Foreign Exchange Derivative Markets

1
Foreign Exchange Derivative Markets

• Chapter 16

2
Background on Foreign Exchange Markets

• Foreign exchange markets consist of a global
  telecommunications network among large commercial
  banks that serve as financial intermediaries
• Banks are located in New York, Tokyo, Hong King,
  Singapore, Frankfurt, Zurich, and London
• The bid price is always lower than the ask price
• Institutional use of foreign exchange markets
• The degree of international investment by
  financial institutions is influenced by potential
  return, risk, and government regulations
• Institutions are increasing their use of the
  foreign exchange markets because of reduced
  information and transaction costs

3
Background on Foreign Exchange Markets (contd)

• Exchange rate quotations
• The spot exchange rate is for immediate delivery
• Forward rates indicate the rate at which a
  currency can be exchanged in the future
• Cross-exchange rates
• Some quotations express the exchange rate between
  two non-dollar currencies

4
Computing A Cross-Exchange Rate

• The euro is worth 1.15, and the Canadian dollar
  is worth 0.60. What is the value of the euro in
  Canadian dollars?

5
Factors Affecting Exchange Rates

• The value of a currency adjusts to changes in
  demand and supply
• In equilibrium, there is no excess or deficiency
  of that currency
• If a currency increases in value, it appreciates
• If a currency decreases in value, it depreciates
• Exchange rates are influenced by
• Differential inflation rates
• Differential interest rates
• Government intervention

6
Speculation in Foreign Exchange Markets

• Commercial banks take positions in currencies to
  capitalize on expected exchange rate movements

7
Speculating on Expected Exchange Rate Movements

• Zena Bank expects the euro to depreciate against
  the dollar and plans to take a short position in
  euros and a long position in dollars. Assume the
  following
• 1. Interest rate on borrowed euros is 5 percent
  annualized
• 2. Interest rate on dollars loaned out is 6
  percent annualized
• 3. Spot rate is 0.90 per dollar
• 4. Expected spot rate in ten days is 0.95 per
  dollar
• 5. Zena Bank can borrow 10 million
• Describe the steps Zena should take to profit
  from shorting euros and going long on dollars.

8
Speculating on Expected Exchange Rate Movements
(contd)

• Zena Bank should take the following steps
• 1. Borrow 10 million and convert to 11,111,111
• 2. Invest the 11,111,111 million for ten days at
  6 percent annualized (or .1667 percent over ten
  days), which will generate 11,129,630
• 3. After ten days, convert the 11,129,630 into
  euros at the existing spot rate, which converts
  to 10,573,148
• 4. Pay back the loan of 10 million plus interest
  of 5 percent annualized (.1389 percent over ten
  days), which equals 10,013,889
• Thus, Zena earns 559,259 over a ten-day period.

9
Foreign Exchange Derivatives

• Foreign exchange derivatives can be used to
• Speculate on future exchange rate movements
• Hedge anticipated cash inflows or outflows in a
  given foreign currency
• Institutional investors have increased their
  international investments, which has increased
  their exposure to exchange rate risk

10
Foreign Exchange Derivatives (contd)

• Forward contracts
• Forward contracts are contracts typically
  negotiated with a commercial bank that allow the
  purchase or sale of a specified amount of a
  particular foreign currency at a specified
  exchange rate on a specified future date
• The forward market facilitates the trading of
  forward contracts
• Commercial banks profit from the difference
  between the bid price and the ask price and are
  exposed to exchange rate risk if their purchases
  do not match their sales of a foreign currency
• Forward purchases can hedge the corporations
  risk that the currencys value may appreciate
• Forward sales can hedge the corporations risk
  that the currencys value may depreciate

11
Foreign Exchange Derivatives (contd)

• Forward contracts (contd)
• The forward rate may sometimes exhibit a premium
  or discount relative to the existing spot rate
• The forward premium reflects the percentage by
  which the forward rate exceeds the spot rate on
  an annualized basis

12
Computing A Forward Rate Premium or Discount

• Assume that the spot rate for the euro is 1.20,
  while the 180-day forward rate for the euro is
  1.22. What is the forward rate premium?

13
Foreign Exchange Derivatives (contd)

• Currency futures contracts
• A currency futures contract is a standardized
  contract that specifies an amount of a particular
  currency to be exchanged on a specified date and
  at a specified exchange rate
• Firms purchase futures to hedge payables
• Firms sell futures to hedge receivables
• Futures contracts have specified settlement dates
  
• Currency swaps
• A currency swap is an agreement that allows one
  currency to be periodically swapped for another
  at specified exchange rates
• Essentially a series of forward contracts

14
Foreign Exchange Derivatives (contd)

• Currency options contracts
• A currency call option provides the right to
  purchase a particular currency at a specified
  price (the exercise price) within a specified
  period
• Used to hedge payables in a foreign currency
• The option will not be exercised if the spot rate
  remains below the exercise price
• A currency put option provides the right to sell
  a particular currency at the exercise price
  within a specified period
• Used to hedge receivables in a foreign currency
• The option will not be exercised if the spot rate
  remains above the exercise price

15
Foreign Exchange Derivatives (contd)

• Use of foreign exchange derivatives for
  speculating
• Speculators who expect the euro to appreciate
  could
• Purchase euros forward and sell them in the spot
  market when received
• Purchase futures contracts on euros and sell
  euros in the spot market when received
• Purchase call options on euros and sell the euros
  in the spot market if the option is exercised

16
Foreign Exchange Derivatives (contd)

• Use of foreign exchange derivatives for
  speculating (contd)
• Speculators who expect the euro to depreciate
  could
• Sell euros forward and purchase them in the spot
  market to fulfill the obligation
• Sell futures contracts on euros and purchase
  euros in the spot market by the settlement date
• Purchase put options on euros and purchase the
  euros in the spot market if the option is
  exercised

17
Speculating with Currency Futures

• Assume the following
• 1. The spot rate for the euro is 1.15
• 2. The price of a futures contract is 1.17
• 3. Expectation of euros spot rate as of the
  settlement date is 1.20
• What could you do to profit from your
  expectations?
• You could buy euro futures. You would receive
  euros on the settlement date for 1.17 and could
  sell euros at 1.20 if your expectations were
  correct. To account for uncertainty, you could
  also develop a probability distribution for the
  future spot rate.

18
Speculating with Currency Options

• Assume the following
• 1. The spot rate for the euro is 1.15
• 2. A call option is available with an exercise
  price of 1.17 and a premium of 0.02 per unit.
• 3. Expectation of euros spot rate as of the
  settlement date is 1.20
• What could you do to profit from your
  expectations?
• You could euro call options. If your expectations
  are correct, you will net 1.20 1.17 0.02
  0.01 per unit.

19
International Arbitrage

• If exchange rates become misaligned, arbitrage
  will occur, forcing realignment
• Locational arbitrage is the act of capitalizing
  on a discrepancy between the spot rate at two
  different locations by purchasing the currency
  where it is priced low and selling it where it is
  priced high
• Some financial institutions watch for locational
  arbitrage opportunities, so any discrepancy in
  exchange rates is quickly corrected

20
Conducting Locational Arbitrage

• Assume the following information
• What actions could an arbitrageur take to benefit
  from these quotes?
• An arbitrageur could conduct locational arbitrage
  by purchasing euros from Blythe Bank for 1.19
  and selling them to Slythe Bank for 1.20.

21
International Arbitrage (contd)

• Covered interest arbitrage
• Interest rate parity refers to the relationship
  between a forward rate premium and the interest
  rate differential of two countries
• If the interest rate is lower in the foreign
  country than in the home country, the forward
  rate of the foreign currency should exhibit a
  premium
• The forward rate premium or discount should be
  about equal to the differential in interest rates
  between the countries of concern

22
Computing A Forward Premium Using Interest Rate
Parity

• Assume that the spot rate of the British pound is
  1.50, the one-year U.S. interest rate is 7
  percent, and the one-year British interest rate
  is 8 percent. What should the forward rate
  premium or discount of the British pound be?
• The forward rate reflects a 0.93 discount below
  the spot rate, or 1.49.

23
International Arbitrage (contd)

• Covered interest arbitrage (contd)
• If interest rate parity does not hold, covered
  interest arbitrage is possible
• E.g., if the spot rate and forward rate for a
  foreign currency are equal and the foreign
  interest rate is higher, arbitrageurs would buy
  the currency now, invest in the foreign country,
  and sell the currency forward
• Interest rate parity prevents investors from
  earning higher returns from covered interest
  arbitrage than can be earned in the U.S.