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Options Leverage Effect
• Australian Speculator
– Has 1000 AUD
– Believes the GBP is going to appreciate versus the AUD
– Spot rate: GBP / AUD 1.42
– Call option strike price: 1.42 --- (Premium = 2c AUD)
N.B. When speculating, you must also consider the opportunity cost (difference between Aus. & UK interest rates)
Market Expectations
Our previous options speculators had a simplistic view of
the market
CONCEPT:
In an efficient market expected movements are
already incorporated into the prices of our derivative
instruments.
• Eg. Lock in the forward rate.
• Example:
– Where the hedger’s expectation is that the volatility is
going to be greater than the market prediction, a hedger
can lock in a forward rate to cover their exposure with
respect to direction and use a ‘Straddle’ as the bet on
volatility.
– A speculator would simple enter into the Straddle.
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Long Straddle
Payoff
+ Buy Call
(Including Premiums)
St
Buy Put
-
X Straddle
St
-
Short Straddle
Payoff
+
Write Call Write Put
(Including Premiums)
St
Payoff Straddle
+
X St
-
7 International Arbitrage And Interest Rate Parity
Chapter Objectives
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Introducing arbitrage
Shleifer and Vishny in the Journal of Finance,
Vol. LII, no. 1 (1997) page 35
“…arbitrage in financial markets requires
no capital and entails no risk…[it involves]
the simultaneous purchase and sale of the
same, or essentially similar, security in two
different markets for advantageously
different prices”
International Arbitrage
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International Arbitrage
Locational Arbitrage
▪ Defined as the process of buying a currency at the location
where it is priced cheap and immediately selling it at another
location where it is priced higher. (See Exhibit 7.1)
▪ Gains from locational arbitrage are based on the amount of
money used and the size of the discrepancy. (See Exhibit 7.2)
▪ Realignment due to locational arbitrage drives prices to
adjust in different locations so as to eliminate discrepancies.
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Exhibit 7.2 Locational Arbitrage
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Locational Arbitrage (AUD example)
Locational Arbitrage:
exploiting quotation differences between dealers.
Triangular Arbitrage
▪ Defined as currency transactions in the spot market to
capitalize on discrepancies in the cross exchange rates between
two currencies. (See Exhibits 7.3, 7.4, & 7.5)
▪ Gains from triangular arbitrage: Currency transactions are
conducted in the spot market to capitalize on the discrepancy in
the cross exchange rate between two countries.
▪ Accounting for the Bid/Ask Spread: Transaction costs
(bid/ask spread) can reduce or even eliminate the gains from
triangular arbitrage.
▪ Realignment due to triangular arbitrage forces exchange
rates back into equilibrium. (See Exhibit 7.6)
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Exhibit 7.3 Example of Triangular Arbitrage
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Exhibit 7.4 Currency Quotes for a Triangular
Arbitrage Example with Transaction Costs
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Exhibit 7.5 Example of Triangular Arbitrage
Accounting for Bid/Ask Spreads
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Exhibit 7.6 Impact of Triangular Arbitrage
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Triangular Arbitrage (Two directions)
• We should have less than we started with after a round trip.
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Investment Flows
Current Spot : 0.9883 / 0.9890 CHF / AUD
1 Year Forward : 1.0268 / 1.0291 CHF / AUD
Swiss 1 Year Rate : 2.5%
Australian 1 Year Rate : 6.5%
(Now) Spot
1000 AUD 1011.12 CHF
Invest AUD
Invest CHF
(1 Year)
1065 AUD
Forward
1064.18 AUD 1036.40 CHF
Investment Flows
Current Spot : s0 CHF / AUD Swiss Interest : if
1 Year Forward : f1 CHF / AUD Australian Interest : ih
Let us assume this is a Direct Quote => Unit = FC
Note: We can assume this is an Indirect Quote and
determine an alternative formula if we so wish.
(Now) Spot
1 AUD 1/s0 CHF
Invest AUD
Invest CHF
(1 Year)
1+ih AUD
Forward
F(1+if) / s0 AUD (1+if) / s0 CHF
Theoretical Forward Rate
F (1 i f )
Investment Flows: (1 ih )
(Prior slide) S
(1 ih )
Synthetic Forward: F * (1 i f )
(We will see how to create this
using the Money Market in future weeks) S
S (1 ih )
Theoretical Forward Rate: F *
(Whether based off Investment Flows (1 i f )
or the use of the Money Market)
Forward Rates are a function of:
1 i
home
Forward Spot
1 iforeign
1. The current spot rate
2. The domestic interest rate
3. The foreign interest rate
If ihome > iforeign....foreign currency is expected to appreciate over
time. (FC ↑ )
If iforeign > ihome…foreign currency is expected to depreciate over
time. (FC ↓ )
If F* < > F
=> Possible Arbitrage
F* > F
=> F relatively undervalued
=> Buy Fwd Foreign Currency (Fwd Ask)
F* < F
=> F relatively overvalued
=> Sell Fwd Foreign Currency (Fwd Bid)
International Arbitrage
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Exhibit 7.7 Example of Covered Interest Arbitrage
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Covered Interest Arbitrage for fun
and profit (The Signal does not Match)
Current Spot : 0.9883 / 0.9890 CHF / AUD
1 Year Forward : 1.0168 / 1.0191 CHF / AUD [ASSUME]
Swiss 1 Year Rate : 2.5%
Australian 1 Year Rate : 6.5%
1.065
F * Bid .9890 1.0276
1.025
1.0276 > 1.0168
Fwd Undervalued =>Buy CHF Forward => Forward Ask
=> No Match => Can’t Arbitrage
Covered Interest Arbitrage for fun
and profit (The Signal Matches)
Current Spot : 0.9883 / 0.9890 CHF / AUD
1 Year Forward : 1.0168 / 1.0191 CHF / AUD [ASSUME]
Swiss 1 Year Rate : 2.5%
Australian 1 Year Rate : 6.5%
1.065
F * Ask .9883 1.0269
1.025
1.0269 > 1.0191
Fwd Undervalued =>Buy CHF Forward => Ask
=> Match => Arbitrage Opportunity
Covered Interest Arbitrage
for fun and profit (The Money)
(Now) Spot (Bid)
Borrow 1000 CHF 988.30 AUD
Invest AUD
To Repay: 1025 CHF
(1 year)
Forward (Ask)
1032.81 CHF 1052.54 AUD
F S (1 ih ) (1 i f )
p
S (1 i f )
F S ih i f
p
S 1 i f
Interest Rate Parity
Theory suggesting that the forward rate differs from the spot
rate by an amount that reflects the interest differential
between two currencies.
iH iF equals f 0 s0
1 iF s0
Interest Rate Parity
1 ih
p 1
1 i f
where
p forward premium
ih home interest rate
i f foreign interest rate
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Interest Rate Parity
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Interest Rate Parity
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Interest Rate Parity
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Interest Rate Parity
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Interest Rate Parity
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Exhibit 7.10 Potential for Covered Interest Arbitrage
When Considering Transaction Costs
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Variation in Forward Premiums
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Exhibit 7.11 Quoted Interest Rates for Various
Times to Maturity
50
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Exhibit 7.12 Relationship over Time between the
Interest Rate Differential and the Forward Premium
51
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Forecasting Foreign Exchange
• Are parity models inconsistent with a random
walk?
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SUMMARY (Cont.)
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SUMMARY (Cont.)
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