2011 Examination Q & A (3) Question 3 (a) Show diagrammatically with explanations how inflation affects nominal exchange rate, leaving real exchange rate unchanged, in the framework of the purchasing power parity (PPP) theory. (6 marks) Inflation at home erodes the value of home currency. As the home currencys purchasing power declines at home, its value vis--vis foreign currency will also decline in the forex market, if the rate of inflation in the foreign currency is lower 2011 Examination Q & A Thus, for example, if inflation rate is 4% in country A and 3% in country B, As currency will depreciate against Bs, reflecting the 1% differential. According to PPP theory, a 3% inflation differential is just offset by a 3% appreciation of the foreign currency (as shown by the parity line in the diagram). Thus, real exchange rate remains the same: fall in NER does not improve competitiveness. 2 2011 Examination Q & A Question 3 (b) Explain the direction in which funds would move between New York and London if: (1) The return on a GBP instrument is 11% in London and that on a comparable USD instrument in New York in 7%, given a 3% forward discount on GBP. (2 marks) Funds will move from New York to London (11-3>7). 3 2011 Examination Q & A Q3b (ii) the return on a GBP instrument is 10% in London and that on a comparable USD instrument in New York is 6%, given a 4% forward discount on GBP. (2 marks). No incentive for funds to move from New York to London or the other way around (10-4 = 6). 4 2011 Examination Q & A Q3 (iii) the return on a GBP instrument in 6% in London and that on a comparable USD instrument in New York in 7%, given a 2% forward premium on GBP. (2 marks) Funds will move from New York to London (6+2 > 7).. 5 Currency Futures & Options Markets LECTURE 6 PART ONE Futures Contracts 7 FUTURES CONTRACTS I.Currency Futures Market History:. Background a. Long history > 100 years b. Extremely volatile due to their information driven nature c.The market plays a Price Discovery Role for other financial markets such as the cash markets 8 FUTURES CONTRACTS (contd) d. International Monetary Market (IMM) 1972: opened by the Chicago Mercantile Exchange (CME) Purpose: to provide a stable market for the exchange of currency futures. 9 FUTURES CONTRACTS (contd) * Currency futures and options contracts represent new breed of derivatives Derivatives are contracts that derive value from underlying assets such as stocks, bonds, etc. Popular derivatives include swaps, forwards, futures and options Can help manage forex risk or take speculative positions on currencies 10 FUTURES CONTRACTS (contd) 2.International Monetary Market (IMM) provides a.an outlet for hedging currency risk with futures contracts. Definition of a Futures Contract: contracts written requiring a standard quantity of an available currency at a fixed exchange rate at a set delivery date. 11 FUTURES CONTRACTS (contd) b.Available Futures Contracts: - in over 20 different currencies (e.g. Aust $, Brazilian real, British pound, Canadian $, Chinese renminbi, Japanese yen, NZ $, Russian ruble, South African rand, Swiss franc and euro.- cross-rate contracts (depending on volume) c. Contracts patterned after those for grain and commodity futures contracts traded on Chicagos exchanges for > 100 years 12 FUTURES CONTRACTS d.Transaction costs: in the form of a commission payment to a floor trader e.Leverage is high 1) Initial margin required is relatively low (less than 2% of contract value). 2) Low cost, high leverage make it attractive for speculators 13 FUTURES CONTRACTS 3) Commissions charged (as little as $15 for round trip: one buy and one sell. Costs about 0.02% of value) 4) Minimum price moves ($10-12 per contract) 5) Daily price limits on contracts (when limits are reached, additional margin required) 6) Profits & losses of futures contracts are paid over every day at the end of trading (the daily settlement feature is called marking to market) 14 FUTURES CONTRACTS: SAFEGUARDS f.Maximum price movement rules: Contracts set daily to a price limit that restricts maximum daily upward and downward movements g. Maintenance Margins: When account balance falls below the maintenance margin, a margin call may be necessary to maintain minimum balance 15 FUTURES CONTRACTS: PLAYERS The low cost and the high degree of leverage provide inducement for speculators to participate in the market. Other market participants are traders, companies with foreign currency assets & liabilities, and bankers 16 Global futures exchanges: 1.)I.M.M. (international Monetary Market) 2.)L.I.F.F.E. (London International Financial Futures Exchange) 3.)C.B.O.T. (Chicago Board of Trade) 4.) S.I.M.E.X. (Singapore International Monetary Exchange) 5.)D.T.B. (Deutsche Termin Bourse) 6.)H.K.F.E. (Hong Kong Futures Exchange) 17 FUTURES EXCHANGES FORWARD vs FUTURES CONTRACTS Basic differences: 1. Trading Locations6. Quotes 2. Regulation7. Margins 3. Frequency of 8. Credit risk delivery 4. Size of contract 5. Transaction Costs 18 FUTURES VS FORWARDS Trading: Futures traded in competitive arena; Forwards by telephone/telex Regulation: IMM futures regulated by Commodity Futures Trading Commission Forwards are self-regulating Delivery frequency: Futures: < 1% actual delivery Forwards: >90% actual delivery Contract size: Futures: standardized currency amount Forwards: Individually tailored; much larger 19 FUTURES VS FORWARDS (contd) Delivery date: IMM futures contracts available for delivery on a few specified dates only Forward contracts for delivery on any date Settlement: Futures: daily via the Exchanges Clearing House; gains may be withdrawn; losses are collected daily (marking to market) Forwards: on the date agreed to in the contract Quotes: Futures quoted in American terms (dollars per foreign currency unit) Forwards quoted in European terms (local currency units per US dollar) 20 FUTURES VS FORWARDS (contd) Transaction Cost: Futures entail brokerage fees for buy/sell orders Forwards costs are based on bid-ask spread Margins: Futures market requires margins; In the forward market, margins are not required Credit risk: substantially small for futures as the Clearing House of the Exchange takes the opposite side to each futures contract In forwards, credit risk borne by each party 21 FUTURES CONTRACTS: PROS & CONS Advantages of futures: 1.) Easy liquidation 2.) Well-organized and stable market. Disadvantages of futures: 1.) Limited to certain currencies 2.) Limited dates of delivery 3.) Rigid contract sizes. 22 MAIN FEATURES OF FUTURES MKTS Contract sizes and maturities are standardized Specific delivery dates only CME contracts trade only in round lots (AUD 100,000, GBP 62,500, CAD 100,000, EUR 125,000, JPY 12,500,000, MXP 500,000, SFR 125,000: all priced in USD) Limited range of maturities All these ensure higher volume, superior liquidity, smaller price fluctuations and lower transaction costs 23 CONTRACT SIZE Currency Lot Euro 125,000 Yen 12.5 m Aus $ 100,000 Br Pound 62,500 Can $ 100,000 Mex Peso 500,000 Swiss Franc 125,000 No of Lots For 10 m For 50 m Daily-settlement practice example: 1.Tues morning, an investor takes a long position in SFR futures contract that matures on Thurs afternoon 2. Agreed-on price: USD/SFR $ 0.95 for SFR 125, Investor deposits into his account initial performance bond of $27, Tues close, price rises to $ Investor receives cash profit (125,000 x = $625) 6. Existing contract priced at $0.95 is canceled and replaced with new contract with prevailing price of $ Thus, value of futures contract is set to zero at the end of the trading day 25 MARKING TO MARKET MARKING TO MARKET (contd) 8. Wed close, price declines to $ Investor incurs/pays loss (125,000 x = $1,250) and replaces the old for a new contract with price of Thurs close, price drops to $ Investor pays his $500 loss (125,000 x 0.004) 12 Investor takes delivery of SFR at the prevailing price of $0.941 for a total payment of $117,625 (125,000 x 0.941) 13. Net loss on the contract: $1,125 ( , ) Contract value of SFR 125,000: $0.95 x 125,000 = $118,750 Realized value of SFR 125,000: $0.941 x 125,000 = $117,625 Loss: $1,125 (118,750 117,625) Daily settlement reduces futures default risk relative to forward contracts 26 FUTURES & ARBITRAGE Arbitrageurs play important role on the CME, linking the futures market with the forward market Arbitrage opportunities translate CME futures rates into interbank forward rates and keep CME futures rates in line with bank forward rates Buying (selling) in the futures mkt and selling (buying) in the forward mkt will raise (reduce) futures price and reduce (raise) forward price towards equality. Empirical evidence: forward and futures prices dont differ significantly 27 FORWARD-FUTURES ARBITRAGE Example: Forward bid for June 18 on GBP is $1.8927, while the price of CME sterling futures on June 18 is $ Dealer simultaneously buys June GBP futures contract for $ 118, (62,500 x $1.8915) and sells equivalent amount of GBP forwar d worth $118, (62,500 x $1.8927) for June delivery, and makes a $75 profit per contract. If 10 futures contracts are traded, the profit will multiply to $750 28 Currency Options 29 PART TWO CURRENCY OPTIONS OPTIONS Currency options account for roughly one-tenth of daily volume in the forex market 1.options offer another method to hedge exchange rate risk 2.first offered on Philadelphia Exchange (PHLX) in 1983; now traded on the United Currency Options Market (UCOM) 30 HOW CURRENCY OPTIONS ARE PURCHASED Buyers Sellers=Writers Buy SellBuySell CALL PUT Premium 31 CURRENCY OPTIONS(contd) 4. Definition: a contract from a writer ( the seller) that gives the right, not the obligation, to the holder (the buyer) to buy or sell a specified amount of an available currency at a fixed exchange rate for a fixed expiration date. The holder has the option to buy / to sell, but the writer must fulfill the contract. 32 CURRENCY OPTIONS (contd) 5.Expiration Dates of Currency Options: a.American exercise date may occur any time up to the expiration date. b.European exercise date occurs only at the expiration date and not before. 33 CURRENCY OPTIONS (contd) 6. Whats is the premium? Premium is the price of an option that the writer charges the buyer. (Call values rise and put values fall when dom interest rate increases or foreign interest rate decreases. Options become more expensive when ER volatility rises or when dom-foreign interest rate differential increases) 7. Exercise Price (price at which the option is exercised) a. Sometimes known as the strike price. b.The exchange rate at which the option holder can buy/sell the contracted currency. 34 CURRENCY OPTIONS (contd) c. Types of Currency Options: 1.)Calls give the owner the right to buy the currency 2.)Puts give the owner the right to sell the currency * Knock-out Options: a cheaper way to bet on currency movements, buying a call or a put with a clause to cancel (knock out) the deal if ER crosses a predetermined level called the outstrike 35 CURRENCY OPTIONS (contd) 8.Status of an option a.In-the-money (advantage position) Call:spot price > strike price Put:spot price < strike price b.Out-of-the-money ( disadv. position) Call:spot price < strike price Put:spot price > strike price c.At-the-money (neutral position) spot price = the strike price 36 CURRENCY OPTIONS (contd) 9. Why Use Currency Options? a.For the firm that hedges foreign exchange risk when a future event is very uncertain. b.For speculators who profit from favorable exchange rate changes. 37 CURRENCY OPTIONS: MARKET STRUCTURE United Currency Options Market (UCOM) in Philadelphia and the over-the-counter (OTC) market represent organized exchanges. Others: European Options Exchange in Amsterdam, Chicago Mercantile Exchange, and Montreal Stock Exchange Listed options = standardized contracts with set strike prices and expiration period UCOM options available in 6 currencies (AUD, CAD, GBP, EUR, JPY, SFR) in std contracts, half the size of CME futures 38 CURRENCY OPTIONS CONTRACT SIZE Currency Lot Euro 62,500 Yen 6,250,000 Aus $ 50,000 Can $ 50,000 Br Pound 31,250 Swiss Franc 62,500 No of Lots No of Lots for 10 m for 50 m , , CURRENCY OPTIONS: MARKET STRUCTURE (contd) OTC options are traded by commercial and investment banks nearly everywhere OTC options traded in round lots commonly $5-10 million in NYC, $2-3 million in London Maturity of OTC options mostly range 2-6 months; over 1 year is rare PHLX offers customized currency options 40 OTC OPTIONS MARKET OTC options market comprises: (1) retail market, composed of non-bank customers (e.g. traders, MNCs) who prefer customized product to meet their specific needs (2) wholesale market, composed of commercial banks, investment banks and specialized trading firms, very similar to interbank markets for spot and forward exchange Holder can only lose the premium paid, but the writers risk of loss is potentially unlimited 41 TAKE-HOME MESSAGES 1. Currency Futures and Options Contracts provide (a) protection against currency risk for traders and investors and (b) opportunities for arbitrageurs and speculators 2. Low cost coupled with high degree of leverage make futures contracts attractive for the participants 3. Futures contracts differ from forward contracts in a variety of ways: represent alternative means to ward off currency risks 42 TAKE-HOME MESSAGES (contd) 4. Main advantage of futures contracts: the small size of the contract and freedom to liquidate at any time before maturity in a well-organized market with low default risk 5. Main disadvantage of futures contracts: the limited number of currencies traded, the limited delivery dates, and the rigid contractual amounts of currencies to be delivered 6. It is of value especially to the customers who have a stable and continuous stream of payments or receipts in foreign currency 43 TAKE-HOME MESSAGES (contd) 7. Currency futures are poor substitutes for currency forwards, but can be good supplements. 8 Forward-Futures Arbitrage application serves to bid up the futures price and bid down the forward price, where the futures price the forward price) until approximate equality is restored. 44 TAKE-HOME MESSAGES (contd) 9. Empirical evidence: forward and futures prices converge (do not differ significantly) 10. Currency Options comprises (a) call options and (b) put options, where the holder is the customer and the writer is the dealer or the agent 11. Call options give the customer the right to buy the contracted currencies at the expiration date 12 Put options give the customer the right to sell the contracted currencies at the expiration date 45 TAKE-HOME MESSAGES (contd) 13. American option can be exercised at any time up to the expiration date 14. European option can be exercised only at maturity 15. In-the-money is advantageous to customers holding call options where strike price spot rate (selling at a premium) 16. Out-of-the money is disadvantageous to customers holding call options where strike price > spot rate (buying at a premium) or customers holding put positions where strike price < spot rate (selling at a discount) 46 STAY BLESSED! 47 END OF LECTURE 6