Foreign Exchange Rate Hedging and Arbitrage Na Yang Foreign exchange rate A foreign exchange rate is the price of one country s currency in units of another country s currency and it refers to as the value of a country s currency in terms of another country s currency Traded currency appear in pairs the most popular currency pairs are USD EUR USD JPY USD GBP and USD AUD Page 3 3 Foreign Exchange Rates Quotations Any two currencies Direct vs Indirect Direct HC FC eg 1 4287 is a direct quotation for a US investor Indirect FC HC eg 1 4287 is an indirect quotation for an Irish investor Dollar American vs European American FC e g 1 62 pound European FC e g 82 yen Page 4 4 Foreign Exchange Rates Quotations Bid and Ask Quotations Interbank quotes are given as a bid and ask The bid is the price at which a dealer is willing buy another currency The ask is the price at which a dealer will sell another currency Example USD EUR 1 4286 88 is the bid ask for Euro Exchange rate is usually quoted in mid rates 1 4287 which is the average of the bid ask Page 5 5 Foreign Exchange Rates Quotations Spot Exchange Rates current exchange rate quotes for spot transactions actually settled within 1 or 2 business days Forward Exchange Rates an exchange rate quoted today for settlement at some future date Quotes for specified future transactions 3 business days and longer settlement Forward exchange rate allows businesses and investors to lock in an exchange rate for some future period of time Page 6 6 Forward exchange rate Forward exchange rate is calculated from three observable numbers The current spot rate The foreign currency interest rate The home currency interest rate Forward exchange rate formulas is FFC USD SFC USD 1 IFC 1 IUS Page 7 7 Foreign Exchange Rates Quotations Cross Rates Exchange rate is determined through their relationship with third currency Example Citibank Japan quotes 83 30 C Bank of Canada quotes 0 72 C Cross Rate JPY EUR 83 30 C 0 72 C 115 69 Page 8 8 Triangular Arbitrage Example Citibank Japan quotes 83 30 C Bank of Canada quotes 0 72 C Bank of Finland quotes End 1 002M 115 45 115 694 M Page 9 115 45 Begin 1 million 0 72 C C 83 30 C C 1 39 M 9 Hedging Hedging is the practice of taking a position either through acquiring a cash flow an asses or a contract a forward contract a future contract to offset and balance against the value in an existing position Why Hedging Page 10 10 Hedging with a Forward Contract A currency forward contract is an agreement that two parties agree to buy and sell a certain amount of a foreign currency at a specific price and predetermined future date Forward contracts are traded in the over the counter market Forward contracts allow businesses and investors to lock in an exchange rate for some future period of time Page 11 11 Hedging with a Forward Contract USD GBP Country Currency Wed Tues UK pound 1 6158 1 6231 1 mos forward 1 6225 1 6152 3 mos forward 1 6211 1 6138 6 mos forward 1 6187 1 6115 Page 12 12 Hedging with a Future Contract A currency future contract is very similar to a forward contract Currency future contracts are traded on organized exchanges Chicago Mercantile Exchange Currency future contracts are standardized settled through exchange s clearinghouse and the contracts are marked to market each day according to their market value Maturities are based on a quarterly cycle of March June September and December Page 13 13 Hedging with a Future Contract Page 14 14 Currency Futures and Forward Compared Characteristic Currency Futures Currency Forward Size of Contract Standard contracts per currency Any size desired Pricing Open outcry process on the exchange floor Prices are determined by bid and ask quotes Margin Collateral Initial margin is marked to market on a daily basis No explicit collateral standard banking relationship needed Settlement Rarely delivered upon settlement normally takes place through purchasing of offsetting position Normally delivered upon Counterparties unknown to each other Parties are in direct contact Liquidity Liquid but relatively small in total sales volume and value Liquid but relatively large in total sales volume and value Page 15 15 Hedging with a Currency Option A currency option contract gives buyers the right not the obligation to buy or sell a given amount of foreign currency at a fixed price for a specific time period Currency options are traded both on organized exchanges and over the counter market It provides opportunities for buyer to benefit from favorable exchange rate movement and has maximum loss of option premium Page 16 16 Put Option Contract Put Option Contract to sell 1 million pound in six months The strike price is 1 62 the premium is 1 7 cent in the contract Cost of Option 17 000 If spot exchange rate at maturity is less than or equal to 1 62 exercise and receive 1 62 million If the spot exchange rate at maturity is more than 1 62 not exercise and sell in the spot market Page 17 17 Hedging with Currency Swap A currency swap is an agreement between two parties to exchange a given amount of one currency for equivalent amount of another In a currency swap both the principle and interests are exchanged Three stages 1 the principals are exchange at the spot exchange rate 2 interest payments are exchanged on each coupon date 3 the principals are re exchanged at the swap s maturity Page 18 18 Take aways Hedging can reduce uncertainty and risks but reduce risk doesn t mean add value Two criteria help a market participant to choose strategy 1 the risk tolerance the participant can assume 2 anticipation for the direction and distance of the exchange rate Page 19 19 Questions Page 20 20 Reference 5 10 2011 Foreign exchange market http en wikipedia org wiki Foreign exchange market Moffett Michael Arthur Stonehill and David Eiteman Fundamentals of multinational finance 2nd Addison Wesley 2005 Print 5 10 2011 Hedging Finance http en wikipedia org wiki Hedge finance 4 28 2011 Foreign exchange Forwards and Futures http thismatter com money forex fx forwards htm 5 18 2011 Exchange Rates New York Closing Snapshot http online wsj com mdc public page 2 3021 forex 20110518 html mod mdc pastcalendar 5 10 2011 Currency Futures http en wikipedia org wiki Currency future 5 18 2011 Currency futures http online wsj com mdc public page 2 3023 fut currency futures 20110518 html mod mdc pastcalendar 5 18 2011 Arbitrage http en wikipedia org wiki Arbitrage 5 18 2011 Foreign exchange rate http www citibank co jp en