CHAPTER 11 Foreign Exchange Futures

1
CHAPTER 11Foreign Exchange Futures

• In this chapter, we discuss foreign exchange
  futures. This chapter is organized as follows
• Price Quotations
• Geographical and Cross-Rate Arbitrage
• Forward and Futures Market Characteristics
• Determinants of Foreign Exchange Rates
• Futures Price Parity Relationships
• Speculation in Foreign Exchange Futures
• Hedging with Foreign Exchange Futures

2
Price Quotation

• In the foreign exchange market, every price is a
  relative price. That is, there is a reciprocal
  rate.
• Example
• To say that 1 2.5 (2.5 euros) implies that
  2.5 will buy 1
• Or
• 1 0.40
• Figure 11.1 shows foreign exchange rate
  quotations as they appear in the Wall Street
  Journal.

3
Price Quotation

• Insert Figure 11.1 here

4
Price Quotation

• Forward rates are the rates that you can contract
  today for the currency.
• If you buy a forward rate, you agree to pay the
  forward rate in 30 days to receive the currency
  in question.
• If you sell a forward rate, you agree to deliver
  the currency in question in receipt of the
  forward rate.
• The transactions are in the interbank market. The
  transactions are for 1,000,000 or more.
• One rate is the inverse of the other (e.g., /
  reverse of /).
• Using the previous example 1 2.5

5
CMEs Euro FX FuturesProduct Profile
6
Geographical and Cross-Rate Arbitrage

• Pricing relationships exist in the foreign
  exchange market. This sections explores two of
  these relationships and associated arbitrage
  opportunities
• Geographical Arbitrage
• Cross-Rate Arbitrage

7
Geographical Arbitrage

• Geographical arbitrage occurs when one currency
  sells for a different prices in two different
  markets.
• Example
• Suppose that the following exchange rates exist
  between German marks and U.S. dollars as quoted
  in New York and Frankfurt for 90-day forward
  rates
• New York / 0.42
• Frankfurt / 2.35
• To identify the opportunity for an arbitrage we
  can compute the inverse. From the price in New
  York, we can compute the appropriate exchange
  rate in Frankfurt.

8
Geographical Arbitrage

• If the transpose is equal to the price of the
  currency in another market, there is no
  opportunity for a geographic arbitrage.
• If the transpose is not equal to the price of the
  currency in another market, the opportunity for a
  geographic arbitrage exists. In this case

In New York, the / rate is 2.381, but in
Frankfurt it is 2.35. Thus, an arbitrage
opportunity exists. Table 11.1 shows how to
exploit this pricing discrepancy.
9
Geographical Arbitrage
10
Cross-Rate Arbitrage

• Cross-rate arbitrage, if present, allows you to
  exploit misalignments in cross rates. A
  cross-rate is the exchange rate between two
  currencies that is implied by the exchange on
  other currencies.
• Example
• In New York, there is a rate quoted for the U.S.
  dollar versus the euro. There is also a rate
  quoted for the U.S. dollar versus the British
  pound. Together these two rates imply a rate that
  should exist between the euro and the British
  pound that do not involve the dollar. This
  implied exchange rate is called the cross rate.
  Cross rates are reported in the Wall Street
  Journal.

Figure 11.2 shows quotations for cross rates from
the Wall Street Journal.
11
Cross-Rate Arbitrage

• Insert Figure 11.2 here

12
Cross-Rate Arbitrage

• If the direct rate quoted somewhere does not
  match the cross rate, an arbitrage opportunity
  exists.
• Suppose that we have the following 90-day forward
  rates. FS indicates the Swiss franc (FS)
• New York / 0.42
• /SF 0.49
• Frankfurt /SF 1.20
• The exchange rates quoted in New York imply the
  following cross rate in New York for the /SF

13
Cross-Rate Arbitrage

• Because the rate directly quoted in Frankfurt
  differs from the cross rate in New York, an
  arbitrage opportunity is present.
• Table 11.2 shows the transactions required to
  conduct the arbitrage.

14
Forward and Futures Market Characteristics

• The institutional structure of the foreign
  exchange futures market resembles that of the
  forward market, with a number of notable
  exceptions as shown in Table 11.3.

15
Determinants of Foreign Exchange Rates

• This section explores the following determinants
  of foreign exchange rates
• Balance of Payments
• Fixed Exchange Rates
• Other Exchange Rate Systems
• Freely Floating
• Managed Float or Dirty Float Policy
• Pegged Exchange Rate System
• Joint Float

16
Balance of Payments

• Balance of payments is the flow of payments
  between residents of one country and the rest of
  the world. This flow of payments affects exchange
  rates.
• The balance of payments encompasses all kinds of
  flows of goods and services among nations,
  including
• The movement of real goods
• Services
• International investment
• All types of financial flows
• Deficit Balance of Payment
• Expenditures by a particular country exceed
  receipts. A constant balance of payments deficit
  will cause the value of the countrys currency to
  fall.
• Surplus Balance of Payment
• Receipts by particular country exceed
  expenditures.

17
Fixed Exchange Rates

• Fixed Exchange Rates
• A fixed exchange rate is a stated exchange rate
  between two currencies at which anyone may
  transact.
• For a particular country, a continual excess of
  imports over exports puts pressure on the value
  of its currency as its world supply continues to
  grow.
• Eventually, the fixed exchange rate between the
  countrys currency and that of other nations must
  be adjusted either by devaluating or revaluating.
• Devaluation the value of the currency will fall
  relative to other countries.
• Revaluation the value of the currencies will
  increase relative to other countries.
• Exchange Risk
• The risk that the value of a currency will change
  relative to other currencies.
• Today a free market system of exchange rates
  prevails. Daily fluctuations exists in the
  exchange rates market.

18
Other Exchange Rates Systems

• Freely Floating
• A currency has no system of fixed exchange rates.
  The country's central bank does not influence the
  value of the currency by trading in the foreign
  exchange market.
• Managed Float or Dirty Float Policy
• The central bank of a country influences the
  exchange value of its currency, but the rate is
  basically a floating rate.
• Pegged Exchange Rate System
• The value of one currency might be pegged to the
  value of another currency, that itself floats.
• Joint Float
• In a joint float, currencies participating in the
  joint float have fixed exchange values relative
  to other currencies in the joint float, but the
  group of currencies floats relative to other
  currencies that do not participate in the joint
  float. This is particularly important for the
  foreign exchange futures market.

19
Future Price Parity Relationships

• In this section, other price relationships will
  be examined, including
• Interest Rate Parity Theorem (IRP)
• Purchasing Power Parity Theorem (PPP)

20
Interest Rate Parity Theorem

• The Interest Rate Parity Theorem states that
  interest rates and exchange rates form one
  system.
• Foreign exchange rates will adjust to ensure that
  a trader earns the same return by investing in
  risk-free instruments of any currency, assuming
  that the proceeds from investment are converted
  into the home currency by a forward contract
  initiated at the beginning of the holding period.
• To illustrate the interest rate parity, consider
  Table 11.4.

21
Interest Rate Parity Theorem

• If interest rate parity holds, you should earn
  exactly the same return by following either of
  two strategies
• Strategy 1
• Invest in the U.S. for 180 days with a current
  rate of 20
• Strategy 2
• Sell for euros () at the current rate (spot
  rate) of 0.42.
• Invest proceeds for 180 days in Germany with
  a current rate of 32.3 percent.
• Receive the proceeds of the German investment
  receiving ( 2.7386 in 180 days).
• Sell the proceeds of the German Investment for
  dollars through a 180-day forward contract
  initiated at the outset of the investment
  horizon for a rate of 0.40.

22
Interest Rate Parity Theorem

• Strategy 1
• Invest in the U.S. for 180 days. You will have
  the following in 6 months
• FV PV(1i)N
• Alternative notation
• FV DC (1RDC)
• FV 1(1.20)0.5
• FV 1.095

23
Interest Rate Parity Theorem

• Strategy 2
• Sell for euros () at the current rate (spot
  rate) or 0.42. You will receive

• Invest euro proceeds for 180 days in Germany
  with a current rate of 32.3 percent.
• FV PV(1i)N or FV DC (1RDC)
• 2.381(1.323)0.5
• 2.7386
• c) Receive the proceeds of the German
  Investment(receiving 2.7386 in 180 days). Take
  your euros out of bank.

24
Interest Rate Parity Theorem

• Strategy 2
• d) Sell the proceeds of the German investment for
  dollars through a 180-day forward contract
  initiated at the outset of the investment
  horizon for a rate of 0.40.
• U.S. (/)
• U.S. 2.7386 (0.40) or U.S. 1.09544
• This amount can be stated as

DC/FC the rate at which the domestic currency
can be converted to the foreign currency
today. rFC the rate that can be earned over
the time period of interest on the foreign
currency. F0,t the forward or futures contract
rate for conversion of the foreign currency
into the domestic currency.
25
Interest Rate Parity Theorem

• The two strategies produce the same return, so
  there is no arbitrage opportunity available. If
  the two produced different returns, an arbitrage
  strategy would be present.

26
Interest Rates Parity Theorem

• The equality between the two strategies can also
  be stated as
• DC(1 rDC) (DC/FC)(1 rFC)F0,t
• Where
• DC the dollar amount of the domestic currency
• rDC the rate that can be earned over the time
  period of interest on the domestic currency
• DC/FC the rate at which the domestic currency
  can be converted to the foreign currency
  today
• rFC the rate that can be earned over the time
  period of interest on the foreign currency
• Fo,t the forward or futures contract rate for
  conversion of the foreign currency into
  the domestic currency

27
Interest Rates Parity Theorem
Using the previous example
We can manipulate the equality to solve for other
variables

• The above equation says that, for a unit of
  foreign currency, the futures price equals the
  spot price of the foreign currency times the
  quantity

This quantity is the ratio of the interest factor
for the domestic currency to the interest factor
for the foreign currency.
28
Interest Rates Parity Theorem

• We can compare the last equation to the
  Cost-of-Carry Model in perfect markets with
  unrestricted short selling, we obtain

The cost of carry approximately equals the
difference between the domestic and foreign
interest rates for the period from t 0 to the
futures expiration. Applying this equation for
the 180-day horizon using the rates from Table
11.4. F0,t .40 S0 .42 rDC .095445 for
the half-year rFC .150217 for the
half-year The result is
29
Exploiting Deviations from Interest Rate Parity

• In the event that the two rates are not equal,
  the arbitrage that would be undertaken is
  referred to as covered interest arbitrage. Where
  we would borrow the 1 needed to undertake
  Strategy 2 above. If the rate earned on the
  investment is higher than the cost of borrowing
  the 1, an arbitrage profit can be earned. This
  is equivalent to cash-and-carry arbitrage.
• This cash-and-carry strategy is known as the
  covered interest arbitrage in the foreign
  exchange market.

30
Exploiting Deviations from Interest Rate Parity
If Interest Rate Parity (IRP), the exchange rate
equivalent of the Cost-of-Carry Model, holds the
trader must be left with zero funds. Otherwise an
arbitrage opportunity exists.
31
Exploiting Deviations from Interest Rate Parity

• Using the data from our previous example, Table
  11.5 shows the transactions that will exploit
  this discrepancy.

32
Purchasing Power Parity Theorem

• The Purchasing Power Parity Theorem (PPP) asserts
  that the exchange rates between two currencies
  must be proportional to the price level of traded
  goods in the two currencies. Violations of PPP
  can lead to arbitrage opportunities, such as the
  example of Tortilla Arbitrage shown in Table
  11.6.
• Assume that transportation and transaction costs
  are zero and that there are no trade barriers.
  The spot value of Mexican Peso (MP) is .10.

33
Purchasing Power Parity Theorem

• Over time, exchange rates must conform to PPP.
  Table 11.7 presents prices and exchange rates at
  two different times (PPP at t 0, PPP at t 1).

34
Speculation in Foreign Exchange Speculating with
an Outright Position

• Assume that today, April 7, a speculator has the
  following information about the exchange rates
  between the U.S. and the euro. Table 11.10 shows
  the exchange rates.
• Based on the exchange rate information, the
  market believes the euro will rise relative to
  the dollar. The speculator disagrees. The
  speculator believes that the price of the euro,
  in terms of dollars, will actually fall over the
  rest of the year.

35
Speculation in Foreign Exchange Speculating with
an Outright Position

• Table 11.11 shows the speculative transactions
  that the speculator enters to take advantage of
  her/his belief.

The speculators hunch was correct, and thus made
a profit.
36
Speculation in Foreign Exchange Speculating with
Spreads

• Spread strategies include intra-commodity and
  inter-commodity. Assume that a speculator
  believes that the Swiss franc will gain in value
  relative to the euro but is also uncertain about
  the future value of the dollar relative to either
  of these currencies.
• The speculator gathers market prices for June 24
  /C and /SF spot and future exchange rates.
  Table 11.12 summarizes the information.

37
Speculation in Foreign Exchange Speculating with
Spreads

• Table 11.13 shows the transactions that the
  speculator enters to exploit his/her belief that
  the December cross rate is too low.

38
Speculation in Foreign Exchange Speculating with
Spreads

• Assume that a speculator observes the spot and
  futures prices as shown in Table 11.14. The
  speculator observes that the prices are
  relatively constant, but believes that the
  British economy is even worse than generally
  appreciated. She anticipates that the British
  inflation rate will exceed the U.S. rate.
  Therefore, the trader expects the pound to fall
  relative to the dollar.

Because the speculator is risk averse, she
decides to trade a spread instead of an outright
position.
39
Speculation in Foreign Exchange Speculating with
Spreads

• Table 11.15 shows the transactions that the
  speculator enters to exploit her belief.

As a result of her conservatism, the profit is
only 150. Had the trader taken an outright
position by selling the MAR contract, the profit
would have been 517.50.
40
Hedging with Foreign Exchange FuturesHedging
Transaction Exposure

• You are planning a six-month trip to Switzerland.
  You plan to spend a considerable sum during this
  trip. You gather the information in Table 11.6.

After analyzing the data, you fear that spot
rates may rise even higher, so you decide to
lock-in the existing rates by buying Swiss franc
futures.
41
Hedging with Foreign Exchange FuturesHedging
Transaction Exposure

• Table 11.17 shows that transaction that you enter
  in order to lock in your exchange rate.

In this example, you had a pre-existing risk in
the foreign exchange market, since it was already
determined that you would acquire the Swiss
francs. By trading futures, you guaranteed a
price of .5134 per franc.
42
Hedging with Foreign Exchange FuturesHedging
Import/Export Transaction

• You, the owner of a import/export business, just
  finished negotiating a large purchase of 15,000
  Japanese watches from a firm in Japan. The
  Japanese company requires your payment in yens
  upon delivery. Delivery will take place in 6
  months. The price of the watches is set to Yen
  2850 per watch (todays yen exchange rate). Thus,
  you will have to pay Yen 42,750,000 in about
  seven months.
• You gather the information shown in Table 11.18.
  After analyzing the information, you fear that
  dollar may lose ground against the yen.

43
Hedging with Foreign Exchange FuturesHedging
Import/Export Transaction

• To avoid any worsening of your exchange position,
  you decide to hedge the transaction by trading
  foreign exchange futures. Table 11.19 shows the
  transactions.

Notice that because you were not able to fully
hedge your position, you still had a loss.
44
Hedging with Foreign Exchange FuturesHedging
Translation Exposure

• Many global corporations have subsidiaries that
  earn revenue in foreign currencies and remit
  their profits to a U.S. parent company. The U.S.
  parent reports its income in dollars, so the
  parent's reported earnings fluctuate with the
  exchange rate between the dollar and the currency
  of the foreign country in which the subsidiary
  operates. This necessity to restate foreign
  currency earnings in the domestic currency is
  called translation exposure.

45
Hedging with Foreign Exchange FuturesHedging
Translation Exposure

• The Schropp Trading Company of Neckarsulm, a
  subsidiary of an American firm, expects to earn
  4.3 million this year and plans to remit those
  funds to its American parent. The company gathers
  information about the euro exchange rates for
  January 2 and December 15 as shown in Table
  11.20.
• With the DEC futures trading at .4211 dollars per
  euro on January 2, the expected dollar value of
  those earnings is 1,810,730. If the euro falls,
  however, the actual dollar contribution to the
  earnings of the parent will be lower.

46
Hedging with Foreign Exchange FuturesHedging
Translation Exposure

• The firm can either hedge or leave unhedged the
  value of the earnings in euros, as Table 11.21
  shows.