© 2004 South-Western Publishing 1 Chapter 10 Foreign Exchange Futures

2 Outline Forward rates – Interest rate parity – Purchasing power parity Foreign currency futures Dealing with the exposure

3 Interest Rate Term Structure

4 The Real Rate of Interest The nominal interest rate (the stated rate) can be expressed as the sum of: – The real rate – An inflation premium and – A risk premium

5 The Real Rate of Interest (cont’d) The real rate reflects the rate of return investors demand for giving up the current use of funds – Indicates people’s willingness to postpone spending their money – Is not directly observable – Hovers in the 3% to 4% range

6 The Inflation Premium The inflation premium reflects how the general price level is changing – Measures how rapidly the money standard is losing its purchasing power – In the past 75 years, U.S. inflation has averaged about 3.2% annually

7 The Risk Premium The risk premium is the component of interest rates that is most difficult to measure – Risk-averse investors expect to be compensated for risks they take – The price of a risky security must reflect a risk premium to entice someone to buy it – The magnitude of the risk premium depends on how much risk the security carries – The higher the risk premium, the lower the price

8 FX Risk From A Business Perspective A Business Example of Economic Exposure An American importer agrees to purchase 400 Swiss overcoats at a price of CHF1,200 each, for a total of CHF480,000. The coats will take 3 months to produce, and the importer is to pay for them upon delivery.

9 FX Risk From A Business Perspective (cont’d) A Business Example of Economic Exposure (cont’d) If the importer paid for the coats today, each coat would cost the importer: CHF1,200 x $0.8073/CHF = $ The importer is concerned that the U.S. dollar might weaken between now and coat delivery time.

10 FX Risk From A Business Perspective (cont’d) A Business Example of Economic Exposure (cont’d) If the dollar strengthens and the value of the Swiss franc falls to $0.7500, the cost of each coat will be: CHF1,200 x $0.7500/CHF = $ If the dollar weakens to an exchange rate of $0.9000, the cost of each coat will be: CHF1,200 x $0.9000/CHF = $1,080.00

11 FX Risk From An Investment Perspective An Investment Example of Economic Exposure You just placed an order with your broker to purchase 10,000 shares of Kangaroo Lager, trading on the Sydney Stock Exchange. You can currently purchase the shares for AUD1.45 apiece. The current exchange rate is $0.5755/AUD. Thus, the shares cost you: 10,000 x AUD1.45 x $0.5755/AUD = $8,344.75

12 FX Risk From An Investment Perspective (cont’d) An Investment Example of Economic Exposure (cont’d) You hold the Kangaroo shares for six months, at which time the shares sell for AUD1.95. This is a return of (1.95 – 1.45)/1.45 = 34.5%

13 FX Risk From An Investment Perspective (cont’d) An Investment Example of Economic Exposure (cont’d) In six months, the exchange rate is $ If you were to sell the shares, you would receive: 10,000 x AUD1.95 x $0.5500/AUD = $10, This is a return on investment of ($10, $8,344.75)/$8, = 28.52%

14 Managing Exchange rate risk The spot exchange rate is the current exchange rate for two currencies The forward exchange rate is a contractual rate between a commercial bank and a client for the future delivery of a specified quantity of foreign currency

15 Expectation Hypothesis The forward rate is an unbiased estimate of the future spot rate for foreign exchange – E.g., if forward rates show that the dollar is expected to strengthen against the Swiss franc, it would make sense to delay paying Swiss francs as long as possible

16 Forward Rates derivation Purchasing power parity Interest rate parity

17 Purchasing Power Parity Purchasing power parity is an arbitrage- based idea that in a world of perfect markets, the same good should sell for the same price in different countries – Assumes there are no trade barriers, no taxes, etc.

18 Purchasing Power Parity (cont’d) Unexpected inflation causes the value of the home currency to fall Differentials in international inflation rates can be a source of foreign exchange risk

19 Interest Rate Parity Interest rate parity states that differences in national interest rates will be reflected in the currency forward market – Two securities of similar risk and maturity will show a difference in their interest rates equal to the forward premium or discount, but with the opposite sign

20 Interest Rate Parity (cont’d) Computing Implied Foreign Interest Rates It is now January 2, The six-months forward rate for the British pound is £0.5658/$; the spot rate is £0.5576/$. Also, the six-month T-bill rate is 1.01%. What is the implied British 6-month interest rate based on the interest rate parity relationship?

21 Avoiding foreign, domestic or direct, indirect quote confusion – £.5576$1 – X%1.01% – £.5576 *(1+x/2) ↔ 1*( /2) If the forward is quoted per $1 or per 1 £ (1.7674) £.5576 *(1+x/2) = *( /2) = 1 1*( /2) £.5576 *(1+x/2).5658 (we should divide by the $ amount) (we should divide by the £ amount)

22 Interest Rate Parity (cont’d) Computing Implied Foreign Interest Rates (cont’d) The implied British 6-month interest rate is 3.96%: The actual UK rate in early 2004 was 3.90%.

23 Pricing of Foreign Exchange Futures Contracts Futures prices are a function of – The spot price – The cost of carrying the particular asset or financial instrument For foreign currency futures, the cost of holding one currency rather than another is an opportunity cost measured by differences in interest rates

24 Pricing of Foreign Exchange Futures Contracts A basic pricing model:

25 Pricing of Foreign Exchange Futures Contracts (cont’d) Pricing A Foreign Currency Futures Contract Example In the Land of Leptonia interest rates are 10.00%, and the current dollar price of a Lepton is $ The current Eurodollar deposit rate is 7.50%. For how much should a 90-day futures contract on Lepton’s sell?

26 Pricing of Foreign Exchange Futures Contracts (cont’d) Pricing A Foreign Currency Futures Contract Example (cont’d) Using the equation: The futures price for Leptons should be less than their cost in the spot market. This is because Leptonia’s interest rates are 2.5% higher than the U.S. rate.

27 Dealing With the Exposure Introduction Ignore the exposure Reduce or eliminate the exposure Hedge the exposure

28 Introduction The portfolio manager needs to decide whether to: – Ignore the exposure, – Eliminate the exposure, or – Hedge the exposure

29 Ignore the Exposure Investors may be aware of economic exposure but accept it as a fact of life Ignoring the exposure may be appropriate if the dollar amount of the exposure is relatively small Ignoring the exposure may be appropriate if the dollar is expected to depreciate

30 Reduce or Eliminate the Exposure Amounts to selling the foreign security or reducing the size of the position May be appropriate if the dollar is expected to appreciate dramatically

31 Summary Reconcile expectation and Cost of Carry hypothesis of pricing future contracts on foreign exchange Find forward exchange rate based on IRP and PPP Learn term structure of interest rates and its use in pricing financial assets