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Currency
Currency
Currency
Objectives: to understand
The organization of the Foreign Exchange Market (FEM) and the distinction between spot and forward markets How to calculate forward premiums and discounts How forward markets can be used to reduce exchange risk The major participants the FEM and their motives
Fred Thompson
Organization of FEM
Interbank market (95% of transactions, 20 major banks)
Spot market [40%] Forward market [10%] Swaps [50%]
Fred Thompson
Participants
Brokers Arbitrageurs Traders Hedgers Speculators
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Fred Thompson
Sources of Risk
Transaction Exposure: The risk that the domestic cost or proceeds of a transaction may change. Translation Exposure: The risk that the translation of value of foreign-currency-denominated assets is affect by exchange rate changes. Economic Exposure: The risk that exchange rate changes may affect the present value of future income streams.
Fred Thompson
Fred Thompson
Hedging
There are a number of instruments that can be used to hedge foreign exchange risk. Chapter 8 deals with the forward markets, while Chapter 9 introduces foreign exchange futures, options, and swaps.
Fred Thompson
Forward Market
The forward market is the market for the future delivery of a currency. Typical maturity is 1, 3, 6, 9 and 12 months. The forward rate is determined by market participants expectations of the future spot value of the currency which, in turn, depends on other economic variables. Hence, the forward market may provide some information about future spot price movements.
Fred Thompson
Forward Premium
The difference between the spot and forward rates is expressed as the standard (or annualized) forward premium or discount. The standard premium is calculated as the difference between the two rates as a percent of the spot rate, which is then annualized (simple basis).
Fred Thompson
Example
For example, suppose the spot rate is 1.6035 ($/) and the 3-month forward rate is 1.6050. The forward premium on the pound is: [(1.6050-1.6035)/1.6035]*(12/3)*100 = 0.37%
Fred Thompson
Fred Thompson
Fred Thompson
Fred Thompson
Example Continued
Substitute the values into the condition:
[1+(0.0275/4)]=[1+(0.05625/4)](1.4641/1.4898)
(1.006875)=(1.0140625)(0.98275) 1.006875 > 0.99656 Would you want to borrow the dollar and lend the franc or vice versa?
Fred Thompson
Example Continued
Borrow one dollar at 1.40625% for three months. Buy Sfr1.4898 spot. Lend Sfr1.4898 at 0.6875%. Will receive: Sfr1.4898(1.006875) = Sfr1.5000. Sell Sfr1.5000 forward at 1.4641. Will receive: Sfr1.5000/1.4641 = $1.02452
Fred Thompson
Example Continued
Repay dollar loan at a cost of; $1(1.0140625) = $1.0140625. Profit of $1.02452 - $1.0140625 = $0.0105, or 1.05%.
Fred Thompson
Example
Suppose the 90-day U.S. interest rate is 5.5% while the U.K. rate on a similar instrument is 5.0% (both expressed as annual rates). The current spot rate is 1.4546 ($/) and the threemonth forward rate is 1.4900. To use the uncovered interest parity condition, we must convert the interest rates to quarterly values: (0.055)/(12/3) = 0.01375 and (0.05)/(12/3) = 0.0125.
Fred Thompson
Example
Now substitute the values into the CIP condition: 0.01375 - 0.0125 = (1.4900-1.4546)/1.4546, 0.00125 < 0.0243. Though the interest rate on the U.S. instrument is higher than that on the U.K. instrument, the difference is outweighed by the depreciation (forward discount) of the dollar over the time interval.
Fred Thompson
Conclusion
Our finding for the previous example indicates that funds would flow from the United States to the United Kingdom. This flow of funds would affect interest rates in both countries, the forward exchange rate, and/or the spot rate.
Fred Thompson
(FN-S)/S
Funds Flow to the Foreign Economy 45o
Previous example
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Fred Thompson
S1
S0 D D
Q0
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Q1
Quantity
S
F0 F1 D
Q0
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Q1
Quantity
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Q1
QuantityLF
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SLF
R1 R0 DLF Q1
Fred Thompson
Q0
QuantityLF
Fred Thompson
Fred Thompson
Fred Thompson
Se
Funds Flow to the Foreign Economy 45o
Fred Thompson
Example
Suppose the the spot rate of exchange between the dollar and the pound is 1.664 $/. The interest rate on a 3-month U.S. financial instrument is 5.5 percent and the interest rate on a similar U.K. financial instrument is 6.5 percent.
Fred Thompson
Example
Using the formula
Se+1 = S(1+R)/(1+R*), the expected spot rate is: Se+1 = 1.664(1.01375)/(1.01625) = 1.6599. Suppose the actual rate is 1.60. UIP, therefore, indicates that the pound is undervalued.
Fred Thompson