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 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 FinanceYahoo 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