PPT16

PowerPoint Slides for:
Financial Markets
and Institutions
6th Edition
By Jeff Madura
Prepared by
David R. Durst
The University of Akron
CHAPTER
16
Foreign
Exchange
Derivative
Market
Chapter Objectives
 Explain how various factors affect exchange

rates
 Describe how foreign exchange risk can be
hedged with foreign exchange derivatives
 Describe how to use foreign exchange
derivatives to capitalize (speculate) on
expected exchange rate movements
Copyright© 2002 Thomson Publishing. All rights reserved.

Background On Foreign Exchange
Markets
 Exchanging currencies is needed when:
 Trade (real) prompts need for forex
 Capital flows (financial) prompts need for forex
 Foreign exchange trading

 Via global telecommunications network between
mostly large banks
 Bid/ask spread

Foreign Exchange Rates
 Quoted two ways:

 Foreign currency per U.S. dollar
 Dollar cost of unit of foreign exchange
 Appreciation/depreciation of currency
 Appreciation = more forex to buy $
 Purchase more forex with $
 Depreciation = foreign goods cost more $
 Total return to foreign investor decreases

Background on Foreign Exchange
Markets
 Exchange rate quotations are available in the
financial press and on the Internet with spot
exchange rate quotes for immediate delivery
 Forward exchange rate is for delivery at some
specified future point in time
 Forward premium is the percent annualized
appreciation of a currency
 Forward discount is the percent annualized
depreciation of a currency
Markets
 Exchange rates involve different kinds of
quotes for comparing the value of the U.S.
dollar to various foreign currencies
 1 unit of foreign currency worth some amount of
U.S. dollars—e.g. $.70 U.S. per Canadian Dollar
 1 U.S. dollar’s value in terms of some amount of
foreign currency– e.g. CD$1.43 per U.S. dollar
 Note reciprocal relationship
 Cross-exchange rates express relative values

of two different foreign currencies per $1 U.S.
Markets
 Cross-exchange rates are foreign exchange
rates of two currencies relative to a currency.
 Value of one unit of currency A in units of
currency B = value of currency A in $ divided
by value of currency B in $
 British Pound = $1.4555; Euro = $.8983
 Value of Pound in Euros = $1.4555/$.8983
or…
 1.62 Pounds per Euro using the forex rates per
U.S. dollar
Markets
 Currency terminology
 Appreciation means a currency’s value increases
relative to another currency
 Depreciation means a currency’s value decreases
relative to another currency
 Supply and demand influences the values of
currencies
 Many factors can simultaneously affect supply
and demand
Markets
Background on Foreign Exchange Markets
 1944–1971 known as the Bretton Woods Era

 Government maintained exchange rates within a
1% range
 Required government intervention and control
 By 1971 the U.S. dollar was clearly

overvalued
Markets
 Smithsonian Agreement (1971) among major
countries allowed dollar devaluation and
widened boundaries around set values for each
currency
 No formal agreements since 1973 to fix
exchange rates for major currencies
 Freely floating exchange rates involve values set
by the market without government intervention
 Dirty float involves some government intervention

Classification of Exchange Rate
Arrangement
 There is a wide variation in how countries
approach managing or influencing their
currency’s value
 Float with periodic intervention
 Pegged to the dollar or some kind of composite
 Some countries have both controlled and floating
rates
 Some arrangements are temporary and others
more permanent

Factors Affecting Exchange Rates: Real
Sector
 Differential country inflation rates affect the
exchange rate for euros and dollars if inflation
is suddenly higher in Europe
 Theory of Purchasing Power Parity suggests
the exchange rate will change to reflect the
inflation differential—influence from real
sector of economy
 Currency of the higher inflation country (euro)
depreciates compared to the lower inflation
country ($)
Factors Affecting Exchange Rates:
Financial Sector
 Differential interest rates affect exchange rates
by influencing capital flows between countries
 For example, the interest rates are suddenly
higher in the United States than in Europe
 Investors want to buy dollar-denominated
securities and sell European securities
 Euros are sold, dollars bought to buy U.S.
securities
 Downward pressure on the euro, appreciation
of the dollar
Factors Affecting Exchange Rates
 Direct intervention occurs when a country’s

central bank buys/sells currency reserves
 For example, the U.S. central bank, the
Federal Reserve sells one currency and buys
another
 Sale by central bank creates excess supply and that
currency’s value drops relative to the one
purchased
 Market forces of supply and demand can
overwhelm the intervention
 Indirect intervention involves influencing the

factors that affect exchange rates rather than
central bank purchases or sales of currencies
 Interest rates, money supply and inflationary
expectations affect exchange rates
 Historical perspective on indirect intervention
 Peso crisis in 1994
 Asian crisis in 1997
 Russian crisis in 1998

 Some countries use foreign exchange controls

as a form of indirect intervention to maintain
their exchange rates
 Place restrictions on the exchange of currency
 May change based on market pressures on the
currency
 Venezuela in mid-1990s illustrates the issues
involved in controlling rates via intervention
and the affect of market forces
Movements in Exchange Rates
 Foreign exchange rate changes can have an

important effect on the performance of
multinational firms and economic conditions
 Many market participants forecast rates
 Market participants take positions in derivatives
based on their expectations of future rates
 Speculators attempt to anticipate the direction of
exchange rates
 There are several forecasting techniques
Forecasting Techniques
Market-based
Forecasting
Technical Forecasting
Fundamental Forecasting Mixed Forecasting

Forecasting Exchange Rates: Technical
 Technical forecasting is a technique that uses

historical exchange rate data to predict the
future
 Uses statistics and develops rules about the
price patterns—depends on orderly cycles
 If price movements are random, this method
won’t work
 Models may work well some of the time and
not work other times
Forecasting Exchange Rates:
Fundamental
 Fundamental forecasting is based on
fundamental relationships between economic
variables and exchange rates
 May be statistical and based on quantitative
models or be based on subjective judgement
 Regression used to forecast if values of
influential factors have a lagged impact
 Not all factors are known and some have an
instant impact so sensitivity analysis is used to
deal with uncertainty
Forecasting Exchange Rates:
Fundamental
 Limitation of fundamental forecasting
methods:
 Some factors that are important to determining
exchange rates are not easily quantifiable
 Random events can and do affect exchange rates
 Predictor models may not account for these
unexpected events

Forecasting Exchange Rates: Market-
Based
 Market-based forecasting uses market
indicators like the spot and forward rates to
develop a forecast
 Spot rate: recognizes the current value of the
spot rate as based on expectations of
currency’s value in the near future
 Forward rate: used as the best estimate of the
future spot rate based on the expectations of
market participants
Forecasting Exchange Rates: Mixed
 Mixed forecasting is used because no one

method has been found superior to another
 Multinational corporations use a combination
of methods
 Assign a weight to each technique and the
forecast is a weighted average
 Perhaps a weighted combination of technical,
fundamental, and market-based forecasting

Forecasting Exchange Rate Volatility
 Market participants forecast not only

exchange rates but also volatility
 Volatility forecast
 Recognizes how difficult it is to forecast the actual
rate
 Provides a range around the forecast

Forecasting Exchange Rate Volatility
Methods Used To Forecast Volatility
 Volatility of historical data

 Use a times series of volatility patterns in
previous periods
 Derive the exchange rate’s implied standard
deviation from the currency option pricing
model
Speculation in Foreign Exchange Markets
 For example, a dealer takes a short position in

a foreign currency to profit from expected
depreciation
 Dealer forecasts currency 1 to depreciate
relative to foreign currency 2 so the first step
is to borrow currency 1 and then exchange
currency 1 for currency 2
 Invest in currency 2 and receive the investment
returns at maturity
 Convert back to foreign currency 1 and pay back
loan denominated in currency 1
Foreign Exchange Derivative Contracts
Forward Contracts Currency Swaps
Hedge or Speculate
Currency Futures Currency Options

Foreign Exchange Derivatives-Hedge
 Forward contracts
 Negotiated with a counterparty
 Specify a maturity date, amount and which
currency to buy or sell
 Negotiated in over-the-counter market
 Used to lock in the price paid or price received for
a future currency transaction
 Classic hedging contract

 Forward contracts can be used to hedge if a

corporation must pay a foreign currency
invoice in the future
 Purchase foreign currency for amount/date of
invoice
 Locks in cost of invoice
 Hedges foreign exchange risk of transaction
 Forward contracts are also used by hedgers
who have a foreign currency inflow on some
future date
Foreign Exchange Derivatives
 Forward rate premium or discount

FR - S 360
p = x
S n
Where:
P = % annualized premium or discount

FR = Forward exchange rate
S = Spot exchange rate
n = number of days forward

 Currency futures contracts trade on

exchanges, are standardized in terms of the
maturity and amount
 Currency swaps allow one currency to be
periodically swapped for another at a specified
exchange rate
 Currency options contracts offer one-way
insurance to buy (call) or sell (put) a currency

 Buying a call option on a foreign currency is

the right to purchase a specified amount of
currency at the strike price within the
specified time period
 Exercise the option if the spot rate rises above the
strike price
 Do not exercise if the spot rate does not reach or
exceed the strike price
 U.S. business that owes Canadian in 60 days buys
currency call options to hedge spot forex risk
 Buying a put option on a foreign currency is the right

to sell a specified amount of currency at the strike
price within the specified time period
 Exercise the option if the spot rate falls below the strike
price
 Do not exercise if the spot rate does not decline below the
strike price
 U.S. business hedges Canadian dollar payment it will
receive in 30 days by buying CD currency put options—if
CD depreciates against U.S., gain will offset spot loss

Foreign Exchange Derivatives-Speculate
 Business or person has no spot interest in

underlying asset—takes position based on
forecast of currency movements
 Buy/sell foreign currency forward
 When received, sell in the spot market
 Purchase/sell futures contracts

 Purchase call/put options

Foreign Exchange Derivatives-
Speculation
 For example, what position in derivates would
a speculator take if he/she anticipates a
depreciation in a currency?
 Sell foreign currency forward
 At maturity, buy in the spot market
 Sell futures contracts

 Purchase put options

International Arbitrage
 Arbitrage takes advantage of a temporary

price difference in two locations to make
profits buying at a lower price than you can
receive via the simultaneous sale of an asset,
financial instrument or currency
 Risk free because the purchase and sale price
are locked in simultaneously
 As arbitrage occurs, prices in both locations
change until equilibrium (one price) returns
 Covered interest arbitrage activity creates a

relationships between spot rates, interest rates and
forward rates
 Borrow in country 1
 Convert the funds to currency for country 2 using the
spot rate; buy forward contract for return
 Invest in country 2 and earn an investment rate of
return
 Convert back to country 1 currency using forward
contract, repay loan
 Covered interest arbitrage activity makes

forward premium approximately equal to the
differential in interest rates between two
countries
 If forward premium does not equal the interest
rate differential, covered interest arbitrage is
possible
 If the forward premium or discount equals the
interest rate differential, there are no
opportunities for arbitrage
 Equation for covered interest arbitrage

( 1 + ih )
P = – 1
(1 + if )
Where:
P = Forward premium or discount
ih = Home country interest rate

if = Foreign interest rate

Explaining Price Movements of Foreign
Exchange Derivatives
 Indicators of foreign exchange derivatives are
closely monitored by market participants
 Hedgers and speculators continuously forecast
direction and degree of movement and
monitor
 Inflation rates between countries
 Interest rates
 Economic indicators

Foreign Exchange Markets
 Exchanging Currencies Is Needed When:

 Trade (real) prompts need For forex
 Capital flows (financial) prompts need for forex
 Foreign Exchange Trading

 Via global telecommunications network between
mostly large banks
 Bid/ask spread

Foreign Exchange Rates
 Quoted Two Ways:

 Foreign currency per U.S. Dollar
 Dollar cost Of unit Of foreign exchange
 Appreciation/Depreciation of Currency
 Appreciation = more forex To buy $
 Purchase more forex with $
 Depreciation = foreign goods cost more $
 Return To foreign investor decreases

Exchange Rate Systems
 Bretton Woods Era (1944-1971)

 Fixed Or pegged forex rates
 Central bank maintained rates
 Could not adjust To major economic change
 Smithsonian Agreement (1971)

 Devalued dollar
 Widened trading range Of forex
 First Step Toward Market-Determined Forex

Exchange Rate Systems
 Market-Determined Rates (1973)

 Dirty Float
 Exchange Rate Mechanisms:
 Currencies pegged to another
 European currency unit (ECU)
 Central Bank involvement
 ERM problems

Major Factors Affecting Forex
 Differential inflation rates between countries

 Goods and services impact demand/supply for
foreign exchange
 Inflating currency declines to provide….
 Purchasing power parity

Major Factors Affecting Forex
 Differential interest rates between countries

 Reflect expected differential inflation rates
 Global Fisher Effect
 Governmental Intervention
 Domestic Economic Policy
 Direct Intervention, e.g., Forex Controls
 Market Forces Reign!!!

Forecasting Foreign Exchange Rates
 Technical forecasting
 Fundamental forecasting
 Market-based forecasting
 Mixed forecasting

Forecasting Forex Volatility
 Forex prices difficult to forecast

 Forecasting volatility creates range of
probable forex rates
 Use best- and worst-case scenarios in planning
 Define future period
 Consider historical volatility
 Time series of previous volatility

Speculation In Forex Market
 Take position based on forex expectations

 Expect To appreciate
 Take long position (buy)
 Forward contract to buy
 Buy forex currency futures contract
 Buy forex call options
 Action taken if depreciation expected??

Foreign Exchange Derivatives
 Speculate vs. Hedging

 Contract To buy/sell forex at specified price on
specified date
 OTC market characteristics
 Reflects expected future spot rate
 Premium vs. Discount from spot
 Interest rate parity concept

Other Forex Derivatives
 Currency futures contracts

 Currency swaps
 Currency option contracts

 Arbitrage defined
 Locational arbitrage
 Covered interest arbitrage
 Maintains interest rate parity
 Forward/spot differential =
 Differential inflation rates
 Interest rate differentials
 Expected future spot rate

Institutional Use Of Forex Market
 Intermediary or dealer of forwards or other

derivative contracts
 Speculating/hedging
 Future investment flows (loans, interest)
 Future financing flows (principal and interest)

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PowerPoint Slides for:

 Explain how various factors affect exchange

Copyright© 2002 Thomson Publishing. All rights reserved.

 Foreign exchange trading

Copyright© 2002 Thomson Publishing. All rights reserved.

 Quoted two ways:

Copyright© 2002 Thomson Publishing. All rights reserved.

 Cross-exchange rates express relative values

Background on Foreign Exchange Markets

 1944–1971 known as the Bretton Woods Era

 By 1971 the U.S. dollar was clearly

Copyright© 2002 Thomson Publishing. All rights reserved.

Copyright© 2002 Thomson Publishing. All rights reserved.

 Direct intervention occurs when a country’s

 Indirect intervention involves influencing the

Copyright© 2002 Thomson Publishing. All rights reserved.

 Some countries use foreign exchange controls

 Foreign exchange rate changes can have an

Fundamental Forecasting Mixed Forecasting

Copyright© 2002 Thomson Publishing. All rights reserved.

 Technical forecasting is a technique that uses

Copyright© 2002 Thomson Publishing. All rights reserved.

 Mixed forecasting is used because no one

Copyright© 2002 Thomson Publishing. All rights reserved.

 Market participants forecast not only

Copyright© 2002 Thomson Publishing. All rights reserved.

Methods Used To Forecast Volatility

 Volatility of historical data

 For example, a dealer takes a short position in

Forward Contracts Currency Swaps

Currency Futures Currency Options

Copyright© 2002 Thomson Publishing. All rights reserved.

Copyright© 2002 Thomson Publishing. All rights reserved.

 Forward contracts can be used to hedge if a

 Forward rate premium or discount

P = % annualized premium or discount

Copyright© 2002 Thomson Publishing. All rights reserved.

 Currency futures contracts trade on

Copyright© 2002 Thomson Publishing. All rights reserved.

 Buying a call option on a foreign currency is

 Buying a put option on a foreign currency is the right

Copyright© 2002 Thomson Publishing. All rights reserved.

 Business or person has no spot interest in

 Purchase/sell futures contracts

Copyright© 2002 Thomson Publishing. All rights reserved.

 Sell futures contracts

Copyright© 2002 Thomson Publishing. All rights reserved.

 Arbitrage takes advantage of a temporary

 Covered interest arbitrage activity creates a

 Covered interest arbitrage activity makes

 Equation for covered interest arbitrage

ih = Home country interest rate

Copyright© 2002 Thomson Publishing. All rights reserved.

Copyright© 2002 Thomson Publishing. All rights reserved.

 Exchanging Currencies Is Needed When:

 Foreign Exchange Trading

Copyright© 2002 Thomson Publishing. All rights reserved.

 Quoted Two Ways:

Copyright© 2002 Thomson Publishing. All rights reserved.

 Bretton Woods Era (1944-1971)

 Smithsonian Agreement (1971)

Copyright© 2002 Thomson Publishing. All rights reserved.

 Market-Determined Rates (1973)

Copyright© 2002 Thomson Publishing. All rights reserved.