Transcript CHAPTER 16

CHAPTER 16
Foreign Exchange Derivative Markets
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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
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Foreign Exchange Quotation
 Direct ( in USD ):
 Indirect (per USD):
$1.25 / euro
0.8 euro / $1
 Exchange rates are typically quoted on a Bid-
Ask basis, the quotations found in
newspapers are usually “Bid-Ask Averages”
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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
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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,
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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.
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D. Foreign Exchange Derivatives
1. Forward Contracts
2. Currency Futures Contracts
3. Currency Swaps
4. Currency Options Contracts
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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.
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Foreign Exchange Futures
 Traded on the Mar, Jun, Sep, Dec cycle.
 Different contract size for different underlyings, based
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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
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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.
2-Jan
15-Dec
Spot
1.2598
1.1955
DEC futures
1.2533
1.1955
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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.
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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
0
1
2
3
4
5
Fixed rate in USD
10%
10%
10%
10%
10%
Fixed rate in Euro
8.0%
8.0%
8.0%
8.0%
8.0%
Party A
Party B
USD
1,250,000
-125,000
-125,000
-125,000
-125,000
-1,375,000
Euro
-1,000,000
80,000
80,000
80,000
80,000
1,080,000
USD
-1,250,000
125,000
125,000
125,000
125,000
1,375,000
Euro
1,000,000
-80,000
-80,000
-80,000
-80,000
-1,080,000
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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 floatfloat.
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Motivation for Swap
 Comparative advantage in borrowing different
currencies.
Party C needs USD, Party D needs Euro
Firm
US dollar rate
Euro rate
party C
10%
7%
party D
9%
8%
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Currency options
 A right to purchase or sell a particular
currency at a specified price within a given
period.
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Foreign Exchange Exposure of
Multinationals
% of revenues from (approx.)
Company
USA
EU
Asia
LatinAmerica
Royal Dutch
Tupperware
Unilever
Wrigley
McDonald’s
Sun Microsystems
Intel
Coca Cola
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30
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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
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Discussion
 Q & A: 5,6
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Summary
 Foreign exchange quotation, cross rates
 PPP and IRP
 Speculation and Hedging strategies.
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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.
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