Foreign Exchange Theory

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Foreign Exchange Theory

• Session 1
• Introduction to Derivatives

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Scenario 1

• You are based in the US and exporting Shinjo (NY
  Mets) and Ichiro (Seattle Mariners) T-shirts to
  Japan.
• From your marketing research you expect to price
  the T-shirts at 3,000 yen. Consumer demand is
  expected to be 10,000 T-shirts. Expected revenue
  is 10,000 x 3,000yen 30 million yen. Revenue is
  expected one month from today.
• The current exchange rate is 125 yen/dollar.
• What should we do?

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Scenario 2

• We have borrowed 100 million yen and must pay
  interest at a fixed rate of 5 per year (????).
  The loan is for ten years. Thus, interest
  payments are fixed each year at 0.05 x 100
  million yen 5 million yen.
• However, we would like to pay interest based on a
  floating rate (?????). In other words, the
  interest payments change each year depending on
  the current interest rate.
• What should we do?

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Derivatives ( ???????????)

• A derivative (or derivative security) is a
  financial instrument whose value depends on the
  values of other, more basic underyling variables.
  (Hull, p.1)
• ?????????????????????(??)????(??????)???
  (????)????????????????????????????????????????????
  ???????????????????? (????2001?p 234)

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Derivative Contract Traded separately
from Underlying asset Example option on Sony
Stock
Underlying Asset Sony stock- traded on Stock
Exchange (TSE)
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Instruments and Markets

• Options Contracts (???????)
• Forward Contracts (????)
• Futures Contracts (????)
• Swap Contracts (??????)

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Underlying Assets (????????)

• Commodities (foods) such as Rice and Wheat
• Metals such as Gold
• Commodities (natural resources) such as Oil and
  Gas
• Foreign Exchange Rates (Currency) Yen, DM, etc.
• Individual Stocks (??????)
• Bonds (?????)
• Stock Indices such as SP 500, TOPIX, etc. (????)
• Electricity
• Weather
• Emission Permits (SO2, CO2 near future?)(???)

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Why Derivatives?
1) Reduce Financial Risk Combine instruments to
reduce risk. Say a Japanese fund manager invests
in a US stock such as IBM. Then the
investor faces or is exposed to several financial
(price) risks. Exposure includes, 1) IBM stock
price, 2) US stock market, 3) Yen/US dollar
exchange rate. The investor could neutralize
some of the risks by entering futures contracts
for the SP500 and currency. 2) Leverage Cost
savings in transaction costs. For example, to
take a position in a currency, index, and/or
bond, you only need to put-up margin.
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3) Informational Efficiency (?????) Harry
Roberts-Eugene Fama Market Efficiency Weak Form
prices, volume Semi-strong Form all public
information Strong Form all public and private
Joint Hypothesis Market Efficiency and Correct
Model Correct model in our context example,
volatility models, Black-Scholes-Merton option
pricing model.
Does derivative (trading) provide us with
(valuable) information on the underlying spot
market and/or other derivative securities markets?
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Nikkei 225 Futures MarketHiraki, Maberly,
Takezawa (J. Banking and Finance, 1995)

• Trading in futures market usually extend beyond
  that of the spot market by 10-15 minutes.
• On the Osaka exchange, the Nikkei futures traded
  until 315 - 15 minutes beyond the spot market.
• Oct. 2, 1990 Futures extended trading reduced to
  10 minutes. This feature is eliminated Feb. 7,
  1992. Does extended trading period result in
  speculative trading.
• We show that the information generated from the
  extended period contains useful information.

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RISK
Business Risk
Market Risk
Financial Risk
Credit Risk, other risks
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Market Risk???????

• Also referred to as price risk.
• This risk comes from a change in price. The
  price change of financial assets and liabilities
  (underlying asset prices).
• The change in price is often referred to as
  volatility (variability of the price).

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• Some of these derivatives can only be purchased
  from a financial institution (or corporate).
• Some of these derivatives can only be purchased
  on an organized exchange.
• Well known exchanges are 1) Chicago Board of
  Trade (CBOT) (www.cbot.com) and 2) Chicago
  Mercantile Exchange (CME) (www.cme.com)
• Tokyo Stock Exchange (TSE) (www.tse.or.jp) stock
  options for 167 different companies as of April
  2001, TOPIX options (?????), TOPIX futures
  (??),JGB futures (?????), options on JGB futures.

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• Futures on the Nikkei 225 Index (????????) are
  traded at the Singapore International Monetary
  Exchange (SIMEX), Chicago Mercantile Exchange
  (CME), Osaka Securities Exchange (OSE)
• Future (or rough equivalent) were traded in Japan
  during the Edo Period. Rice Futures Exchange
  (Dojima) in Osaka ????? established in 1730.