Foreign Exchange Derivative Markets CHAPTER 16 Foreign Exchange Derivative Markets

CHAPTER 16 OVERVIEW This chapter will: A. Explain the quotation of currency B. Explain how various factors affect exchange rates C. Explain how to forecast exchange rates D. Explain how to speculate using different derivatives

Foreign Exchange Quotation Direct ( in USD ): $1.25 / euro Indirect (per USD): 0.8 euro / $1 Exchange rates are typically quoted on a Bid-Ask basis, the quotations found in newspapers are usually “Bid-Ask Averages”

Cross Rates Exchange rate between two non-dollar currencies can be calculated based on their respective quotations relative to the US dollar. 1 British Pound = 1.7867 USD 1 Euro = 1.2186 USD Cross rate: Euro per GBP =(1.7867 USD/GBP) x (0.8206 Euro/USD) = 1.4662 Euro/GBP

Determinants of Foreign Exchange Rates Purchasing Power Parity Theorem (PPP): the exchange rate will change by a percentage that reflects the inflation differential between the two countries of concern. Assume an initial equilibrium where GBP’s spot rate is $1.60, US inflation and British inflation are both 3%. If US inflation suddenly increase to 5 %, the GBP will appreciate against the dollar by approximately 2 % according to PPP. The rational is, after US prices rises, US demand for British goods will increase, placing upward pressure on the GBP’s value.

Determinants of Foreign Exchange Rates Interest Rate Parity Theorem (IRP): interest rate movements affect exchange rates by influencing the capital flows between countries. Assume an initial equilibrium where GBP’s spot rate is $1.60, US interest rate and British interest rate are both 5%. An increase in US interest rate will attract foreign investors, which will place upward pressure on the value of USD.

D. Foreign Exchange Derivatives 1. Forward Contracts 2. Currency Futures Contracts 3. Currency Swaps 4. Currency Options Contracts

Currency Forwards A contract that allow the purchase or sale of a specified amount of a particular foreign currency at a specified exchange rate (the forward rate) on a specified future date. Example s (p439): St. Louis Insurance Company; The pension fund manager of Gonzaga, Inc.

Foreign Exchange Futures Traded on the Mar, Jun, Sep, Dec cycle. Different contract size for different underlyings, based on units of foreign currency. Price is quoted as USD/FOR. Less than 1% of the contracts is settled by delivery of the underlying currency CME/NYBOT are the main currency futures exchanges in the US. Futures vs. Forward markets

Example On January 2 ABC Co. expects 12.8 million euro at the end of the year and plans to remit those funds to its American parent. The company suspects that the euro will depreciate against dollars at the end of year. How can the company use futures to hedge this risk? Assume each contract is 1 million euro.

Foreign Currency Swap An agreement in which one party provides a certain principal in one currency to its counterparty in exchange for another currency, pays fixed or floating rate of interest on the currency it receives, and exchange the principal at the maturity of the contract.

Example Spot rate: euro 0.8/USD ( $1.25/euro) r = 10% in US, r =8% in EU. Party A exchange 1 million euro for 1.25 million USD. Contract tenor is five years. The interest is paid every year. Principal USD 1,250,000 Euro 1,000,000   Year 1 2 3 4 5 Fixed rate in USD 10% Fixed rate in Euro 8.0% Party A -125,000 -1,375,000 -1,000,000 80,000 1,080,000 Party B -1,250,000 125,000 1,375,000 -80,000 -1,080,000

Foreign Currency Swap Cash flows are fixed during the contract tenor. Which party benefits? It depends on the changes in interest rates and foreign exchanges between the two currencies. The combination of interest rates can be fixed-fixed, fixed-float, float-fixed, and float-float.

Motivation for Swap Comparative advantage in borrowing different currencies. Party C needs USD, Party D needs Euro

Currency options A right to purchase or sell a particular currency at a specified price within a given period.

Foreign Exchange Exposure of Multinationals

Forecasting Exchange Rates METHODS OF FORECASTING 1. Technical Forecasting 2. Fundamental Forecasting 3. Market-Based Forecasting a) Use of the Spot Rate b) Use of the Forward Rate

Discussion Q & A: 5,6

Summary Foreign exchange quotation, cross rates PPP and IRP Speculation and Hedging strategies.

Homework Assignment 11 1 1 GBP = 1.6554 USD; 1 Euro = 1.4557 USD; Cross rate: GBP per Euro =? 2 On Feb ABC Co. expects a GBP 35.5 million at the end of the year and plans to remit those funds to its American parent. The company suspects that the GBP will depreciate against dollars at the end of year. How can the company use currency futures to hedge this risk? How many futures contract shall the company buy or sell? Assume each futures contract face value is 500,000 GBP. The current spot rate is $1.4550/GBP and the price of the futures contract that expires at December is 1.4025/GBP. The spot rate at the expiration date of the futures contract is $1.3850/GBP. If the company does not hedge the currency risk, how much is the loss they will incur? 3 Draw cash flow table of a currency swap. Spot rate: GBP 0.6/USD. r = 10% in US, r =8% in British. Party A exchange 1 million GBP for USD. Contract tenor is five years. The interest is paid at the end of every year.