© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ■provide a background on foreign exchange markets ■explain how various factors affect exchange rates ■describe the use of foreign exchange rate derivatives ■explain international arbitrage 16 Foreign Exchange Derivative Markets Chapter Objectives 1

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Foreign exchange markets Foreign exchange markets consist of a global telecommunication network among large commercial banks. ■ Bid price vs. ask price ■ Direct exchange rate Specifies the value of a currency in US dollars. ■ Indirect exchange rate Specifies the number of unites of a currency equal to a US dollar. (reciprocal of the direct exchange rate) ■ Forward rate vs. spot rate ■ Cross-exchange rate 2

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Direct rate vs. indirect rate ■ Direct exchange rate Specifies the value of a unit of currency in US dollars. 1 peso = 0.07 US$ ■ Indirect exchange rate Specifies the number of unites of a currency equal to a US dollar. (reciprocal of the direct exchange rate) 1 US$ = peso 3

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Bid Ask spread Exchange rates are typically quoted by banks on a Bid/Ask basis; The price at which banks will buy a currency (bid) is slightly lower than the price at which they sell it (ask). * the quotations found in newspapers are usually Bid/Ask Averages. Example: EUR/USD bid: $1.20 ask: $1.30 If a bank buys one euro from you, it pays $1.2; If it sells one euro to you, it asks for $1.30. Real quote: 4

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Spot rate vs. forward rate ■The forward rates indicate the exchange rate at which a currency can be exchanged in the future. ■If the forward rate is above (below) the spot, it contains a premium (discount). 5

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Cross-exchange rates ■Example (Canadian firm needs Mexican pesos on page 440) Value of 1 unit of A in units of B If the peso is worth $0.07 and Canadian dollar (C$) is worth $0.70, the value of the peso in Canadian dollars is Value of 1 peso in C$ 6

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Exhibit 16.3 Bank Quotes Used for Locational Arbitrage Example 7

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Triangular arbitrage ■If the cross-exchange rate between two foreign currencies is not aligned with the two corresponding exchange rates, there is a discrepancy in the exchange rate quotations. ■Example (p.453). If 1 peso=$0.07, C$ 1=$0.70 Then C$/peso should be C$1==$0.70/$0.07=10 pesos If the quote is C$1=10.3 peso, then C$ is relatively more expensive than should be. So a trader can make risk-free trades by Sell $ to buy C$, sell C$ to buy peso, and sell peso to buy $. All three transactions should be executed at the same time. 8

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Triangular arbitrage another example If EUR/USD= , GBP/USD=1.4720, EUR/GBP = 0.72 How can a trader make money using triangular arbitrage? Solution: EUR/GBP= So the bank’s quote of EUR/GBP is relatively cheaper than should be. So buy EUR from bank and sell GBP to bank. Suppose he has 1000 USD. He use USD to buy GBP, use GBP to buy EUR, and then use EUR to buy USD. How much is the profit? 9

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Factors affecting exchange rates ■Changes in demand and supply Example (page 443) A large increase in US demand for European goods and securities leads to euro appreciation. 10

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. What changes a currency’s demand and supply ■Differential inflation rates If US inflation suddenly becomes much higher than European inflation, US goods are much more expensive than European goods. The US demand for European goods will increase, and thus demand for euros will increase. At the same time, the European demand for US good decreases and demand for US$ decreases. ■Purchasing Power Parity (PPP) The exchange rate will change by a percentage that reflect the inflation differential between the two countries of concern. 11

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. PPP Derivation (1) ■Home country price indexes: ■Foreign country price indexes: ■Assume : = Over time ■Home country inflation rate: ■Foreign country inflation rate: 12

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. PPP Derivation (2) ■New foreign price index from the home consumer’s perspective: Where is the percentage change in the value of the foreign currency. ■New home price index from the home consumer’s perspective: ■PPP suggests the percentage change in the value of foreign currency should change to maintain parity in the new price indexes of the two countries. Therefore, 13

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. PPP Derivation (3) Since = (price indexes were initially assumed equal in both countries) ■If >, then >0. So foreign currency will appreciate. ■If <, then <0. So foreign currency will depreciate 14

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. PPP Application (example on page 444) 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. solve using the ppp equation. 15

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. What changes a currency’s demand and supply ■Differential interest rates If higher interest rates do not reflect an increase in inflation expectation, the an increase in home interest rates will attract foreign investors and thus the immediate demand for home currency will increase, while the demand for foreign currency will increase in future. ■Interest Rate Parity (IRP) The exchange rate will change by a percentage that reflect the interest rate differential between the two countries of concern. 16

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ARP Derivation (1) ■Amount of the home currency to be invested, $100 ■Spot exchange rate in home currency, $ S ■Interest rate on home deposit, ■Interest rate on foreign deposit, ■Forward rate in home currency, $ F Compare the amount of home currency $ received at the end of the period Strategy A Strategy B 17

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ARP Derivation (2) ■If >, then F>S, which means in the future home currency will depreciate while foreign currency will appreciate. ■If <, then F<S, which means in the future home currency will appreciate while foreign currency will depreciate. 18

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Premium(discount) on forward rate (p.454) 19

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. IRP Application (1) ■Euro spot rate: EUR/USD: $0.60 ■Euro 6-months interest rate: 8% ■USD 6-month interest rate: 4% What is the expected quote of Euro 6 months from today (Forward Rate)? Intuition: returns from investing in $-denominated fixed- income securities should equal returns from such an alternative strategy that exchanging $ for euros, investing in euro-denominated fixed-income securities, and then after 6 months exchanging euro back to $. 20

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. IRP Application (2) ■cash inflow from investing $100 in $-denominated fixed-income securities ■Returns from alternative strategy ■Therefore, ■The 6-month forward rate (theoretical price based on IRP) 21

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Other factors that affect IRP When Assessing Interest Rate Parity, should also consider: a. Transaction Costs b. Political Risk c. Differential Tax Laws 22

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. What changes a currency’s demand and supply ■Central bank intervention direct intervention: buy or sell foreign currencies Indirect intervention: affect interest rates, change money supply 23

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Forecasting Exchange Rates ■Technical forecasting use historical data, time series model ■Fundamental forecasting investigate fundamental relationships between economics variables and exchange rates ■Market-based forecasting use spot rate and forward rate ■Mixed forecasting 24

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Currency forwards ■Forward contracts are contracts typically negotiated with a commercial bank that allow the purchase or sale of a specified amount of a foreign currency at a specified exchange rate (forward rate) on a specified future date. ■Example 1: need to buy foreign currency in the future. (p. 449) ■Example 2: need to sell foreign currency in the future. (p. 449) 25

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Estimating forward premium ■Forward contracts are sometimes referred to in terms of their percentage premium or discount rather than their actual rate. ■Assume the spot rate of the Canadian dollar is $0.70 while the 180-day forward rate is $0.71. the forward rate premium (annualized) is 26

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Forward Premium application 1 ■If the euro’s spot rate is $1.03, and its one-year forward rate has a forward premium of 2 percent, then the one-year forward rate is: 27

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Forward Premium application 2 28

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Currency Futures A standardized “forward contract” traded on an organized and regulated futures exchange. 1.Futures contracts are guaranteed by the exchange’s clearinghouse that eliminates the risk of contra-party default. 2.Each contract is standardized on the quantity, quality, delivery place, delivery date, contract expiration date (3 rd Wed in Mar, Jun, Sep, Dec) 3.A deposit called “margin” is required to both buyers and sellers

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Currency Futures Contracts Traded on the Chicago Mercantile Exchange 30

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Futures application 1 On April 4, a futures contract on 500,000 Mexican pesos and a June settlement date is priced at $0.09. On April 4, speculators who expect the peso will decline sell futures contracts on pesos. On June 17 (settlement date), the spot rate of the peso is $0.08. The gain each contract on this strategy is $5,

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Futures application 2 Teton Co. orders Canadian goods and will need to send C$500,000 to the Canadian exporter. Thus, Teton purchase Canadian dollar futures contracts today, thereby locking in the price to be paid for Canadian dollars at a future settlement date. By holding futures contracts, Teton does not have to worry about changes in the spot rate of the Canadian dollar over time. 32

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Futures application 3 Karla Co. sells futures contracts when it plans to receive a foreign currency from exporting that it will not need. It locks in the price at which it will be able to sell this currency as of the settlement date. Such an action is appropriate if Karla expects the foreign currency to depreciate against Karla’s home currency. 33

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Speculating with Currency Futures ■Spot rate of a British pound is $1.56 ■Price of a December 2015 futures contract is $1.57 ■Expectation of the pound’s spot rate on the settlement date of the futures contract is $1.63. ■Given that the future spot rate is expected to be higher than the futures price, you could buy currency futures. 34

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Currency Options 35

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Exhibit 16.2 Estimating Speculative Gains from Options Using a Probability Distribution ■British Call exercise price =$1.57 ■Premium= $0.03 ■You expect that future spot rate is $

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Call Options Application (1) ■Hedge payables Pike Co. orders Australian goods and makes a payment in Australian dollars (A$) upon delivery. This company can buy an A$ call option that locks in a maximum rate. If the A$’s value remains below the strike price, Pike can purchase A$ at the prevailing spot rate and simply let its call option expire. If the A$’s value rises above the strike price, Pike will execute the option and buy A$ at the strike price. 37

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Call Options Application (1) ■A payment in A$1,000,000 will be delivered at the end of June. ■On March 1, an option on A$500,000 that expires on June 28 has a strike price of $ ■Pike Co. buys 2 A$ Call option contracts on March 1 and pay premiums. On June 28, ■If the spot rate is $1.0000, Pike purchases A$ at the prevailing spot rate, $1.000, and simply let its call options expire. ■If the spot rate is $1.2050, Pike executes the options and pay the strike price, $

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Put Options Application (1) Hedge receivables ■ABC Co. will receive payment in C$2,000,000 at the end of September. ■On March 1, an option on C$500,000 that expires on September 28 has a strike price of $ ■ABC Co. buy 4 C$ Put options on March 1. On September 28, ■If the spot rate is $1.4500, Pike executes the options and sell C$ at the strike price, $ ■If the spot rate is $1.6000/$, ABC sells C$ at the prevailing spot rate, $1.6000, and simply let its put options expire. 39

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Speculation with Call Options (1) ■Spot rate on June, GBP 1 =$ ■Call option premium=$0.012, Strike price=$ ■Settlement date=December, 31 ■Contract amount=31,250 BP ■One investor buy one Call option on June, 1. ■Just before expiration, spot rate=$ Q1: Will the investor exercise the Call option? Yes. He exercises the Call option. Q2: What is his profit/loss? ( )x

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Speculation with Call Options (2) ■CAD/USD, Call option premium=$0.03/ ■Strike price=$0.75 ■Fill in the net profit(or loss) per unit based on the listed possible spot rates of the C$ on the expiration date. 41

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Speculation with Put Options (1) ■Spot rate on June, GBP 1 =$ ■Put option premium=$0.04/, Strike price=$ ■Settlement date=December, 31 ■Contract amount=31,250 BP ■One investor buy one Put option on June, 1. ■Just before expiration, spot rate=$ Q1: Will the investor exercise the Put option? Yes. He will execute the put option. Q2: What is his profit/loss? 42

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Speculation with Put Options (2) ■CAD/USD Put option premium=$0.02 ■Strike price=$0.86 ■Fill in the net profit(or loss) per unit based on the listed possible spot rates of the C$ on the expiration date. 43

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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. 44

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Currency Swap Application 1 (p. 431) ■A US firm expects to receive 2 million British Pounds at the end of each of the next four years. ■It wants to lock in the exchange rate at which it can sell over the next four years. ■A swap contract with a rate of $

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. SWAP Application 2 ■EUR Spot rate= $ ■r = 10% in US, r =8% in EU. ■Party A exchange 1 million euro for 1.25 million $. ■Contract tenor is five years. The interest is paid every year-end. 46 Principal USD1,250,000 Euro1,000,000 Year Fixed rate in USD10% Fixed rate in Euro8.0% Party AUSD1,250, ,000 -1,375,000 Euro-1,000,00080,000 1,080,000 Party BUSD-1,250,000125,000 1,375,000 Euro1,000,000-80,000 -1,080,000

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Homework Assignment 14 ■Chapter 16 Problems 1,2,3,4,5 47