Fi8000

Exchange Rates
Forwards, Futures


Milind Shrikhande

Final Exam
30% of your grade

The exam is comprehensive covers everything
on the syllabus

1.5-2 hours, 4-5 questions

Bring your calculator and a formula sheet (one
page, letter, you may write on both sides)

StockTrak written assignment type and bring
with you to the exam.
Tonight and Next Week
Currency exchange rate
Spot
Forward

Debt instruments
Types
Ratings (default risk)
Spot and forward interest rate
The yield curve
Duration

Currency Exchange Rate (Spot)
A spot currency transaction is an exchange of
one currency for another.

The currency exchange rate is a simple
conversion factor:
The direct exchange rate is the number of $US to be
paid for 1 unit of foreign currency (usually for the
UK and the Euro);
The indirect exchange rate is the number of foreign
currency units paid for 1 $US (usually for the Swiss
franc and Japanese yen).

Currency Exchange Rate
Numeric Example:
The exchange rate between the $US and
UK is 1.6757 $US/ UK - i.e. one has to
pay $1.6757 for 1 (direct).

The same exchange rate can be presented
as 1/1.6757 = 0.5968 UK /$US - i.e. one
has to pay 0.5968 for $1 (indirect).
Currency Exchange Rate
Example continued:
The exchange rate between the $US and
UK is 1.6757 $US/ UK.

The exchange rate between the $US and J
is 0.007331 $US/J.

What should be the exchange rate between
the UK and the J?
Currency Arbitrage
There are at least two ways to convert pounds to
yen:
Direct conversion of UK to J
Conversion using an intermediary currency:
Convert UK to $US
Convert $US to J

If there is no opportunity to make arbitrage
profits, both conversion methods must imply the
same pound to yen exchange rate .
Currency Exchange Rate
Example (data):
1.6757 $US/UK or 0.5968 UK/$US.

0.007331 $US/J or 136.40 J/$US.

We will use the no-arbitrage argument to
calculate the UK/J (or J/UK) exchange
rate.
Currency Exchange Rate
Conversion using an intermediary currency:

Convert UK to $US:
the cost of 1 $US is 0.5968 UK

Convert $US to J:
the cost of 1 J is 0.007331 $US

The UK cost of 1 J:
0.5968 UK/$US * 0.007331 $US/J =
0.004375 UK/J
Currency Exchange Rate
The Pound-Yen no-arbitrage exchange rate:

The UK/J exchange rate is 0.004375,
i.e. the cost of 1 J is 0.004375 UK.

The J/UK exchange rate is
1/0.004375 = 228.5641,
i.e. the cost of 1 UK is 228.5641 J.
Currency Exchange Arbitrage
Example continued:
The $US/ UK exchange rate is 1.6757.

The $US/J exchange rate is 0.007331.

Is there an arbitrage opportunity if the UK/J exchange
rate is 0.004494?

Yes! The UK/J exchange rate in the market is different
from the no-arbitrage rate (two-stage currency exchange):

Market: 0.004494 UK/J > 0.004375 UK/J :No-arbitrage

How can we make an arbitrage profit?
Currency Exchange Arbitrage
Cross currency (triangle) arbitrage strategy:

Sell the expensive J convert J to UK in one step:
1. Sell J for UK
(i.e., Buy UK with J or convert UK to J)


Buy the cheap J - convert UK to J in two steps, using
the $US as an intermediary:
2. Buy $US with UK (convert UK to $US)
3. Buy J with $US (convert $US to J)


Note: this is a round trip transaction. You start with J
(before step 1) and you end up with J (after step 3).
Currency Exchange Arbitrage
Cross currency (triangle) arbitrage strategy:

Sell the expensive J - conversion using the direct UK to
J exchange rate:
1. Sell 1 J for 0.004494 UK
(i.e., Buy 0.004494 UK for 1 J)

Buy the cheap J - conversion from UK to J in two
stages, using the $US as an intermediary:
2. Buy $US for 0.004494 UK (you can buy
0.004494 UK * 1.6757 $US/UK = 0.00753 $US)
3. Buy J for 0.00753 $US (you can buy
0.00753 $US * 136.40 J/$US = 1.02717 J)

Arbitrage profit: you start with 1 J and end up with 1.02717 J.
Currency Exchange Arbitrage
Cross currency arbitrage strategy (end up with $US):

2. Sell 136.40 J for UK (you can buy
136.40 J * 0.004494 UK/J = 0.6130 UK)

3. Buy $US for 0.6130 UK (you can buy
0.6130 UK * 1.6757 $US/UK = 1.02717 $US)

1. Buy J for 1 $US (you can buy
1 $US * 136.40 J/$US = 136.40 J)

Arbitrage profit: you start with 1 $US and end up with
1.02717 $US. An arbitrage profit of 0.02717 $US.

Currency Exchange Rate (Forward)
Forward or Futures Contracts

An agreement between a buyer and a seller, to
trade at a specific date in the future, a specific
quantity of a specific currency for an agreed
exchange rate.

Forward tailored OTC market contracts for
creditworthy traders and large trades.

Futures formal markets of standardized
contracts (International Monetary Market in
Chicago, London International Financial Futures
Exchange).
Covered Interest Arbitrage
There are at least two ways to invest money
without risk for one year:

Domestic risk-free investment
Buy US Treasury Bills

Foreign risk-free investment
Convert $US for foreign currency
Buy foreign risk-free bonds for 1 year
Convert the foreign currency back to $US (forward contract)

If there is no opportunity to make arbitrage
profits, both investment strategies should have
the same dollar denominated percentage return.
Covered Interest Arbitrage
Numeric Example:
Suppose you would like to invest $100,000 in a
risk-free instrument.

In the US the annual risk free rate is 5.00%, while
in the UK the annual risk free rate is 5.20%.

Is there an arbitrage opportunity? Compare the
domestic and foreign investment strategies.
Covered Interest Arbitrage
Numeric Example Continued:
We need the spot and forward (one year)
$US/UK exchange rates to answer that question.

Note that if we do not use a forward contract to
lock in the exchange rate, the foreign alternative
becomes a risky (exchange rate risk) rather than a
risk-free investment strategy.

Is there an opportunity to make arbitrage profits, if
the spot rate is 1.6750 $US/UK and the (one
year) forward exchange rate is 1.6500 $US/UK?
Comparing the Two Strategies
Domestic risk-free investment:
1. Buy US Treasury Bills




Strategy t = 0 t = 1
CF ($US) CF (UK) CF ($US) CF (UK)
Buy T-Bills
(5.00%)
-100,000 +105,000
Total -100,000 0 +105,000 0
Comparing the Two Strategies
Foreign risk-free investment:
1. Convert $US for foreign currency
2. Buy foreign risk-free bonds for 1 year
3. Convert the foreign currency back to $US (forward contract)



Strategy t = 0 t = 1
CF ($US) CF (UK) CF ($US) CF (UK)
Convert $US to UK
(spot rate 1.6750)
-100,000 +59,701
Buy UK risk-free bonds
(5.20%)
-59,701 +62,806
Convert UK to $US
(forward rate 1.6500)
+103,630

-62,806
Total -100,000 0 +103,630 0
Arbitrage Strategy
Buy Cheap: Domestic risk-free investment
Buy US Treasury Bills
get 5% dollar denominated risk free rate

Sell Expensive: Foreign risk-free investment
Convert UK to $US
Short sell UK risk-free bonds for 1 year
Convert $US back to UK (forward contract)
pay 3.63% dollar denominated risk free rate
Covered Interest Arbitrage
Strategy t = 0 t = 1
CF ($US) CF (UK) CF ($US) CF (UK)
Buy US T-Bills
(5.00%)
-100,000 +105,000
Convert UK to $US
(spot rate 1.6750)
+100,000 -59,701
Sell UK risk-free bonds
(5.20%)
+59,701 -62,806
Convert $US to UK
(forward rate 1.6500)
-105,000 +63,636
Total 0 0 0 +803




Covered Interest Arbitrage

What is the no-arbitrage UK risk free rate? (r = 6.5909%)


Strategy t = 0 t = 1
CF ($US) CF (UK) CF ($US) CF (UK)
Buy US T-Bills
(5.00%)
-100,000 +105,000
Convert UK to $US
(spot rate 1.6750)
+100,000 -59,701
Sell UK risk-free bonds
(5.20%)
+59,701 -59,701(1+r)
Convert $US to UK
(forward rate 1.6500)
-105,000 +63,636
Total 0 0 0 =0 +803
Interest Rate Parity
(Covered Interest Arbitrage)
Intuition:
If two investments are risk-free they must have the same
rate of return. Therefore, any difference in the domestic
and foreign risk-free rates must be offset by a difference in
the spot and forward exchange rates.

Formula:


0 0
1 $ $
1
T
US
UK
r US US
F E
UK UK r
| |
+
| | | |
=
|
| |
+
\ . \ .
\ .
Interest Rate Parity
(Covered Interest Arbitrage)
Notation:
E
0
= spot exchange rate ($US/UK) or (UK/$US)
F
0
= forward exchange rate ($US/UK) or (UK/$US)
* Note that if you use the UK/$US (indirect) exchange rate
you will also have to reverse the ratio of interest rates.
Formula:


0 0
0 0
1 $ $
1
1
$ $ 1
T
US
UK
T
UK
US
r US US
F E
UK UK r
or
r UK UK
F E
US US r
| |
+
| | | |
=
| | |
+
\ . \ .
\ .
| |
+
| | | |
=
| | |
+
\ . \ .
\ .
Practice Problems
Practice Problem #1
The annual risk-free rate in the US is 5.00%
while in Japan it is 3.20%.

What should be the spot J/$US exchange
rate, if the (one year) forward J/$US
exchange rate is 107.875?

Answer: E
0
(J/$US) = 109.7565
Practice Problems
Practice Problem #2
The annual risk-free rate in the US is 4.60% while
in Japan it is 3.50%.

The spot J/UK exchange rate is 205.00, the spot
$US/UK exchange rate is 1.8825, the (one year)
forward J/UK exchange rate is 204.00 and the
forward $US/UK exchange rate is 1.8900.

Describe an arbitrage transaction. Write down the
same stages and use the table format presented in
the lecture notes.
Practice Problems
BKM Ch. 23: 10, 12-14.
Practice problems:
Forward and futures contracts 1-5;
Currency exchange rates 6-9.