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Background
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Foreign Exchange Risk
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Foreign Exchange Risk
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Foreign Exchange Risk
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Foreign Exchange Risk
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Foreign Exchange Risk
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Foreign Exchange Risk
Spot Rate
The price quoted for immediate settlement on a
commodity, a security or a currency. The spot rate,
also called spot price, is based on the value of an
asset at the moment of the quote. ... As a result,
spot rates change frequently and sometimes
dramatically.
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Foreign Exchange Risk
Spot Rate
In finance, a spot contract, spot transaction, or
simply spot, is a contract of buying or selling a
commodity, security or currency for settlement
(payment and delivery) on the spot date, which is
normally two business days after the trade date.
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Foreign Exchange Risk
Forward Rate or Forward Contract
In finance, a forward contract or simply a forward is a non-
standardized contract between two communities to buy or to sell
an asset at a specified time at a price agreed upon today, making
it a type of derivative instrument. The party agreeing to buy the
underlying asset in the future assumes a long position, and the
party agreeing to sell the asset in the future assumes a short
position. A closely related contract is a futures contract; they
differ in certain respects. Forward contracts are very similar to
futures contracts, except they are not exchange-traded, or defined
on standardized assets.
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Foreign Exchange Risk
Forward Rate or Forward Contract
A forward contract is a customized contract between
two parties to buy or sell an asset at a specified price on
a future date. A forward contract can be used for
hedging or speculation, although its non-standardized
nature makes it particularly apt for hedging.
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Foreign Exchange Risk
Futures Rate or Futures Contract
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Foreign Exchange Risk
First of all, futures contracts are exchange-traded and,
therefore, are standardized contracts. Forward
contracts, on the other hand, are private agreements
between two parties and are not as rigid in their stated
terms and conditions. Because forward contracts are
private agreements, there is a high counterparty risk
i.e. a chance that a party may default on its side of the
agreement. Futures contracts have clearing houses
that guarantee the transactions, which drastically
lowers the probability of default to almost never.
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Foreign Exchange Risk
Secondly, the specific details concerning settlement
and delivery are quite distinct. For forward contracts,
settlement of the contract occurs at the end of the
contract. Futures contracts are marked-to-market
daily, which means that daily changes are settled day
by day until the end of the contract. Furthermore,
settlement for futures contracts can occur over a
range of dates. Forward contracts, on the other hand,
only possess one settlement date.
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Foreign Exchange Risk
Options Contract
An options contract is an agreement between a buyer
and seller that gives the purchaser of the option the
right to buy or sell a particular asset at a later date at an
agreed upon price. Options contracts are often used in
securities, commodities, and real estate transactions.
An options contract is an agreement between two
parties to facilitate a potential transaction on the
underlying security at a preset price, referred to as the
strike price, prior to the expiration date.
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Foreign Exchange Risk
The right, but not the obligation, to buy (for a call
option) or sell (for a put option) a specific amount of a
given stock, commodity, currency, index, or debt, at a
specified price (the strike price) during a specified
period of time. For stock options, the amount is usually
100 shares. Each option contract has a buyer, called the
holder, and a seller, known as the writer. If the option
contract is exercised, the writer is responsible for
fulfilling the terms of the contract by delivering the
shares to the appropriate party.
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Foreign Exchange Risk
Options Contract
In the case of a security that cannot be delivered such
as an index, the contract is settled in cash. For the
holder, the potential loss is limited to the price paid to
acquire the option. When an option is not exercised, it
expires. No shares change hands and the money spent
to purchase the option is lost. For the buyer, the upside
is unlimited. Option contracts, like stocks, are therefore
said to have an asymmetrical payoff pattern. For the
writer, the potential loss is unlimited unless the
contract is covered, meaning that the writer already
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owns the security underlying the option. (including 20
Foreign Exchange Risk
Option contracts
Option contracts, like stocks, are therefore said to have
an asymmetrical payoff pattern. For the writer, the
potential loss is unlimited unless the contract is
covered, meaning that the writer already owns the
security underlying the option. (including both
commissions and the bid/ask spread) is higher on a
percentage basis than trading the underlying stock. In
addition, options are very complex and require a great
deal of observation and maintenance. also called
option.
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Foreign Exchange Risk
Swaps contracts
A swap is one of the most simple and successful forms
of OTC-traded derivatives. It is a cash-settled contract
between two parties to exchange (or "swap") cash flow
streams. As long as the present value of the streams is
equal, swaps can entail almost any type of future cash
flow. They are most often used to change the character
of an asset or liability without actually having to
liquidate that asset or liability.
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Foreign Exchange Risk
Swaps contracts
For example, an investor holding common stock can
exchange the returns from that investment for lower
risk fixed income cash flows - without having to
liquidate his equity position.
The difference between a forward contract and a swap
is that a swap involves a series of payments in the
future, whereas a forward has a single future payment.
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Foreign Exchange Risk
Swaps contracts Two of the most basic swaps are:
Interest Rate Swap - This is a contract to exchange
cash flow streams that might be associated with some
fixed income obligations. The most popular interest rate
swaps are fixed-for-floating swaps, under which cash
flows of a fixed rate loan are exchanged for those of a
floating rate loan.
Currency Swap - This is similar to an interest rate
swap except that the cash flows are in different
currencies. Currency swaps can be used to exploit
inefficiencies in international debt markets.
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FX Risk Exposure
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Trading Activities
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Profitability of Foreign Currency
Trading
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Profitability of Foreign Currency
Trading (continued)
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Risk and Hedging
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No Arbitrage Condition:
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Diversification Effects
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Diversification Effects (continued)
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