Exchange Rate Risk

1
Exchange Rate Risk

• The value of an individuals wealth, asset or net
  worth could change because of an unexpected
  change in the foreign exchange rate, this is
  exposure to foreign exchange rate risk.
• In response to this, people Hedge their position
  or Speculate
• Hedging act of reducing or eliminating a net
  asset or liability position in foreign currency
• Speculating act of acquiring a net asset of net
  liability position in foreign currency

2
Tools Used To Minimize Exchange Rate Risk

• Forward Contracts
• Futures Contracts
• Foreign Currency Options
• Foreign Currency Swaps

3
Forward Contracts

• Suppose a U.S. watch importer wishes to purchase
  watches from Switzerland. Importer could purchase
  Swiss francs in the spot market to settle a
  contract payable now. However, importer may wish
  to place the order now but schedule delivery at a
  future date, say 3 months. Payment options
  include
• Wait three months then buy francs. However, the
  SF could appreciate, rendering the deal
  unprofitable for the importer (i.e. will require
  more dollars to buy a given quantity of Swiss
  francs).
• Buy Swiss francs now and hold or invest them for
  three months. In this way, importer knows the
  exact amount of needed. However, investing
  francs is risky so in addition to giving up
  (which could earn interest for 3 months),
  importer may make a poor investment using francs.

4
Forward Rates continued

• Use the forward exchange market (where currencies
  are bought/sold for delivery in a future period)
  This payment option establishes a set exchange
  rate between the dollar and the franc however,
  importer does not have to purchase francs until
  they are needed in three months. Although similar
  to the above alternative, it is not necessary for
  importer to part with now nor to have knowledge
  of investment opportunities in francs.
• If the forward exchange rate of a currency
  exceeds the current spot rate, that currency is
  selling at a forward premium.
• If the forward exchange rate of a currency is
  less than the current spot rate, that currency is
  selling at a forward discount.
• If the spot and forward rates are equal, the
  currency is flat.

5
Futures Market

• The futures market is a market where foreign
  currencies may be bought/sold for delivery at a
  future day. Futures market differs from the
  foreign exchange market (spot, forward and swap
  transactions) in the following ways
• Trading occurs in a specific geographic location
  (i.e. its an organized exchange). The largest
  currency futures market is the International
  Monetary Market (IMM) of the Chicago Mercantile
  Exchange. The foreign exchange market is a global
  over-the-counter market.
• It only trades a few currencies. IMM futures are
  traded on the , A, , SF, Ps, , DM. Foreign
  exchange market involves all currencies from
  major developed countries.

6
Futures Market

• Trading occurs in standardized contracts, with
  contracts maturing on the 3rd Wednesday of March,
  June, September and December. In forward
  exchange market, contracts are typically 30, 90
  or 180 days long and are maturing every day of
  the year.
• Contracts written for fixed amounts. In forward
  exchange market (e.g. forward transaction),
  contracts are written for any amount agreed upon
  by the parties involved.
• Futures contracts used by small firms. Forward
  contracts are conducted at the wholesale level
  thus used by large financial institutions and
  large business firms that deal in very large
  amount of foreign exchange.

7
Foreign Currency Options

• Call Option A contract that provides the option,
  the right, (not obligation) to buy a given amount
  of foreign currency at a specified price (called
  the strike price).
• Example
• An US importer buys Swiss equipment and has to
  pay SF1 million after 30-days.
• Current spot rate is 0.70 per franc (has to pay
  700,000)
• 30-day forward rate is 0.74 per franc (has to
  pay 740,000).
• Importer can buy a Call Option the option to buy
  a pre-specified amount of SF at a strike price of
  0.72 per franc in 30 days. He has to pay a
  price for the option.
• If the SF does not appreciate beyond 0.71, he
  does not exercise the option just loses the
  price of the option. On the other hand, if it
  does appreciate, he exercises the option, and
  saves the difference (less the price).

8
Swap Rates Basis Point

• A foreign exchange swap is a trade that combines
  both a spot and a forward transaction into one
  deal. Specifically, a swap is the same as
  borrowing one currency while lending another
  currency for the duration of the swap period
  currencies are traded at one date and the trade
  is reversed at a later date. Swap can be for any
  length of time.
• Swap agreements are popular among interbank
  trading (e.g. trade between Citibank and Lloyds).
• When discussing swap rates, a currency selling at
  a forward premium/discount is quoted in terms of
  basis points rather than in a currency amount
  (e.g. a .10 premium swap rate of 1000 basis
  points).
• A basis point 1/100 of 1 .01 .0001
• To convert the current premium/discount into a
  spot rate, divide the currency figure by .0001.
  (e.g. 0.10/.0001 1,000 basis points)