ECONOMICS 3150B Lecture 3 September 23, 2004

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ECONOMICS 3150BLecture 3September 23, 2004
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Links between Spot and Forward Rates

• Covered interest rate parity
• Invest C1 for one year in Government of Canada
  bond at interest rate of R(1,C) 1 1R(1,C) ?
  C
• Invest C1 for one year in US Government bond at
  interest rate of R(1, US) 1E1R(1,US) ? US
  ? convert into C at end of year at spot exchange
  rate at that time (speculate) or enter into
  forward contract at beginning of year at forward
  rate of F
• For investor to be indifferent between two
  investments and not speculate 1R(1,C)
  E1R(1,US) /F
• ? R(1,C) E1R(1,US) F/F ? R(1,US)
  (E-F)/F ? R(1,US) (F-E)/E
• Covered return
• Forward premium on C when F gt E ? R(1,US) gt
  R(1,C)
• Forward discount on C when F lt E ? R(1,US) lt
  R(1,C)

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Hedging

• Eliminate foreign exchange risks resulting from
  possible revaluation of exchange rate
• Consider case of Bombardier selling RJs to
  Skywest 10 deliveries per year
• Consider exchange rate risk in first year
  assume that all planes are delivered at end of
  year and fully paid for at that time cost per
  plane US30 M
• Bombardier to receive US300 M at end of first
  year
• Foreign exchange rate risk How many C will
  Bombardier receive at end of year? Depends on
  value of spot rate at that time
• At current spot rate (E0.7684), US 300 M yields
  C390 M
• If C appreciates during year, US300 M yields
  less than C390 M
• _at_ E as of September 15/03 (0.7332), US300 M
  would have yielded C409 M
• If C depreciates, US300M yields more than 390
  M

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Hedging

• Options for Bombardier
• Speculate maximum exposure depends upon degree
  of appreciation
• Hedge avoid exposure
• Hedging options
• Forward contract lock in forward rate F(1) ?
  Bombardier will receive with certainty at end of
  year 300 M/F(1)
• Bombardier foregoes possibility of gaining from
  depreciation
• One-year futures contract
• One-year put option to sell US300 M and receive
  C ?? most costly form of hedging but allows
  Bombardier to gain from depreciation of C

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Demand for Financial Assets

• Relative expected rates of return returns on
  financial assets denominated in different
  currencies must be compared in the same currency
• Risk variability of expected return, default
  risk and expected losses in case of default
• Comparison of expected return for same degree of
  risk
• Diversification of portfolio to reduce overall
  risk for portfolio
• Liquidity cost/speed of converting asset into
  cash
• Precautionary motive for holding liquid assets

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Demand for Financial Assets

• Two financial assets Government of Canada bond
  with one year to maturity US Government Bond
  with one year to maturity
• C bonds have higher degree of risk and are more
  illiquid than US bonds ? ? represents value of
  risk and illiquidity
• Covered interest rate parity condition must hold
  (with expected E E(e) in place of F) adjusted
  for greater risk and less liquidity of C
  government bonds
• R(1,C) R(1,US) (E(e)-E)/E ?
• (E(e)-E)/E expected change in value of C
• (E(e)-E)/E gt 0 ? C expected to depreciate
• (Ee-E)/E lt 0 ? C expected to appreciate

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E
1
E0
R(1,US)0, ?0, E(e)0
R(1,C)
R0
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Impact on Exchange Rate

• Impact on E
• ? R(1,US)
• ? R(1,C)
• ??
• ? E(e)

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E
? R(1,US), ?, or E(e)
2
E1
1
E0
3
E2
R(1,US)0, ?0, E(e)0
R(1,C)
R1
R0