FINA2330 tutorial 8

International finance and derivatives

Currency board: monetary policy
Hong Kong adopts currency board, where 1
USD corresponds to 7.75 – 7.85 HKD
HKMA intervenes whenever the exchange rate
reaches the boundary. Currently HKD is
overvalued, so HKMA needs to sell USD
denominated assets and purchase HKD to stop
depreciation. International reserve balance has
decreased significantly.
Little flexibility in implementing monetary policies
Policy trilemma
 Why it is impossible to enjoy the advantages of these
three features together?
1. Flexibility in monetary policy
2. Freedom in capital flow
3. Fixed exchange rate

 HKD has 2 and 3,

 USD, EUR and JPY have 1 and 2.
 CNY: 1 and partially 3 (restrictions in CNY holdings
abroad, managed float)
1992 Sterling crisis
 GBP pegged to Deutsche Mark from 1990, but broken by
September 1992 due to strong depreciation pressure at
the UK:
 Very high inflation rate relative to Germany
 Reluctance to raise interest rate due to risk of recession
 Reluctance for Germany to lower interest rates
 Expecting depreciation, George Soros shorted billions of
GBP, forcing intervention from Bank of England. Soros
eventually succeeded and profits from depreciation.
Forward vs futures
 Both involves purchasing the underlying at a fixed price
by expiration date, useful in hedging risks.
 Forward is a private agreement between two parties
 Future is a standardized agreement, tradable in
exchanges, investors enjoy much higher liquidity and
lower default risk in general
 Futures more popular than forwards nowadays.
How to hedge interest rate risks

 Treasury bond futures

 Forward price determined by the initiation of contract.
No payments settled at the time.
 When time to expiration is reached, if T-bond price
higher exceeds the forward price, long position holder
receives the price difference from short position holder.
 If T-bond price lower than forward price, long position
holder pays the price difference to short position holder.
How to hedge interest rate risks

 If your assets worth less with increasing interest rates,

which position should you engage in T-bond futures to
hedge the interest rate risks? Explain.
How to hedge interest rate risks

 You may hedge the interest rate risk by short positions in

T-bond futures.
 You receive money when interest rate rises in the future,
where the T-bond price is lower than the forward price.
You will be compensated with the price difference.
 You will be worse off than not hedging if interest rate
drops in the future. Nevertheless, your position will face
less uncertainty with respect to uncertain interest rates.
Practice Question 8 Q2

Policymakers may not want to see their country's currency

appreciate because
A) this would hurt consumers in their country by making
foreign goods more expensive.
B) this would hurt domestic businesses by making foreign
goods cheaper in their country.
C) this would increase inflation in their country.
D) this would decrease the wealth of the country.
Practice Question 8 Q8

Who would be most likely to buy a long stock index future?

A) A mutual fund manager who believes the market will
rise
B) A mutual fund manager who believes the market will fall
C) A mutual fund manager who believes the market will
be stable
D) None of the above would be likely to purchase a
futures contract
Practice Question 8 Q9
If a firm is due to be paid in euros in two months, to hedge
against exchange rate risk the firm should
A) sell foreign exchange futures short.
B) buy foreign exchange futures long.
C) stay out of the exchange futures market.
D) do none of the above.
Practice Question 8 Q13
By the end of 2012, China had accumulated more than $3
trillion of international reserves. How did China accomplish
this? Is the policy sustainable?