Loading...

PPT – CHAPTER 11 Foreign Exchange Futures PowerPoint presentation | free to download - id: 34958-ZTU4Y

The Adobe Flash plugin is needed to view this content

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

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.

Price Quotation

- Insert Figure 11.1 here

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

CMEs Euro FX Futures Product Profile

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

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.

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.

Geographical Arbitrage

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.

Cross-Rate Arbitrage

- Insert Figure 11.2 here

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

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.

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.

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

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.

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.

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.

Future Price Parity Relationships

- In this section, other price relationships will

be examined, including - Interest Rate Parity Theorem (IRP)
- Purchasing Power Parity Theorem (PPP)

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.

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.

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

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.

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.

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.

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

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.

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

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.

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.

Exploiting Deviations from Interest Rate Parity

- Using the data from our previous example, Table

11.5 shows the transactions that will exploit

this discrepancy.

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.

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).

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.