10 - Foreign Exchange Derivative Market

CHAPTER
16
Foreign
Exchange
Derivative
Market
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
Copyright 2002 Thomson Publishing. All rights reserved.
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
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
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

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. dollarse.g. $.70 U.S. per Canadian Dollar
1 U.S. dollars 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.

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

Markets
Currency terminology
Appreciation
means a currencys value increases

relative to another currency
Depreciation means a currencys value decreases
relative to another currency
Supply and demand influences the values of

currencies
Many factors can simultaneously affect supply
and demand

Markets
Background on Foreign Exchange Markets
19441971 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

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
Classification of Exchange Rate

Arrangement
There is a wide variation in how countries

approach managing or influencing their
currencys 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
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 differentialinfluence from real
sector of economy
Currency of the higher inflation country (euro)
depreciates compared to the lower inflation
country ($)
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
Factors Affecting Exchange Rates

Direct intervention occurs when a countrys
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

currencys value drops relative to the one
purchased
Market forces of supply and demand can
overwhelm the intervention

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

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
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

Forecasting Techniques
Market-based
Forecasting
Technical Forecasting
Fundamental Forecasting
Mixed Forecasting
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 patternsdepends on orderly cycles
If price movements are random, this method
wont work
Models may work well some of the time and
not work other times
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
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
Forecasting Exchange Rates: MarketBased

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
currencys value in the near future
Forward rate: used as the best estimate of the
future spot rate based on the expectations of
market participants
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
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
Forecasting Exchange Rate Volatility
Methods Used To Forecast Volatility

Volatility of historical data
Use a times series of volatility patterns in
previous periods
Derive the exchange rates implied standard
deviation from the currency option pricing
model
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
Foreign Exchange Derivative Contracts

Forward Contracts
Currency Swaps
Hedge or Speculate
Currency
Currency Futures
Futures
Currency Options
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
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
Foreign Exchange Derivatives
Forward rate premium or discount

p =
FR - S
Where:
360
n
P = % annualized premium or discount

FR = Forward exchange rate
S = Spot exchange rate
n = number of days forward

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
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
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 optionsif
CD depreciates against U.S., gain will offset spot loss
Foreign Exchange Derivatives-Speculate

Business or person has no spot interest in
underlying assettakes 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
Foreign Exchange DerivativesSpeculation

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
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
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
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
Equation for covered interest arbitrage

P =
Where:
( 1 + ih)
(1 + if )
P = Forward premium or discount

ih = Home country interest rate
if = Foreign interest rate
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
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
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
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
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
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
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!!!
Forecasting Foreign Exchange Rates

Technical forecasting
Fundamental forecasting
Market-based forecasting
Mixed forecasting
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
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??
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
Other Forex Derivatives

Currency futures contracts
Currency swaps
Currency option contracts
Arbitrage defined
Locational arbitrage
Covered interest arbitrage
Maintains
interest rate parity

Forward/spot differential =
Differential
inflation rates
Interest rate differentials
Expected future spot rate
Institutional Use Of Forex Market

Intermediary or dealer of forwards or other
derivative contracts
Speculating/hedging
Future
investment flows (loans, interest)

Future financing flows (principal and interest)

10 - Foreign Exchange Derivative Market

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CHAPTER

Copyright 2002 Thomson Publishing. All rights reserved.

Background On Foreign Exchange

Exchanging currencies is needed when:

(real) prompts need for forex

Foreign exchange trading

global telecommunications network between

Copyright 2002 Thomson Publishing. All rights reserved.

Foreign Exchange Rates

Quoted two ways:

currency per U.S. dollar

= more forex to buy $

Background on Foreign Exchange

Copyright 2002 Thomson Publishing. All rights reserved.

Background on Foreign Exchange

Exchange rates involve different kinds of

unit of foreign currency worth some amount of

Cross-exchange rates express relative values

Background on Foreign Exchange

Pounds per Euro using the forex rates per

Background on Foreign Exchange

means a currencys value increases

Supply and demand influences the values of

Copyright 2002 Thomson Publishing. All rights reserved.

Background on Foreign Exchange

19441971 known as the Bretton Woods Era

maintained exchange rates within a

By 1971 the U.S. dollar was clearly

Background on Foreign Exchange

floating exchange rates involve values set

Classification of Exchange Rate

There is a wide variation in how countries

with periodic intervention

Factors Affecting Exchange Rates: Real

Copyright 2002 Thomson Publishing. All rights reserved.

Factors Affecting Exchange Rates:

Copyright 2002 Thomson Publishing. All rights reserved.

Factors Affecting Exchange Rates

by central bank creates excess supply and that

Factors Affecting Exchange Rates

Factors Affecting Exchange Rates

Copyright 2002 Thomson Publishing. All rights reserved.

Movements in Exchange Rates

participants take positions in derivatives

There are several forecasting techniques

Copyright 2002 Thomson Publishing. All rights reserved.

Forecasting Exchange Rates: Technical

Copyright 2002 Thomson Publishing. All rights reserved.

Forecasting Exchange Rates:

Copyright 2002 Thomson Publishing. All rights reserved.

Forecasting Exchange Rates:

Limitation of fundamental forecasting

factors that are important to determining

Copyright 2002 Thomson Publishing. All rights reserved.

Forecasting Exchange Rates: MarketBased

Copyright 2002 Thomson Publishing. All rights reserved.

Forecasting Exchange Rates: Mixed

Copyright 2002 Thomson Publishing. All rights reserved.

Forecasting Exchange Rate Volatility

how difficult it is to forecast the actual

Copyright 2002 Thomson Publishing. All rights reserved.

Forecasting Exchange Rate Volatility

Methods Used To Forecast Volatility

Copyright 2002 Thomson Publishing. All rights reserved.