10 - foreign exchange derivative market

8/16/2019 10 - Foreign Exchange Derivative Market

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CHAPTER

1616ForeignExchange

Derivative

Market


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Copyright© 2002 Thomson Publishing !ll rights reserve"

Chapter ObjectivesChapter Objectives

Explain ho# various $actors a$$ect exchange

rates

Describe ho# $oreign exchange risk can behe"ge" #ith $oreign exchange "erivatives

Describe ho# to use $oreign exchange

"erivatives to capitali%e &speculate' onexpecte" exchange rate movements


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Background On Foreign ExchangeBackground On Foreign Exchange

MarketsMarkets

Exchanging currencies is nee"e" #hen(

Tra"e &real' prompts nee" $or $orex

Capital $lo#s &$inancial' prompts nee" $or $orex

Foreign exchange tra"ing )ia global telecommunications net#ork bet#een

mostly large banks

*i"+ask sprea"


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Foreign Exchange RatesForeign Exchange Rates

,uote" t#o #ays(

Foreign currency per -. "ollar

Dollar cost o$ unit o$ $oreign exchange

!ppreciation+"epreciation o$ currency !ppreciation / more $orex to buy

Purchase more $orex #ith Depreciation / $oreign goo"s cost more

Total return to $oreign investor "ecreases


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Background on Foreign ExchangeBackground on Foreign Exchange

MarketsMarkets

Exchange rate 1uotations are available in the

$inancial press an" on the nternet #ith spot

exchange rate 1uotes $or imme"iate "elivery

For#ar" exchange rate is $or "elivery at some

speci$ie" $uture point in time

For#ar" premium is the percent annuali%e"

appreciation o$ a currency

For#ar" "iscount is the percent annuali%e"

"epreciation o$ a currency


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MarketsMarkets

Exchange rates involve "i$$erent kin"s o$

1uotes $or comparing the value o$ the -.

"ollar to various $oreign currencies 3 unit o$ $oreign currency #orth some amount o$

-. "ollars4eg 50 -. per Cana"ian Dollar

3 -. "ollar6s value in terms o$ some amount o$

$oreign currency7 eg CD389 per -. "ollar :ote reciprocal relationship

Cross;exchange rates express relative values

o$ t#o "i$$erent $oreign currencies per 3 -.


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MarketsMarkets

Cross;exchange rates are $oreign exchangerates o$ t#o currencies relative to a currency

)alue o$ one unit o$ currency ! in units o$currency * / value o$ currency ! in "ivi"e" by value o$ currency * in

*ritish Poun" / 38




MarketsMarkets

Currency terminology !ppreciation means a currency6s value increases

relative to another currency

Depreciation means a currency6s value "ecreases

relative to another currency

.upply an" "eman" in$luences the values o$

currencies Many $actors can simultaneously a$$ect supply

an" "eman"




MarketsMarkets

3?8873?53 kno#n as the *retton Boo"s Era overnment maintaine" exchange rates #ithin a

3 range e1uire" government intervention an" control

*y 3?53 the -. "ollar #as clearly

overvalue"

*ackgroun" on Foreign Exchange Markets




MarketsMarkets

.mithsonian !greement &3?53' among maor

countries allo#e" "ollar "evaluation an"

#i"ene" boun"aries aroun" set values $or each

currency

:o $ormal agreements since 3?59 to $ix

exchange rates $or maor currencies

Freely $loating exchange rates involve values set

by the market #ithout government intervention

Dirty $loat involves some government intervention



Classification of Exchange RateClassification of Exchange Rate

ArrangementArrangement

There is a #i"e variation in ho# countries

approach managing or in$luencing their

currency6s value Float #ith perio"ic intervention

Pegge" to the "ollar or some kin" o$ composite

.ome countries have both controlle" an" $loating

rates

.ome arrangements are temporary an" others

more permanent



Factors Affecting Exchange Rates RealFactors Affecting Exchange Rates Real

!ector!ector

Di$$erential country in$lation rates a$$ect theexchange rate $or euros an" "ollars i$ in$lationis su""enly higher in Europe

Theory o$ Purchasing Po#er Parity suggeststhe exchange rate #ill change to re$lect thein$lation "i$$erential4in$luence $rom real

sector o$ economy Currency o$ the higher in$lation country &euro'

"epreciates compare" to the lo#er in$lationcountry &'



Factors Affecting Exchange RatesFactors Affecting Exchange Rates

Financial !ectorFinancial !ector

Di$$erential interest rates a$$ect exchange rates by in$luencing capital $lo#s bet#een countries

For exampleG the interest rates are su""enlyhigher in the -nite" .tates than in Europe

nvestors #ant to buy "ollar;"enominate"securities an" sell European securities

Euros are sol"G "ollars bought to buy -.securities

Do#n#ar" pressure on the euroG appreciation

o$ the "ollar




Direct intervention occurs #hen a country6s

central bank buys+sells currency reserves

For exampleG the -. central bankG theFe"eral eserve sells one currency an" buys

another .ale by central bank creates excess supply an" that

currency6s value "rops relative to the one

purchase"

Market $orces o$ supply an" "eman" can

over#helm the intervention




n"irect intervention involves in$luencing the

$actors that a$$ect exchange rates rather than

central bank purchases or sales o$ currencies

nterest ratesG money supply an" in$lationary

expectations a$$ect exchange rates

Historical perspective on in"irect intervention Peso crisis in 3??8

!sian crisis in 3??5

ussian crisis in 3??>




.ome countries use $oreign exchange controls

as a $orm o$ in"irect intervention to maintain

their exchange rates

Place restrictions on the exchange o$ currency

May change base" on market pressures on the

currency

)ene%uela in mi";3??0s illustrates the issues

involve" in controlling rates via intervention

an" the a$$ect o$ market $orces



Movements in Exchange RatesMovements in Exchange Rates

Foreign exchange rate changes can have an

important e$$ect on the per$ormance o$

multinational $irms an" economic con"itions

Many market participants $orecast rates

Market participants take positions in "erivatives

base" on their expectations o$ $uture rates

.peculators attempt to anticipate the "irection o$

exchange rates

There are several $orecasting techni1ues



Forecasting "echni#uesForecasting "echni#ues

Technical Forecasting

Fun"amental Forecasting

Market;base"

Forecasting

Mixe" Forecasting



Forecasting Exchange Rates "echnicalForecasting Exchange Rates "echnical

Technical $orecasting is a techni1ue that uses

historical exchange rate "ata to pre"ict the

$uture

-ses statistics an" "evelops rules about the

price patterns4"epen"s on or"erly cycles

$ price movements are ran"omG this metho"

#on6t #ork

Mo"els may #ork #ell some o$ the time an"

not #ork other times



Forecasting Exchange RatesForecasting Exchange Rates

FundamentalFundamental

Fun"amental $orecasting is base" on$un"amental relationships bet#een economicvariables an" exchange rates

May be statistical an" base" on 1uantitativemo"els or be base" on subective u"gement

egression use" to $orecast i$ values o$

in$luential $actors have a lagge" impact :ot all $actors are kno#n an" some have an

instant impact so sensitivity analysis is use" to"eal #ith uncertainty



Forecasting Exchange RatesForecasting Exchange Rates

FundamentalFundamental

Iimitation o$ $un"amental $orecasting

metho"s( .ome $actors that are important to "etermining

exchange rates are not easily 1uanti$iable

an"om events can an" "o a$$ect exchange rates

Pre"ictor mo"els may not account $or these

unexpecte" events



Forecasting Exchange Rates Market$Forecasting Exchange Rates Market$

BasedBased

Market;base" $orecasting uses market

in"icators like the spot an" $or#ar" rates to

"evelop a $orecast

.pot rate( recogni%es the current value o$ the

spot rate as base" on expectations o$

currency6s value in the near $uture

For#ar" rate( use" as the best estimate o$ the

$uture spot rate base" on the expectations o$

market participants



Forecasting Exchange Rates MixedForecasting Exchange Rates Mixed

Mixe" $orecasting is use" because no one

metho" has been $oun" superior to another

Multinational corporations use a combination

o$ metho"s

!ssign a #eight to each techni1ue an" the

$orecast is a #eighte" average

Perhaps a #eighte" combination o$ technicalG

$un"amentalG an" market;base" $orecasting


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Forecasting Exchange Rate %olatilit&Forecasting Exchange Rate %olatilit&

Market participants $orecast not only

exchange rates but also volatility

)olatility $orecast ecogni%es ho# "i$$icult it is to $orecast the actual

rate

Provi"es a range aroun" the $orecast


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Forecasting Exchange Rate %olatilit&Forecasting Exchange Rate %olatilit&

)olatility o$ historical "ata

-se a times series o$ volatility patterns in

previous perio"s Derive the exchange rate6s implie" stan"ar"

"eviation $rom the currency option pricing

mo"el

Metho"s -se" To Forecast )olatility


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!peculation in Foreign Exchange Markets!peculation in Foreign Exchange Markets

For exampleG a "ealer takes a short position ina $oreign currency to pro$it $rom expecte""epreciation

Dealer $orecasts currency 3 to "epreciaterelative to $oreign currency 2 so the $irst stepis to borro# currency 3 an" then exchange

currency 3 $or currency 2 nvest in currency 2 an" receive the investment

returns at maturity

Convert back to $oreign currency 3 an" pay back

loan "enominate" in currency 3


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Foreign Exchange 'erivative ContractsForeign Exchange 'erivative Contracts

Currency Futures

Currency Futures

He"ge or .peculate

For#ar" Contracts Currency .#aps

Currency Jptions


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Foreign Exchange 'erivatives$(edgeForeign Exchange 'erivatives$(edge

For#ar" contracts :egotiate" #ith a counterparty

.peci$y a maturity "ateG amount an" #hich

currency to buy or sell

:egotiate" in over;the;counter market

-se" to lock in the price pai" or price receive" $or

a $uture currency transaction Classic he"ging contract


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For#ar" contracts can be use" to he"ge i$ acorporation must pay a $oreign currencyinvoice in the $uture

Purchase $oreign currency $or amount+"ate o$invoice

Iocks in cost o$ invoice

He"ges $oreign exchange risk o$ transaction

For#ar" contracts are also use" by he"gers#ho have a $oreign currency in$lo# on some$uture "ate


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Foreign Exchange 'erivativesForeign Exchange 'erivatives

For#ar" rate premium or "iscount

P = % annualized premium or discount

FR = Forward exchange rate

S = Spot exchange rate

n = number of days forward

Where:

xFR - S

S

3!

n

p =


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Currency $utures contracts tra"e on

exchangesG are stan"ar"i%e" in terms o$ the

maturity an" amount

Currency s#aps allo# one currency to be

perio"ically s#appe" $or another at a speci$ie"

exchange rate

Currency options contracts o$$er one;#ay

insurance to buy &call' or sell &put' a currency


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*uying a call option on a $oreign currency is

the right to purchase a speci$ie" amount o$

currency at the strike price #ithin the

speci$ie" time perio" Exercise the option i$ the spot rate rises above the

strike price

Do not exercise i$ the spot rate "oes not reach orexcee" the strike price

-. business that o#es Cana"ian in A0 "ays buys

currency call options to he"ge spot $orex risk


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*uying a put option on a $oreign currency is the right

to sell a speci$ie" amount o$ currency at the strike

price #ithin the speci$ie" time perio"

Exercise the option i$ the spot rate $alls belo# the strike price

Do not exercise i$ the spot rate "oes not "ecline belo# the

strike price

-. business he"ges Cana"ian "ollar payment it #illreceive in 90 "ays by buying CD currency put options4i$

CD "epreciates against -.G gain #ill o$$set spot loss


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Foreign Exchange 'erivatives$!peculateForeign Exchange 'erivatives$!peculate

*usiness or person has no spot interest in

un"erlying asset4takes position base" on

$orecast o$ currency movements

For#ar" contracts

*uy+sell $oreign currency $or#ar"

Bhen receive"G sell in the spot market

Purchase+sell $utures contracts

Purchase call+put options


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Foreign Exchange 'erivatives$Foreign Exchange 'erivatives$

!peculation!peculation

For exampleG #hat position in "erivates #oul"

a speculator take i$ he+she anticipates a

"epreciation in a currencyK

For#ar" contracts

.ell $oreign currency $or#ar"

!t maturityG buy in the spot market

.ell $utures contracts

Purchase put options


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)nternational Arbitrage)nternational Arbitrage

!rbitrage takes a"vantage o$ a temporary

price "i$$erence in t#o locations to make

pro$its buying at a lo#er price than you can

receive via the simultaneous sale o$ an assetG$inancial instrument or currency

isk $ree because the purchase an" sale price

are locke" in simultaneously

!s arbitrage occursG prices in both locations

change until e1uilibrium &one price' returns


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Covere" interest arbitrage activity creates a

relationships bet#een spot ratesG interest rates an"

$or#ar" rates

*orro# in country 3 Convert the $un"s to currency $or country 2 using the

spot rate= buy $or#ar" contract $or return

nvest in country 2 an" earn an investment rate o$return

Convert back to country 3 currency using $or#ar"

contractG repay loan


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Covere" interest arbitrage activity makes$or#ar" premium approximately e1ual to the"i$$erential in interest rates bet#een t#o

countries $ $or#ar" premium "oes not e1ual the interest

rate "i$$erentialG covere" interest arbitrage is

possible $ the $or#ar" premium or "iscount e1uals the

interest rate "i$$erentialG there are noopportunities $or arbitrage


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E1uation $or covere" interest arbitrage

P = Forward premium or discount

ih = "ome country interest rate

if = Foreign interest rate

Where:

#$ & ih'

$ & if '

P =


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Explaining *rice Movements of ForeignExplaining *rice Movements of Foreign

Exchange 'erivativesExchange 'erivatives

n"icators o$ $oreign exchange "erivatives are

closely monitore" by market participants

He"gers an" speculators continuously $orecast

"irection an" "egree o$ movement an"

monitor n$lation rates bet#een countries

nterest rates

Economic in"icators


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Foreign Exchange MarketsForeign Exchange Markets

Exchanging Currencies s :ee"e" Bhen(

Tra"e &real' prompts nee" For $orex

Capital $lo#s &$inancial' prompts nee" $or $orex

Foreign Exchange Tra"ing )ia global telecommunications net#ork bet#een

mostly large banks

*i"+ask sprea"


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Foreign Exchange RatesForeign Exchange Rates

,uote" T#o Bays(

Foreign currency per -. Dollar

Dollar cost J$ unit J$ $oreign exchange

!ppreciation+Depreciation o$ Currency !ppreciation / more $orex To buy

Purchase more $orex #ith

Depreciation / $oreign goo"s cost more

eturn To $oreign investor "ecreases


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Exchange Rate !&stemsExchange Rate !&stems

*retton Boo"s Era &3?88;3?53'

Fixe" Jr pegge" $orex rates

Central bank maintaine" rates

Coul" not a"ust To maor economic change

.mithsonian !greement &3?53' Devalue" "ollar

Bi"ene" tra"ing range J$ $orex

First .tep To#ar" Market;Determine" Forex


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Exchange Rate !&stemsExchange Rate !&stems

Market;Determine" ates &3?59'

Dirty Float

Exchange ate Mechanisms(Currencies pegge" to another

European currency unit &EC-'

Central *ank involvement

EM problems


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Major Factors Affecting ForexMajor Factors Affecting Forex

Di$$erential in$lation rates bet#een countries

oo"s an" services impact "eman"+supply $or

$oreign exchange

n$lating currency "eclines to provi"e@

Purchasing po#er parity


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Major Factors Affecting ForexMajor Factors Affecting Forex

Di$$erential interest rates bet#een countries

e$lect expecte" "i$$erential in$lation rates

lobal Fisher E$$ect

overnmental ntervention Domestic Economic Policy

Direct nterventionG egG Forex Controls

Market Forces eignLLL


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Forecasting Foreign Exchange RatesForecasting Foreign Exchange Rates

Technical $orecasting

Fun"amental $orecasting

Market;base" $orecasting Mixe" $orecasting


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Forecasting Forex %olatilit&Forecasting Forex %olatilit&

Forex prices "i$$icult to $orecast

Forecasting volatility creates range o$

probable $orex rates

-se best; an" #orst;case scenarios in planning De$ine $uture perio"

Consi"er historical volatility

Time series o$ previous volatility


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!peculation )n Forex Market!peculation )n Forex Market

Take position base" on $orex expectations

Expect To appreciate

Take long position &buy'

For#ar" contract to buy

*uy $orex currency $utures contract

*uy $orex call options

!ction taken i$ "epreciation expecte"KK


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Foreign Exchange 'erivativesForeign Exchange 'erivatives

.peculate vs He"ging

For#ar" contracts

Contract To buy+sell $orex at speci$ie" price on

speci$ie" "ate

JTC market characteristics

e$lects expecte" $uture spot rate

Premium vs Discount $rom spot

nterest rate parity concept


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Other Forex 'erivativesOther Forex 'erivatives

Currency $utures contracts

Currency s#aps

Currency option contracts


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!rbitrage "e$ine"

Iocational arbitrage

Covere" interest arbitrage Maintains interest rate parity

For#ar"+spot "i$$erential /Di$$erential in$lation rates

nterest rate "i$$erentials

Expecte" $uture spot rate


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)nstitutional +se Of Forex Market)nstitutional +se Of Forex Market

nterme"iary or "ealer o$ $or#ar"s or other

"erivative contracts

.peculating+he"ging Future investment $lo#s &loansG interest'

Future $inancing $lo#s &principal an" interest'

10 - foreign exchange derivative market

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