currency exchange rates, hedging, and arbitrage
DESCRIPTION
Currency Exchange Rates, Hedging, and Arbitrage. Jennie Morse BA 543 Evening Section. Agenda. Intro Exchange Rates Forex Market Hedging vs. Arbitrage Currency Derivatives Forward Contracts Futures Contracts Options Swaps Conclusion and Questions. Introduction. - PowerPoint PPT PresentationTRANSCRIPT
Currency Exchange Rates, Hedging, and Arbitrage
Jennie MorseBA 543
Evening Section
Agenda• Intro• Exchange Rates• Forex Market• Hedging vs. Arbitrage• Currency Derivatives
– Forward Contracts– Futures Contracts– Options– Swaps
• Conclusion and Questions
Introduction
• Exchange rates becoming increasingly important due to:– Globalization– Technology
• Importance of exchange risk to – Investors– Borrowers
Exchange Rates
• Exchange Rate: the price of one currency in terms of another
Examples:– Yahoo Finance
Quoting Exchange Rates
• Direct vs. Indirect
From US Perspective: Direct:$$$$ €
Indirect:€€€€ $
American vs. European
European: - USD is base currency
American:- USD is counter currency
Quoting order: EUR, GBP, AUD, NZD, USD
Foreign Exchange Market
• Decentralized OTC market– Top 3 exchange locations:
London, US, Japan• Very liquid market
– Spot transactions (2 days)• Pegged vs. Floating rates
– 3 factors that cause flucuation:• Economic conditions• Political events• Market Psychology
Hedging & Arbitrage
• Hedging– Used to offset potential
losses and evade potential losses, but is not risk-free
– Ex: SW airlines fuel• Arbitrage
– Risk-free strategy used to capitalize on mispriced assets
– Ex: Triangular Arbitrage
Triangular Arbitrage
Currency Derivatives
• Four Instruments used for mitigating exchange rate risk:– Forward Contracts– Futures Contracts– Options– Currency Swaps
Forward Contracts• Most common way to
alleviate exchange rate risk
• Traded in OTC markets• Locks in future rate:
– Eliminate risk of adverse rate swings
– Relinquish opportunity to benefit from advantageous price changes
• Not good for LT use
Futures Contracts
• Standardized• Traded on exchanges• Only for major
national currencies• 1 year maximum; does
not protect against LT risk
Currency Options• Major currencies
traded on exchanges• Customized options
traded in OTC market• 2 types:
– Regular option where underlying is a currency and strike price is an exchange rate
– Futures Options
Currency Swaps
• Transactionally efficient vehicle to protect against LT risk
• Also used to capitalize on arbitrage opportunities where a borrower could raise funds at a lower rate than what is available domestically
Currency Swaps
• Two companies issue bonds in the other’s bond market– Swap money raised
from bond sale– Make coupon payments
to each other to cover the other’s debt
– Swap par value of bonds on maturity date
Conclusion
• Take-aways:– Definition of exchange rate – How rates are quoted– What exchange rate risk is– Key facts about Forex market:
• Decentralized OTC market; floating rates• Spot Transactions completed in 2 days
– 4 methods to protect against exchange risk• Forwards, Futures, Options, Swaps
Questions