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CHAPTER 11 Foreign Exchange Futures

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Determinants of Foreign Exchange Rates. Futures Price Parity ... Figure 11.1 shows foreign exchange rate quotations as they appear in the Wall Street Journal. ... – PowerPoint PPT presentation

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Title: CHAPTER 11 Foreign Exchange Futures


1
CHAPTER 11 Foreign Exchange Futures
  • In this chapter, we discuss foreign exchange
    futures. This chapter is organized as follows
  • Price Quotations
  • Geographical and Cross-Rate Arbitrage
  • Forward and Futures Market Characteristics
  • Determinants of Foreign Exchange Rates
  • Futures Price Parity Relationships
  • Speculation in Foreign Exchange Futures
  • Hedging with Foreign Exchange Futures

2
Price Quotation
  • In the foreign exchange market, every price is a
    relative price. That is, there is a reciprocal
    rate.
  • Example
  • To say that 1 2.5 (2.5 euros) implies that
    2.5 will buy 1
  • Or
  • 1 0.40
  • Figure 11.1 shows foreign exchange rate
    quotations as they appear in the Wall Street
    Journal.

3
Price Quotation
  • Insert Figure 11.1 here

4
Price Quotation
  • Forward rates are the rates that you can contract
    today for the currency.
  • If you buy a forward rate, you agree to pay the
    forward rate in 30 days to receive the currency
    in question.
  • If you sell a forward rate, you agree to deliver
    the currency in question in receipt of the
    forward rate.
  • The transactions are in the interbank market. The
    transactions are for 1,000,000 or more.
  • One rate is the inverse of the other (e.g., /
    reverse of /).
  • Using the previous example 1 2.5

5
CMEs Euro FX Futures Product Profile
6
Geographical and Cross-Rate Arbitrage
  • Pricing relationships exist in the foreign
    exchange market. This sections explores two of
    these relationships and associated arbitrage
    opportunities
  • Geographical Arbitrage
  • Cross-Rate Arbitrage

7
Geographical Arbitrage
  • Geographical arbitrage occurs when one currency
    sells for a different prices in two different
    markets.
  • Example
  • Suppose that the following exchange rates exist
    between German marks and U.S. dollars as quoted
    in New York and Frankfurt for 90-day forward
    rates
  • New York / 0.42
  • Frankfurt / 2.35
  • To identify the opportunity for an arbitrage we
    can compute the inverse. From the price in New
    York, we can compute the appropriate exchange
    rate in Frankfurt.

8
Geographical Arbitrage
  • If the transpose is equal to the price of the
    currency in another market, there is no
    opportunity for a geographic arbitrage.
  • If the transpose is not equal to the price of the
    currency in another market, the opportunity for a
    geographic arbitrage exists. In this case

In New York, the / rate is 2.381, but in
Frankfurt it is 2.35. Thus, an arbitrage
opportunity exists. Table 11.1 shows how to
exploit this pricing discrepancy.
9
Geographical Arbitrage
10
Cross-Rate Arbitrage
  • Cross-rate arbitrage, if present, allows you to
    exploit misalignments in cross rates. A
    cross-rate is the exchange rate between two
    currencies that is implied by the exchange on
    other currencies.
  • Example
  • In New York, there is a rate quoted for the U.S.
    dollar versus the euro. There is also a rate
    quoted for the U.S. dollar versus the British
    pound. Together these two rates imply a rate that
    should exist between the euro and the British
    pound that do not involve the dollar. This
    implied exchange rate is called the cross rate.
    Cross rates are reported in the Wall Street
    Journal.

Figure 11.2 shows quotations for cross rates from
the Wall Street Journal.
11
Cross-Rate Arbitrage
  • Insert Figure 11.2 here

12
Cross-Rate Arbitrage
  • If the direct rate quoted somewhere does not
    match the cross rate, an arbitrage opportunity
    exists.
  • Suppose that we have the following 90-day forward
    rates. FS indicates the Swiss franc (FS)
  • New York / 0.42
  • /SF 0.49
  • Frankfurt /SF 1.20
  • The exchange rates quoted in New York imply the
    following cross rate in New York for the /SF

13
Cross-Rate Arbitrage
  • Because the rate directly quoted in Frankfurt
    differs from the cross rate in New York, an
    arbitrage opportunity is present.
  • Table 11.2 shows the transactions required to
    conduct the arbitrage.

14
Forward and Futures Market Characteristics
  • The institutional structure of the foreign
    exchange futures market resembles that of the
    forward market, with a number of notable
    exceptions as shown in Table 11.3.

15
Determinants of Foreign Exchange Rates
  • This section explores the following determinants
    of foreign exchange rates
  • Balance of Payments
  • Fixed Exchange Rates
  • Other Exchange Rate Systems
  • Freely Floating
  • Managed Float or Dirty Float Policy
  • Pegged Exchange Rate System
  • Joint Float

16
Balance of Payments
  • Balance of payments is the flow of payments
    between residents of one country and the rest of
    the world. This flow of payments affects exchange
    rates.
  • The balance of payments encompasses all kinds of
    flows of goods and services among nations,
    including
  • The movement of real goods
  • Services
  • International investment
  • All types of financial flows
  • Deficit Balance of Payment
  • Expenditures by a particular country exceed
    receipts. A constant balance of payments deficit
    will cause the value of the countrys currency to
    fall.
  • Surplus Balance of Payment
  • Receipts by particular country exceed
    expenditures.

17
Fixed Exchange Rates
  • Fixed Exchange Rates
  • A fixed exchange rate is a stated exchange rate
    between two currencies at which anyone may
    transact.
  • For a particular country, a continual excess of
    imports over exports puts pressure on the value
    of its currency as its world supply continues to
    grow.
  • Eventually, the fixed exchange rate between the
    countrys currency and that of other nations must
    be adjusted either by devaluating or revaluating.
  • Devaluation the value of the currency will fall
    relative to other countries.
  • Revaluation the value of the currencies will
    increase relative to other countries.
  • Exchange Risk
  • The risk that the value of a currency will change
    relative to other currencies.
  • Today a free market system of exchange rates
    prevails. Daily fluctuations exists in the
    exchange rates market.

18
Other Exchange Rates Systems
  • Freely Floating
  • A currency has no system of fixed exchange rates.
    The country's central bank does not influence the
    value of the currency by trading in the foreign
    exchange market.
  • Managed Float or Dirty Float Policy
  • The central bank of a country influences the
    exchange value of its currency, but the rate is
    basically a floating rate.
  • Pegged Exchange Rate System
  • The value of one currency might be pegged to the
    value of another currency, that itself floats.
  • Joint Float
  • In a joint float, currencies participating in the
    joint float have fixed exchange values relative
    to other currencies in the joint float, but the
    group of currencies floats relative to other
    currencies that do not participate in the joint
    float. This is particularly important for the
    foreign exchange futures market.

19
Future Price Parity Relationships
  • In this section, other price relationships will
    be examined, including
  • Interest Rate Parity Theorem (IRP)
  • Purchasing Power Parity Theorem (PPP)

20
Interest Rate Parity Theorem
  • The Interest Rate Parity Theorem states that
    interest rates and exchange rates form one
    system.
  • Foreign exchange rates will adjust to ensure that
    a trader earns the same return by investing in
    risk-free instruments of any currency, assuming
    that the proceeds from investment are converted
    into the home currency by a forward contract
    initiated at the beginning of the holding period.
  • To illustrate the interest rate parity, consider
    Table 11.4.

21
Interest Rate Parity Theorem
  • If interest rate parity holds, you should earn
    exactly the same return by following either of
    two strategies
  • Strategy 1
  • Invest in the U.S. for 180 days with a current
    rate of 20
  • Strategy 2
  • Sell for euros () at the current rate (spot
    rate) of 0.42.
  • Invest proceeds for 180 days in Germany with
    a current rate of 32.3 percent.
  • Receive the proceeds of the German investment
    receiving ( 2.7386 in 180 days).
  • Sell the proceeds of the German Investment for
    dollars through a 180-day forward contract
    initiated at the outset of the investment
    horizon for a rate of 0.40.

22
Interest Rate Parity Theorem
  • Strategy 1
  • Invest in the U.S. for 180 days. You will have
    the following in 6 months
  • FV PV(1i)N
  • Alternative notation
  • FV DC (1RDC)
  • FV 1(1.20)0.5
  • FV 1.095

23
Interest Rate Parity Theorem
  • Strategy 2
  • Sell for euros () at the current rate (spot
    rate) or 0.42. You will receive
  • Invest euro proceeds for 180 days in Germany
    with a current rate of 32.3 percent.
  • FV PV(1i)N or FV DC (1RDC)
  • 2.381(1.323)0.5
  • 2.7386
  • c) Receive the proceeds of the German
    Investment (receiving 2.7386 in 180 days). Take
    your euros out of bank.

24
Interest Rate Parity Theorem
  • Strategy 2
  • d) Sell the proceeds of the German investment for
    dollars through a 180-day forward contract
    initiated at the outset of the investment
    horizon for a rate of 0.40.
  • U.S. (/)
  • U.S. 2.7386 (0.40) or U.S. 1.09544
  • This amount can be stated as

DC/FC the rate at which the domestic currency
can be converted to the foreign currency
today. rFC the rate that can be earned over
the time period of interest on the foreign
currency. F0,t the forward or futures contract
rate for conversion of the foreign currency
into the domestic currency.
25
Interest Rate Parity Theorem
  • The two strategies produce the same return, so
    there is no arbitrage opportunity available. If
    the two produced different returns, an arbitrage
    strategy would be present.

26
Interest Rates Parity Theorem
  • The equality between the two strategies can also
    be stated as
  • DC(1 rDC) (DC/FC)(1 rFC)F0,t
  • Where
  • DC the dollar amount of the domestic currency
  • rDC the rate that can be earned over the time
    period of interest on the domestic currency
  • DC/FC the rate at which the domestic currency
    can be converted to the foreign currency
    today
  • rFC the rate that can be earned over the time
    period of interest on the foreign currency
  • Fo,t the forward or futures contract rate for
    conversion of the foreign currency into
    the domestic currency

27
Interest Rates Parity Theorem
Using the previous example
We can manipulate the equality to solve for other
variables
  • The above equation says that, for a unit of
    foreign currency, the futures price equals the
    spot price of the foreign currency times the
    quantity

This quantity is the ratio of the interest factor
for the domestic currency to the interest factor
for the foreign currency.
28
Interest Rates Parity Theorem
  • We can compare the last equation to the
    Cost-of-Carry Model in perfect markets with
    unrestricted short selling, we obtain

The cost of carry approximately equals the
difference between the domestic and foreign
interest rates for the period from t 0 to the
futures expiration. Applying this equation for
the 180-day horizon using the rates from Table
11.4. F0,t .40 S0 .42 rDC .095445 for
the half-year rFC .150217 for the
half-year The result is
29
Exploiting Deviations from Interest Rate Parity
  • In the event that the two rates are not equal,
    the arbitrage that would be undertaken is
    referred to as covered interest arbitrage. Where
    we would borrow the 1 needed to undertake
    Strategy 2 above. If the rate earned on the
    investment is higher than the cost of borrowing
    the 1, an arbitrage profit can be earned. This
    is equivalent to cash-and-carry arbitrage.
  • This cash-and-carry strategy is known as the
    covered interest arbitrage in the foreign
    exchange market.

30
Exploiting Deviations from Interest Rate Parity
If Interest Rate Parity (IRP), the exchange rate
equivalent of the Cost-of-Carry Model, holds the
trader must be left with zero funds. Otherwise an
arbitrage opportunity exists.
31
Exploiting Deviations from Interest Rate Parity
  • Using the data from our previous example, Table
    11.5 shows the transactions that will exploit
    this discrepancy.

32
Purchasing Power Parity Theorem
  • The Purchasing Power Parity Theorem (PPP) asserts
    that the exchange rates between two currencies
    must be proportional to the price level of traded
    goods in the two currencies. Violations of PPP
    can lead to arbitrage opportunities, such as the
    example of Tortilla Arbitrage shown in Table
    11.6.
  • Assume that transportation and transaction costs
    are zero and that there are no trade barriers.
    The spot value of Mexican Peso (MP) is .10.

33
Purchasing Power Parity Theorem
  • Over time, exchange rates must conform to PPP.
    Table 11.7 presents prices and exchange rates at
    two different times (PPP at t 0, PPP at t 1).

34
Speculation in Foreign Exchange Speculating with
an Outright Position
  • Assume that today, April 7, a speculator has the
    following information about the exchange rates
    between the U.S. and the euro. Table 11.10 shows
    the exchange rates.
  • Based on the exchange rate information, the
    market believes the euro will rise relative to
    the dollar. The speculator disagrees. The
    speculator believes that the price of the euro,
    in terms of dollars, will actually fall over the
    rest of the year.

35
Speculation in Foreign Exchange Speculating with
an Outright Position
  • Table 11.11 shows the speculative transactions
    that the speculator enters to take advantage of
    her/his belief.

The speculators hunch was correct, and thus made
a profit.
36
Speculation in Foreign Exchange Speculating with
Spreads
  • Spread strategies include intra-commodity and
    inter-commodity. Assume that a speculator
    believes that the Swiss franc will gain in value
    relative to the euro but is also uncertain about
    the future value of the dollar relative to either
    of these currencies.
  • The speculator gathers market prices for June 24
    /C and /SF spot and future exchange rates.
    Table 11.12 summarizes the information.

37
Speculation in Foreign Exchange Speculating with
Spreads
  • Table 11.13 shows the transactions that the
    speculator enters to exploit his/her belief that
    the December cross rate is too low.

38
Speculation in Foreign Exchange Speculating with
Spreads
  • Assume that a speculator observes the spot and
    futures prices as shown in Table 11.14. The
    speculator observes that the prices are
    relatively constant, but believes that the
    British economy is even worse than generally
    appreciated. She anticipates that the British
    inflation rate will exceed the U.S. rate.
    Therefore, the trader expects the pound to fall
    relative to the dollar.

Because the speculator is risk averse, she
decides to trade a spread instead of an outright
position.
39
Speculation in Foreign Exchange Speculating with
Spreads
  • Table 11.15 shows the transactions that the
    speculator enters to exploit her belief.

As a result of her conservatism, the profit is
only 150. Had the trader taken an outright
position by selling the MAR contract, the profit
would have been 517.50.
40
Hedging with Foreign Exchange Futures Hedging
Transaction Exposure
  • You are planning a six-month trip to Switzerland.
    You plan to spend a considerable sum during this
    trip. You gather the information in Table 11.6.

After analyzing the data, you fear that spot
rates may rise even higher, so you decide to
lock-in the existing rates by buying Swiss franc
futures.
41
Hedging with Foreign Exchange Futures Hedging
Transaction Exposure
  • Table 11.17 shows that transaction that you enter
    in order to lock in your exchange rate.

In this example, you had a pre-existing risk in
the foreign exchange market, since it was already
determined that you would acquire the Swiss
francs. By trading futures, you guaranteed a
price of .5134 per franc.
42
Hedging with Foreign Exchange Futures Hedging
Import/Export Transaction
  • You, the owner of a import/export business, just
    finished negotiating a large purchase of 15,000
    Japanese watches from a firm in Japan. The
    Japanese company requires your payment in yens
    upon delivery. Delivery will take place in 6
    months. The price of the watches is set to Yen
    2850 per watch (todays yen exchange rate). Thus,
    you will have to pay Yen 42,750,000 in about
    seven months.
  • You gather the information shown in Table 11.18.
    After analyzing the information, you fear that
    dollar may lose ground against the yen.

43
Hedging with Foreign Exchange Futures Hedging
Import/Export Transaction
  • To avoid any worsening of your exchange position,
    you decide to hedge the transaction by trading
    foreign exchange futures. Table 11.19 shows the
    transactions.

Notice that because you were not able to fully
hedge your position, you still had a loss.
44
Hedging with Foreign Exchange Futures Hedging
Translation Exposure
  • Many global corporations have subsidiaries that
    earn revenue in foreign currencies and remit
    their profits to a U.S. parent company. The U.S.
    parent reports its income in dollars, so the
    parent's reported earnings fluctuate with the
    exchange rate between the dollar and the currency
    of the foreign country in which the subsidiary
    operates. This necessity to restate foreign
    currency earnings in the domestic currency is
    called translation exposure.

45
Hedging with Foreign Exchange Futures Hedging
Translation Exposure
  • The Schropp Trading Company of Neckarsulm, a
    subsidiary of an American firm, expects to earn
    4.3 million this year and plans to remit those
    funds to its American parent. The company gathers
    information about the euro exchange rates for
    January 2 and December 15 as shown in Table
    11.20.
  • With the DEC futures trading at .4211 dollars per
    euro on January 2, the expected dollar value of
    those earnings is 1,810,730. If the euro falls,
    however, the actual dollar contribution to the
    earnings of the parent will be lower.

46
Hedging with Foreign Exchange Futures Hedging
Translation Exposure
  • The firm can either hedge or leave unhedged the
    value of the earnings in euros, as Table 11.21
    shows.
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