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OSU BA 543 - Foreign Exchange Rate, Hedging and Arbitrage

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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 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/AUDPage  44Foreign 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  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 ($1.4287/€), which is the average of the bid-ask.Page  66Foreign Exchange Rates QuotationsSpot Exchange Rates:•current exchange rate, quotes for spot transactions (actually settled within 1 or 2 business days)Forward Exchange Rates:– an exchange rate quoted today for settlement at some future date.–Quotes for specified future transactions (3 business days and longer settlement).–Forward exchange rate allows businesses and investors to “lock” in an exchange rate for some future period of time.Page  77Forward exchange rate Forward exchange rate is calculated from three observable numbers:•The (current) spot rate•The foreign currency interest rate•The home currency interest rateForward exchange rate formulas is:FFC/USD=SFC/USD*(1+IFC)/(1+IUS)Page  88Foreign Exchange Rates QuotationsCross Rates–Exchange rate is determined through their relationship with third currency–Example: Citibank, Japan quotes  83.30/C$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  1010Hedging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  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 marketForward contracts allow businesses and investors to “lock” in an exchange rate for some future period of time.Page  1212Hedging with a Forward ContractUSD/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 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 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 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  1717Put 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 marketPage  1818Hedging 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 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 valueTwo 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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OSU BA 543 - Foreign Exchange Rate, Hedging and Arbitrage

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