1. CHAPTER 3: Exchange Rate & Currency Derivatives

2. Exchange Rate Determination3
Exchange Rate Determination
Chapter Objectives
This chapter will:
A. Explain how exchange rate movements are measured
B. Explain how the equilibrium exchange rate is determined
C. Examine factors that determine the equilibrium
exchange rate
D. Explain the movement in cross exchange rates 2

3. Measuring Exchange Rate Movements
Depreciation: decline in a currency’s value
Appreciation: increase in a currency’s value
Comparing foreign currency spot rates over two points in time, S and St-1
Example: Assume the spot rate of the British pound is $ The expected spot rate one year from now is assumed to be $ What percentage depreciation does this reflect?

4. Exchange Rate Equilibrium
The exchange rate represents the price of a currency, or the rate at which one currency can be exchanged for another.
Demand for a currency increases when the value of the currency decreases, leading to a downward sloping demand schedule.
Supply of a currency increases when the value of the currency increases, leading to an upward sloping supply schedule.
In liquid spot markets, exchange rates are not highly sensitive to large currency transactions.

5. Exhibit 4.2 Demand Schedule for British Pounds5

6. Exhibit 4.3 Supply Schedule of British Pounds for Sale6

7. Exhibit 4.4 Equilibrium Exchange Rate Determination7

8. Factors That Influence Exchange Rates

9. Factors That Influence Exchange Rates
Relative Inflation: Increase in U.S. inflation leads to increase in U.S. demand for foreign goods, an increase in U.S. demand for foreign currency, and an increase in the exchange rate for the foreign currency.
Relative Interest Rates: Increase in U.S. rates leads to increase in demand for U.S. deposits and a decrease in demand for foreign deposits, leading to a increase in demand for dollars and an increased exchange rate for the dollar.
Fisher Effect:

10. Factors That Influence Exchange Rates
3. Relative Income Levels: Increase in U.S. income leads
to increased in U.S. demand for foreign goods and
increased demand for foreign currency relative to the
dollar and an increase in the exchange rate for the
foreign currency.
4. Government Controls via:
Imposing foreign exchange barriers
Imposing foreign trade barriers
Intervening in foreign exchange markets
Affecting macro variables such as inflation, interest rates, and income levels.

11. Factors That Influence Exchange Rates
Expectations: If investors expect interest rates in one
country to rise, they may invest in that country leading
to a rise in the demand for foreign currency and an
increase in the exchange rate for foreign currency.
Impact of signals on currency speculation. Speculators may overreact to signals causing currency to be temporarily overvalued or undervalued.

12. Factors that Influence Exchange Rates
Interaction of Factors: some factors place upward
pressure while other factors place downward pressure.
Influence of Factors across Multiple Currency
Markets: common for European currencies to move
in the same direction against the dollar.

13. Summary of How Factors Can Affect Exchange Rates13

14. CROSS EXCHANGE RATE
The value of currency A in currency B from the perspective of country C.
Why: some currency pairs are not actively traded, thus use a third currency for example MYR and Mexicon Pesos, so use USD
So the Mexican trader can buy USD and then change to MYR to settle his trade with Malaysian trader
Eg: JPY/USD=¥ and MXN/USD=Ps13.223
So the Mexican trader can buy USD and then change to JPY to settle his trade with Japanese trader.
% of movement in cross exchange rate can be measured.

15. Movements in Cross Exchange Rates
If currencies A and B move in same direction
no change in the cross exchange rate.
When currency A appreciates against the dollar by a greater (smaller) degree than currency B
currency A appreciates (depreciates) against B.
When currency A appreciates (depreciates) against the dollar, while currency B is unchanged against the dollar
currency A appreciates (depreciates) against
currency B by the same degree as it appreciates
against the dollar.

16. Currency Derivatives 3 Chapter Objectives This chapter will:
A. Explain how forward contracts are used to hedge based on anticipated exchange rate movements
B. Describe how currency futures contracts are used to speculate or hedge based on anticipated exchange rate movements
C. Explain how currency option contracts are used to speculate or hedge based on anticipated exchange rate movements 16

17. What is a Currency Derivative?
A currency derivative is a contract whose price is derived from the value of an underlying currency.
Examples include forwards/futures contracts and options contracts.
Derivatives are used by MNCs to:
Speculate on future exchange rate movements
Hedge exposure to exchange rate risk
Definition of 'Hedge'
Making an investment to reduce the risk of adverse price movements in an asset.

18. Forward Market
Agreement between a corporation and a financial institution
To exchange a specified amount of currency
At a specified exchange rate (called the forward rate)
On a specified date in the future

19. Premium or Discount on the Forward Rate
F = S(1 + p)
where:
F is the forward rate
S is the spot rate
p is the percentage by which the forward rate exceeds the spot rate.

20. Currency Futures Market
Similar to forward contracts in terms of obligation to purchase or sell currency on a specific settlement date in the future.
Differ from forward contracts because futures have standard contract specifications:
Standardized number of units per contract
Offer greater liquidity than forward contracts
Typically based on U.S. dollar, but may be offered on cross-rates.
Commonly traded on the Chicago Mercantile Exchange (CME).

21. Exhibit 5.3 Comparison of the Forward and Futures Market

22. How Firms Use Currency Futures
Purchasing futures to hedge payables
Selling futures to hedge receivables

23. Exhibit 5.5 Source of Gains from Buying Currency Futures23

24. Options Currency Options Markets
A financial derivative that represents a contract sold by one party (option writer) to another party (option holder). The contract offers the buyer the right, but not the obligation, to buy (call) or sell (put) a security or other financial asset at an agreed-upon price (the strike price) during a certain period of time or on a specific date (exercise date).
Currency Options Markets
Options Exchanges
Over-the-counter market

25. Currency Call Options
Grants the right to buy currency at a designated exercise (strike) price.
If the spot rate rises above the strike price, the owner of a call can exercise the right to buy currency at the strike price.
The buyer of the options pays a premium
If the spot exchange rate is greater than the strike price, the option is in the money. If the spot rate is equal to the strike price, the option is at the money. If the spot rate is lower than the strike price, the option is out of the money.

26. Factors Affecting Currency Call Option Premiums
Spot price relative to the strike price
Length of time before expiration
Potential variability of currency

27. How Firms Use Currency Call Options
Using call options to hedge payables
Using call options to hedge project bidding.
Using call options to hedge target bidding.
Speculating.

28. Currency Put Options
Grants the right to sell currency at a designated exercise (strike) price.
If the spot rate falls below the strike price, the owner of a put can exercise the right to sell currency at the strike price.
The buyer of the options pays a premium. Maximum possible loss is the premium.
If the spot exchange rate is lower than the strike price, the option is in the money. If the spot rate is equal to the strike price, the option is at the money. If the spot rate is greater than the strike price, the option is out of the money.

29. Factors Affecting Put Option Premiums
Spot rate of currency relative to the strike price.
Length of time until expiration.
Variability of the currency.

30. Contingency Graphs For Currency Options
Contingency graph for a purchaser of a call option.
Contingency graph for a seller of a call option.
Contingency graph for a buyer of a put option.
Contingency graph for a seller of a put option.

31. Exhibit 5.6 Contingency Graphs for Currency Options31

32. Conditional Currency Options
The premium is conditioned on the actual movement in the currency’s value over the period of concern.

33. Exhibit 5.7 Comparison of Conditional and Basic Currency Options33