Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall.1 CHAPTER 33 The Market for Foreign Exchange and Risk Control Instruments

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. 2 FOREIGN EXCHANGE RATES Foreign exchange risk, or currency risk, is the risk that a currency’s value may change adversely (i.e., it “moves against your position”) An exchange rate (FX rate) is defined as the amount of one currency that can be exchanged for a unit of another currency 2

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. 3 FOREIGN EXCHANGE RATES (continued) Foreign Exchange Risk (FX Risk) From the perspective of a U.S. investor, the cash flows of assets determined in a foreign currency expose the investor to uncertainty (i.e., risk) as to the cash flow in U.S. dollars This change in value due to a change in exchange rates is called foreign exchange risk 3

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. 4 SPOT MARKET The spot exchange market, also called cash exchange rate, is the market for settlement of foreign-denominated transactions within two business days Spot rates are determined by several factors that enter into the supply-demand formula, such as speculative demand and trade deficits 4

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. 5 SPOT MARKET (continued) The basic determinant is purchasing power parity, or the relative degrees of inflation among countries If the U.S. has greater inflation than the European Union, the dollar will depreciate relative to the euro 5

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. 6 SPOT MARKET (continued) Arbitrage assures that the exchange rates will be the same between two countries Quoting in terms of U.S. dollars per unit of foreign currency is called American terms, while quoting in terms of the number of units of the foreign currency per U.S. dollar is called European terms 6

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. 7 SPOT MARKET (continued) Cross Rates The exchange rate between two countries other than the U.S. can be inferred from their exchange rates with the U.S. dollar The rates thus obtained are known as cross rates 7

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. 8 SPOT MARKET (continued) Cross Rates These are computed as follows for two countries X and Y: (Quote in American terms of currency X) / (Quote in American terms of currency Y) 8

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. 9 SPOT MARKET (continued) Cross Rates Triangular arbitrage ensures that these rates will stay in line with each other When investors sell the overvalued currency (relative to dollars) in one market and purchase the undervalued currency (relative to dollars) in another market, they help to close the price differences across the three currencies 9

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. 10 SPOT MARKET (continued) Dealers There is no organized exchange where foreign currency is traded Instead, dealers are linked by telephone and by various information transfer services Consequently, the foreign exchange market can best be described as an inter-bank OTC market 10

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. 11 INSTRUMENTS FOR HEDGING FOREIGN EXCHANGE RISK Currency Forward Contracts Similar to interest rate forward contracts mentioned earlier, currency forward contracts establish a price now for a future transaction Forward contracts are available for major world currencies They can be used to hedge FC receipts or FC payables 11

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. 12 INSTRUMENTS FOR HEDGING FOREIGN EXCHANGE RISK (continued) Currency Forward Contracts Most forward contracts have a maturity of less than two years Long-term forward contracts are not readily available and when obtainable have a large bid-ask spread 12

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. 13 INSTRUMENTS FOR HEDGING FOREIGN EXCHANGE RISK (continued) Pricing currency forward contracts Theoretical parity is rarely attained, since it is based on several assumptions –There are no transactions costs for executing an arbitrage strategy –Investors can borrow and lend at the same rate 13

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. 14 INSTRUMENTS FOR HEDGING FOREIGN EXCHANGE RISK (continued)

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. 15 INSTRUMENTS FOR HEDGING FOREIGN EXCHANGE RISK (continued) Currency Futures Contracts As opposed to forward contracts made through banks and dealers, currency futures contracts are traded on organized exchanges and are highly liquid The tradeoffs for increased liquidity and lower credit risk are standardization by term to maturity, size of contract, and rates of exchange 15

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. 16 INSTRUMENTS FOR HEDGING FOREIGN EXCHANGE RISK (continued) As in the forward markets, the longest maturity is one year, so futures contracts may not be good hedging instruments for long-dated foreign currency exposures 16

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. 17 INSTRUMENTS FOR HEDGING FOREIGN EXCHANGE RISK (continued) Currency Option Contracts Foreign currency options work similar to regular options They may be obtained OTC or traded on organized exchanges In the latter case they are standardized by units, time periods, and exchange rates Options limit downside risk to the premiums paid and allow upward gains 17

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. 18 INSTRUMENTS FOR HEDGING FOREIGN EXCHANGE RISK (continued) Currency Swaps Currency swaps constitute an exchange of principal and interest payments The situation can be modified to incorporate one party with floating-rate debt and a party with fixed-rate debt Such an arrangement is called a currency coupon swap 18

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. 19 INSTRUMENTS FOR HEDGING FOREIGN EXCHANGE RISK (continued) Currency Swaps See Figure 33-2 on the next slide 19

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. 20 INSTRUMENTS FOR HEDGING FOREIGN EXCHANGE RISK (continued)

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. 21 INSTRUMENTS FOR HEDGING FOREIGN EXCHANGE RISK (continued) Reasons for development of the currency swap market In a perfect world, arbitrage would make sure that the borrowing costs would be uniform throughout the world But market imperfections persist and it is often possible to reduce borrowing costs by issuing foreign currency debt 21

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. 22 INSTRUMENTS FOR HEDGING FOREIGN EXCHANGE RISK (continued) Reasons for development of the currency swap market Hedges may be desirable against the associated exchange risk, but the forward and futures markets provide no long-term contracts Swaps consist of packages of forward contracts, so they hold the potential to save transactions costs 22

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. 23 Summary An exchange rate is defined as the amount of one currency that can be exchanged for another currency The spot exchange rate market is the market for settlement of a currency within two business days The foreign exchange market is an over-the- counter market dominated by large international banks that act as dealers 23

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. 24 Summary (continued) Currency forward contracts, currency futures contracts, currency options, and currency swaps are four instruments that borrowers and investors can use to protect against adverse foreign exchange rate movements Interest rate parity give the relationship among the spot exchange rate, the interest rates in two countries, and the forward rate 24

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. 25 Summary (continued) In implementing covered interest arbitrage, the relevant interest rates are those in the Eurocurrency market, the market for bank deposits and bank loans denominated in a currency other than that of the country where the bank initiating the transaction is located 25

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. 26 Summary (continued) Exchange-traded options on major foreign currencies and futures options on the same currencies trade in the United States A currency swap is effectively a package of currency forward contracts, with the advantage that it allows hedging of long- dated foreign exchange risk and it is more transactionally efficient than futures or forward contracts 26