Name : Nazwa Advianisa Sitorus

Class : IMaBs B (20210410462)

Subject : International Financial

Summary Chapter 3!

Forward Markets and Exchange Risk

This chapter related concepts in the financial world. A forward market is an over-the-counter
marketplace that sets the price of a financial instrument or asset for future delivery. It is used for
trading a range of instruments, including currencies, securities, interest rates, and commodities. In the
context of forward markets, exchange risk is a factor that can affect the pricing and settlement of
forward contracts. For example, the forward price in the foreign exchange market is derived from the
interest rate differential between the two currencies, which is applied over the period from the
transaction date to the settlement date of the contract.

3.1 Transaction Exchange Risk

Whenever you engage in an international financial transaction that involves an exchange of currencies
in the future, you will almost always be unsure about what the spot exchange rate will be in the future
when you conduct this transaction. This is true even under regimes of fixed exchange rates because
political and economic events can always trigger devaluation or revaluation of the domestic currency
relative to foreign currencies. Under the flexible exchange rate system that has characterized the
foreign exchange markets for the major currencies for nearly 40 years, exchange rates fluctuate a
good deal from day to day. As a financial manager, you must be able to gauge where the exchange
rate might head and how likely such fluctuations may be. This range of possible future values for the
exchange rate and the likelihood of their occurring will give you an idea of the foreign exchange risk
your firm faces and whether it’s a good idea to hedge.

This paragraph emphasizes the risks inherent in international financial transactions due to the
uncertainty of future spot exchange rates. It illustrates these risks through examples involving
Motorola and Oracle, highlighting how exchange rate fluctuations can lead to unexpected losses or
gains. In addition, the report also emphasizes the importance of considering estimates of future spot
exchange rates rather than relying solely on current exchange rates when evaluating potential
exchange rate losses or gains. This paragraph concludes by introducing concepts that formally
describe the uncertainty of future spot prices, which will be discussed further in the following section.

3.2 Describing Uncertain Future Exchange Rate

Assessing Exchange Rate Uncertainty Using Historical Data

Historical data provide insight not only to what has happened in the past but what might happen in the
future. Exhibit 3.1 presents a histogram of monthly percentage changes in the exchange rate of the
U.S. dollar per British pound ($/£). The exhibit also superimposes on the graph a normal distribution
curve, with the same mean and standard deviation as the data.
This table explains that explains the statistical analysis of monthly percentage changes in the dollar
exchange rate against the pound from 1975 to 2010. It begins by explaining the construction of a
histogram that represents the distribution of exchange rate changes over the period. The histogram is
based on bins of equal width, with the points on the curve indicating the center point of the bin and
the vertical axis representing the frequency with which exchange rate changes occur for each bin.

Discusses the average monthly percentage change and the standard deviation of that change. The
average change was -0.05%, indicating a slight depreciation of the dollar relative to the pound on
average. The standard deviation measuring the spread of exchange rate changes around the mean is
calculated as 3.03%. Exchange rate changes within one standard deviation of the mean (-3.08% to
2.98%) are considered more common, while changes away from the mean are less common.
Furthermore, the paragraph highlights that exchange rate changes of two standard deviations from the
mean (smaller than -6.12% or greater than 6.01%) are rare. For example, exchange rate changes
higher than 7.42% only occur less than 1% of the time based on detailed data analysis. Overall, this
paragraph illustrates how statistical measures such as the mean and standard deviation can provide
insight into the distribution and frequency of exchange rate changes, helping to assess the level of risk
associated with currency fluctuations.

The Probability Distribution of Future Exchange Rates

Financial managers are also interested in the probability distribution of future spot exchange rates.
Given that we observe an exchange rate of S 1t2 today, we can find the probability distribution of
future exchange rates in, say, 90 days from the probability distribution of the percentage change in the
exchange rate. From Equation (3.1), we see that the possible future spot exchange rates are
S(t+90) = S(t) * [1 (t+90)]
where s(t+90) denotes the percentage change in the exchange rate over the next 90 days, s(t+90) =
[S(t+90) - S(t)]/S(t).

Conditional Means and Volatilities

The probability distribution of the future exchange rate depends on all the information available at
time t, we say that it is a conditional probability distribution (see the appendix to this chapter).
Consequently, the mean, which is the expected value of this distribution, is also referred to as the
conditional mean, or the conditional expectation, of the future exchange rate. Because the conditional
expectation of the future exchange rate plays an important role in what is to follow, we use the
following symbolic notation to represent it:
Conditional expectation at time t of the future spot exchange rate at time t+90 = Et[S(t+90)]

One nice feature of the normal distribution is that the probability of any range of possible future
exchange rates is completely summarized by its mean and the standard deviation, which is also often
referred to as volatility.

Assessing the Likelihood of Particular Future Exchange Rate Ranges

Given a probability distribution of future exchange rates, we can also determine the probability that
the exchange rate in the future will be greater or less than a particular future spot rate.

3.3 Hedging Transaction Exchange Risk

Forward Contracts and Hedging

The concept of forward contracts as a means to mitigate transaction exchange risk. In a forward
contract, a bank and a customer agree to exchange a specified amount of one currency for another
currency at a fixed future date, with the exchange rate (forward rate) determined at the time of
contract initiation. If an entity owes foreign currency in the future, it can "buy the foreign currency
forward" by arranging with a bank to deliver the required foreign currency at a predetermined rate,
thereby fixing the amount of domestic currency needed to fulfill the obligation. Conversely, if an
entity is expecting to receive foreign currency in the future, it can "sell it forward" to lock in the
amount of domestic currency it will receive. By using forward contracts, entities can eliminate
transaction exchange risk entirely because the total amount owed or received is determined at the
contract initiation, independent of future exchange rate fluctuations. This process essentially hedges
against risk by acquiring a foreign currency asset or liability that offsets the corresponding currency
exposure within the business's operations.

Hedging Currency Risk of Fancy Foods

In short, by utilizing futures contracts, Fancy Foods effectively neutralizes the risk of exchange rate
fluctuations between the pound and the dollar. This is achieved by creating a balance of foreign
currency assets and liabilities, thereby ensuring that the company's exposure to currency risk is
minimized.

Hedging at Nancy Foods

In short, this discussion discusses utilizing forward contracts, Nancy Foods effectively converts its
foreign currency assets (expected receipts of £1,000,000) into domestic currency assets (dollars)
without the associated foreign exchange risk. This helps mitigate changes in exchange rate positions,
thereby ensuring the company's finances remain stable.

Exposure of Hedged Versus Unhedged Strategies

As we know, the price of the foreign currency (pounds) in terms of the domestic currency (dollars)
rises. In other words, the foreign currency is appreciating. On the vertical axis are the domestic
currency costs per unit of foreign currency (if you must buy the foreign currency in the future) or the
domestic currency revenue per unit of foreign currency (if you must sell the foreign currency in the
future). Hence, we can represent the domestic currency revenue or cost of hedging or not hedging as a
function of the actual value of the future spot exchange rate using simple lines.

The Costs and Benefits of a Forward Hedge

Here discusses the appropriate way to think about the cost of a forward hedge in hedging transaction
exchange risk, considering both ex-post (after the fact) and ex-ante (before the fact) perspectives.

1. Ex-post perspective: This refers to looking at the cost after the transaction has occurred and
comparing it with what would have been paid if no hedge was used, based on the realized future spot
rate. If the future spot rate is higher than the forward rate, hedging provides benefits. Conversely, if
the future spot rate is lower than the forward rate, hedging results in regrets.

2. Ex ante perspective: This involves considering the expected cost or benefit of hedging before the
transaction occurs. It's noted that without hedging, there's exposure to foreign exchange risk, and the
actual future spot rate is likely to deviate from the expected future spot rate.

Explains that whether there's an expected cost or benefit to hedging depends on how the forward rate
compares to the expected future spot exchange rate. Specifically:
- If the expected future spot rate is lower than the forward rate, there's an expected cost to hedging
because it would require transacting at a higher domestic currency price than expected without
hedging.
- If the expected future spot rate is higher than the forward rate, there's an expected benefit to hedging
because it allows purchasing foreign currency with domestic currency more cheaply than expected.

POINT–COUNTERPOINT
Hedging Versus Speculating: Suttle Trooth is analyzing a case involving Kashima, where the actions
of the corporate finance department led to speculation in the currency markets. Suttle acknowledges
that pure speculation is not advisable for corporate finance departments, especially if it involves
hiding losses from shareholders, which is illegal in most countries. Consequently, Japan's regulatory
authorities implemented new disclosure rules regarding unrealized losses or profits from forward
contracts in the foreign exchange markets following incidents involving oil companies.

To Hedge or Not to Hedge?: While hedging can provide stability by locking in future transaction
prices and reducing the impact of uncertain exchange rates, Suttle questions whether it's the best long-
term strategy for these companies. He considers the possibility that forward contracts, which are
typically liquid for shorter maturities and may have higher transaction costs for longer-term contracts,
might be different hedging instruments. Additionally, he raises concerns about the impact of inflation
and oil price movements on the companies' bottom line and whether hedging would be beneficial in
such scenarios. Suttle concludes that he needs to further explore the benefits and drawbacks of
hedging by delving into international financial management literature.

3.4 The Forward Foreign Exchange Market

Market Organization
Such simple forward contracts, called outright forward contracts, are a relatively unimportant
component of the foreign exchange market. A Bank for International Settlements (2010) survey found
that only 12% of all transactions in the foreign exchange market are outright forward contracts. The
survey also found that forward contracts are much more often part of a package deal, called a swap.
About 44% of forex market transactions are swaps. A swap transaction involves the simultaneous
purchase and sale of a certain amount of foreign currency for two different dates in the future. Given
the importance of swaps, we discuss the swap market after we describe some of the details regarding
the trading of forward contracts.

Forward Contract Maturities and Value Dates

Forward exchange rates are contractual prices, quoted today, at which trade will be conducted in the
future. The parties agree to the price today, but no monies change hands until the maturity of the
contract, which is called the forward value date, or forward settlement date. in which this part explains
about outlines the mechanics of determining maturity dates and value dates for forward contracts in
the foreign exchange market, taking into account business days, weekends, and holidays in different
countries involved in the transaction.

Forward Market Bid-Ask Spreads

Discusses bid-ask spreads in the forward market compared to the spot market in foreign exchange
trading. suggests that while bid-ask spreads widen as maturity increases in the forward market,
spreads for active maturities remain relatively small, providing efficient trading opportunities for
market participants. However, bid-ask spreads become wider for contracts with longer maturities,
which may impact trading costs for these contracts.

Liquidity in the Forward Market

The liquidity of the forward market compared to the spot market, highlights why bid-ask spreads are
larger in the forward market. It explains that liquidity refers to the ease of buying and selling assets
without significantly impacting market prices. In liquid markets, traders can execute transactions with
minimal transaction costs and without affecting prices much. However, the forward market is
generally less liquid than the spot market due to two main reasons. Overall, the lack of liquidity in the
interbank forward market, driven by concerns about counterparty default risk and difficulty in
managing open positions, contributes to larger bid-ask spreads, especially for less heavily traded
contracts.

Net Settlement
Most outright forward contracts are settled by payment and delivery of the amounts in the contract. It
is possible, however, to settle a contract by paying or receiving a net settlement amount that depends
on the value of the contract. Net settlement is often used in the forex futures market, which we
discuss in Chapter 20, and for emerging market currencies. In many emerging markets, there are
capital controls in place, making it more difficult to trade foreign exchange for non-residents. Foreign
exchange dealers have responded by developing offshore markets in forward contracts that do not
require physical delivery of currency but are cash-settled, mostly in U.S. dollars.

The Foreign Exchange Swap Market

Swaps are very popular in the foreign exchange market because they combine two transactions with
different value dates but in opposite directions. The most common example is combining a spot
contract and a forward contract. This occurs naturally in various financial activities such as interest
rate arbitrage and international investments in bonds and equities. Portfolio managers often use swaps
to hedge currency risk when investing in foreign markets. Banks also utilize swaps to manage their
currency exposure by adjusting the maturity structure without changing their overall exposure to a
currency. Swaps allow convenient and efficient management of currency positions with a single
transaction, thereby contributing to their popularity in the market.

How Swap Prices Are Quoted

before we examine the details of the cash flows associated with a swap, let’s look at how prices are
quoted. We focus on swaps involving a spot transaction and a forward transaction. The following is
an example of a swap quote: Spot 30-day ¥>$ 104.30–35 15>20 A quote mentions the spot rates (first
column) and the swap points (second column). The spot rates quoted by a bank in this example are
¥104.30>$ bid and ¥104.35>$ ask. Remember that the bank’s bid price is the rate at which the bank
buys dollars from someone in exchange for yen. In contrast, the bank’s ask or offer price is the rate at
which the bank sells dollars to someone and receives yen from them. The swap points are a set of pips
that must be either added to or subtracted from the current spot bid and ask prices to yield the actual
30-day bid and ask forward prices.

A Rule for Using Swap Points

The rule for using swap points in the foreign exchange market is to determine the forward exchange
rate by adding or subtracting the swap value from the spot exchange rate. such as:
1. Determine the Spot Exchange Rate: Start by finding out the current spot exchange rate, which
represents the current market price for exchanging one currency for another.
2. Add or Subtract Swap Points: Swap Points represent the interest rate difference between the two
currencies being exchanged. If you buy foreign currency, you will add swap points to the spot rate to
calculate the forward rate. Conversely, if you sell foreign currency, you will subtract swap points
from the spot rate to calculate the forward rate.

3.5 Forward Premium and Discounts

If the forward price of the euro in terms of dollars (that is, USD>EUR) is higher than the spot price of
USD>EUR, the euro is said to be at a forward premium in terms of the dollar. Conversely, if the
forward price of the euro in terms of dollars (USD>EUR) is less than the spot price of USD>EUR, the
euro is said to be at a forward discount in terms of the dollar. Remember, as with the terms
appreciation and depreciation, the terms forward premium and forward discount refer to the currency
that is in the denominator of the exchange rate.

Sizes of Forward Premiums or Discounts

here explain the average forward premiums or discounts observed in yen-dollar, dollar-euro, and
dollar-pound forward contracts over 30-day and 90-day periods. in which:
1. Yen-Dollar Contracts: Both 30-day and 90-day yen-dollar forward contracts had negative average
forward premiums. This means that, on average, the dollar traded at a discount in the forward market
compared to the yen. Specifically, the yen-denominated forward prices of the dollar were
approximately 2.8% lower than the spot prices.

2. Dollar-Euro Contracts: The 30-day forward premium for dollar-euro contracts was positive,
indicating that the euro was at a premium relative to the dollar. However, for dollar-pound contracts,
the forward rates were negative, implying that the pound traded at a discount compared to the dollar.
The discount was 1.649% for 30-day contracts and 1.541% for 90-day contracts.

3. Variability: It's important to note that these numbers represent averages and that the forward
discount or premium can change over time. For example, in 2010, the pound and the euro traded at
small discounts relative to the dollar, while the dollar traded at a historically low discount of 0.399%
relative to the yen.

Forward Premiums and Swap Points

Forward contracts are often traded as part of a swap, and swap points indicate whether the
denominator currency is at a premium or a discount. If the dollar is at a forward premium, it is more
expensive to purchase dollars in the future, resulting in larger forward rates when swap points are
added to the spot rates. Conversely, if there is a discount on the dollar, swap points should be
subtracted. In the example provided, where the yen is the denominator currency, the dollar is at a
discount relative to the yen because the forward rate of yen per dollar is smaller than the spot rate.
This means swap points were subtracted from the spot rate. In such cases, swapping out dollars today
and into the currency at a premium (yen, in this case) generates a positive cash flow.

3.6 Change in Exchange Rate Volatility (Advanced)

Volatility Clustering
Volatility is not constant over time; instead, it exhibits a pattern known as volatility clustering. This
pattern involves periods of both high and low volatility, which tend to persist. For example, the daily
data on the dollar-pound exchange rate shows periods of tranquility and turbulence, with volatility
exceeding 20% during turbulent times, such as in 1985 and 1991-1993, and notably in October 2008
during the financial crisis. To model this volatility clustering, researchers have developed models such
as the GARCH (Generalized Autoregressive Conditional Heteroskedasticity) model by Bollerslev
(1986). This model captures the persistence in volatility by incorporating past conditional variance
and unexpected changes in exchange rates. The GARCH model's equation for conditional variance
includes parameters that reflect the sensitivity to past variance and current unexpected changes. This
persistence in volatility can generate the observed patterns of volatility clustering in exchange rate
data.