Slide 1Foreign exchange rateForeign Exchange Rates QuotationsForeign Exchange Rates QuotationsForeign Exchange Rates QuotationsForward exchange rateForeign Exchange Rates QuotationsTriangular ArbitrageHedgingHedging with a Forward ContractHedging with a Forward ContractHedging with a Future ContractHedging with a Future ContractCurrency Futures and Forward ComparedHedging with a Currency OptionPut Option ContractHedging with Currency SwapTake-awaysQuestionsReferenceForeign Exchange Rate, Hedging and ArbitrageNa YangPage 33Foreign exchange rateA 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/AUDPage 44Foreign Exchange Rates QuotationsAny 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 investorDollar: American vs. European ·American: $/FC (e.g. 1.62 $/pound)·European: FC/$ (e.g. 82 yen/$)Page 55Foreign Exchange Rates QuotationsBid 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 ($1.4287/€), which is the average of the bid-ask.Page 66Foreign Exchange Rates QuotationsSpot Exchange Rates:•current exchange rate, quotes for spot transactions (actually settled within 1 or 2 business days)Forward Exchange Rates:– an exchange rate quoted today for settlement at some future date.–Quotes for specified future transactions (3 business days and longer settlement).–Forward exchange rate allows businesses and investors to “lock” in an exchange rate for some future period of time.Page 77Forward exchange rate Forward exchange rate is calculated from three observable numbers:•The (current) spot rate•The foreign currency interest rate•The home currency interest rateForward exchange rate formulas is:FFC/USD=SFC/USD*(1+IFC)/(1+IUS)Page 88Foreign Exchange Rates QuotationsCross Rates–Exchange rate is determined through their relationship with third currency–Example: Citibank, Japan quotes 83.30/C$Bank of Canada quotes € 0.72 /C$Cross Rate JPY/EUR = 83.30/C$/ € 0.72 /C$= 115.69/€Page 99Triangular ArbitrageExample:Citibank, Japan quotes 83.30/C$Bank of Canada quotes € 0.72 /C$Bank of Finland quotes 115.45/€ €C$€ 0.72 /C$ 83.30/C$ 115.45/€Begin:€ 1 millionC$ 1.39 M 115.694 MEnd:€1.002MPage 1010HedgingHedging 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 positionWhy Hedging?Page 1111Hedging 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 marketForward contracts allow businesses and investors to “lock” in an exchange rate for some future period of time.Page 1212Hedging with a Forward ContractUSD/GBPCountry/Currency Wed TuesUK pound 1.6231 1.61581-mos forward 1.6225 1.61523-mos forward 1.6211 1.61386-mos forward 1.6187 1.6115Page 1313Hedging with a Future ContractA currency future contract is very similar to a forward contractCurrency future contracts are traded on organized exchanges. Chicago Mercantile ExchangeCurrency future contracts are standardized, settled through exchange's clearinghouse and the contracts are marked to market each day according to their market valueMaturities are based on a quarterly cycle of March, June, September and DecemberPage 1414Hedging with a Future ContractPage 1515Currency Futures and Forward ComparedCharacteristic Currency Futures Currency ForwardSize of Contract Standard contracts per currencyAny size desiredPricing Open outcry process on the exchange floorPrices are determined by bid and ask quotesMargin/Collateral Initial margin is marked to market on a daily basisNo explicit collateral, standard banking relationship needed.Settlement Rarely delivered upon;settlement normally takes place through purchasing of offsetting positionNormally delivered uponCounterparties unknown to each other Parties are in direct contactLiquidity Liquid but relatively small in total sales volume and valueLiquid but relatively large in total sales volume and valuePage 1616Hedging with a Currency OptionA 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 periodCurrency 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 1717Put Option ContractPut Option Contract to sell ₤1 million pound in six monthsThe 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 marketPage 1818Hedging with Currency SwapA currency swap is an agreement between two parties to exchange a given amount of one currency for equivalent amount of anotherIn a currency swap both the principle and interests are exchangedThree stages:1)the principals are exchange at the spot exchange rate2) interest payments are exchanged on each coupon date3)the principals are re-exchanged at the swap's maturityPage 1919Take-aways Hedging can reduce uncertainty and risks, but reduce risk doesn't mean add valueTwo criteria help a market participant to choose strategy1.the risk tolerance the participant can assume 2.anticipation for the direction and distance of the exchange rate.Page 2020QuestionsPage
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