Tài chính doanh nghiệp - Chapter 16: Foreign exchange derivative markets

Chapter 16Foreign Exchange Derivative MarketsFinancial Markets and Institutions, 7e, Jeff MaduraCopyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.1Chapter OutlineBackground on foreign exchange marketsFactors affecting exchange ratesMovements in exchange ratesForecasting exchange ratesForecasting exchange rate volatilitySpeculation in foreign exchange marketsForeign exchange derivativesInternational arbitrageExplaining price movements of foreign exchange derivatives2Background on Foreign Exchange MarketsForeign exchange markets consist of a global telecommunications network among large commercial banks that serve as financial intermediaries Banks are located in New York, Tokyo, Hong King, Singapore, Frankfurt, Zurich, and LondonThe bid price is always lower than the ask priceInstitutional use of foreign exchange marketsThe degree of international investment by financial institutions is influenced by potential return, risk, and government regulationsInstitutions are increasing their use of the foreign exchange markets because of reduced information and transaction costs3Background on Foreign Exchange Markets (cont’d)Financial InstitutionParticipation in Foreign Exchange MarketCommercial banksServe as financial intermediaries in the foreign exchange market by buying or selling currenciesSpeculate on foreign currency movements by taking long positions in some currencies and short positions in othersProvide forward contracts to customersOffer currency options to customers, which can be tailored to a customer’s specific needsInternational mutual fundsUse foreign exchange markets to exchange currencies when reconstructing their portfoliosUse foreign exchange derivatives to hedge a portion of their exposureBrokerage firms and investment banking firmsEngage in foreign security transactions for their customers or for their own accounts4Background on Foreign Exchange Markets (cont’d)Financial InstitutionParticipation in Swap MarketInsurance companiesUse foreign exchange markets when exchanging currencies for their international operationsUse foreign exchange markets when purchasing foreign securities for their investment portfolios or when selling foreign securitiesUse foreign exchange derivatives to hedge a portion of their exposurePension fundsRequire foreign exchange of currencies when investing in foreign securities for their stock or bond portfoliosUse foreign exchange derivatives to hedge a portion of their exposure5Background on Foreign Exchange Markets (cont’d)Exchange rate quotationsThe spot exchange rate is for immediate deliveryForward rates indicate the rate at which a currency can be exchanged in the futureCross-exchange ratesSome quotations express the exchange rate between two non-dollar currencies6Computing A Cross-Exchange RateThe euro is worth $1.15, and the Canadian dollar is worth $0.60. What is the value of the euro in Canadian dollars?7Background on Foreign Exchange Markets (cont’d)Types of exchange rate systems1944 to 1971: the exchange rate at which one currency could be exchanged for another was maintained within 1 percent of a specified rate (the Bretton Woods era)1971: an agreement among major countries (Smithsonian Agreement) allowed for devaluation of the dollar and a widening of the boundaries to 2.25%1973: boundaries were eliminated and exchange rates of major countries were allowed to floatDirty floatFreely floating system8Background on Foreign Exchange Markets (cont’d)Types of exchange rate systems (cont’d)Pegged exchange rate systemsSome currencies may be pegged to another currency or a unit of account and maintained within specified boundariesERM until 1999Hong Kong since 1983Argentina from 1991 until 2002A country that pegs its currency does not have complete control over its local interest rates9Background on Foreign Exchange Markets (cont’d)Types of exchange rate systems (cont’d)Classification of exchange rate arrangementsMany countries allow the value of their currency to float against others, but governments intervene periodically to influence its valueMany governments attempt to impose exchange controls to prevent their exchange rate from fluctuatingWhen controls are removed, the exchange rate abruptly adjust to a new market-determined level10Factors Affecting Exchange RatesThe value of a currency adjusts to changes in demand and supplyIn equilibrium, there is no excess or deficiency of that currencyIf a currency increases in value, it appreciatesIf a currency decreases in value, it depreciatesExchange rates are influenced by:Differential inflation ratesDifferential interest ratesGovernment intervention11Factors Affecting Exchange Rates (cont’d)Differential inflation ratesPurchasing power parity (PPP) suggests that the exchange rate will change by a percentage that reflects the inflation differential between the two countries of concernDifferential interest ratesInterest rate movements affect exchanges rates by influencing the capital flows between countriesCentral bank interventionCentral banks attempt to adjust a currency’s value to influence economic conditionsDirect intervention occurs when a country’s central bank sells some of its currency reserves for a different currency12Factors Affecting Exchange Rates (cont’d)Indirect interventionThe Fed can affect the dollar’s value indirectly by influencing the factors that determine its valuee.g., the Fed can attempt to lower interest rates by increasing the money supply, which puts downward pressure on the dollarIndirect intervention during the Peso CrisisThe central bank increased interest rates to discourage foreign investors from withdrawing their investments in Mexico’s debt securitiesIndirect intervention during the Asian CrisisSome Asian countries increased their interest rates to encourage investors to leave their funds in AsiaIndirect intervention during the Russian crisisThe Russian central bank attempted to prevent outflows by tripling interest rates13Factors Affecting Exchange Rates (cont’d)Foreign exchange controlsControls, such as restrictions on the exchange of a currency, can be used as a form of indirect interventione.g., Venezuela imposed foreign exchange controls in the mid-1990sUnder severe pressure, governments tend to let the currency float temporarily toward its market-determined level14Forecasting Exchange RatesMarket participants take derivative positions based on their expectations of future exchange ratesTechnical forecasting involves the use of historical exchange rate data to predict future valuese.g., time-series models that examine moving averages and allow the forecaster to develop some ruleFundamental forecasting is based on fundamental relationships between economic variables and exchange ratese.g., high inflation in a country can lead to depreciation in its currency15Forecasting Exchange Rates (cont’d)Market-based forecasting is the process of developing forecasts based on the spot rate or the forward rateUse of the spot rateCorporations can use the spot rate to forecast, since it represents the market’s expectation of the spot rate in the near futureUse of the forward rateSpeculators would take positions if there was a large discrepancy between the forward rate and expectations of the future spot ratee.g., if the forward rate for the pound was $1.40 and the spot rate was expected to be $1.45, everyone would buy pounds forward and sell them at the future spot rate16Forecasting Exchange Rates (cont’d)Mixed forecasting involves using a combination of forecasting techniquesNo single technique has been found to be consistently superiorEach of the techniques is assigned a weight, and the more reliable techniques receive a higher weightThe actual forecast used by an MNC is a weighted average of the various forecasts developed17Forecasting Exchange Rate VolatilityParticipants forecast exchange rate volatility to develop a range surrounding their forecastTo develop a volatility forecast:Determine the relevant period of concernDecide on a method to forecast volatilitye.g., historical exchange rate volatility, time series of volatility patterns, implied standard deviations18Speculation in Foreign Exchange MarketsCommercial banks take positions in currencies to capitalize on expected exchange rate movements19Speculating on Expected Exchange Rate MovementsZena Bank expects the euro to depreciate against the dollar and plans to take a short position in euros and a long position in dollars. Assume the following:1. Interest rate on borrowed euros is 5 percent annualized2. Interest rate on dollars loaned out is 6 percent annualized3. Spot rate is €0.90 per dollar4. Expected spot rate in ten days is €0.95 per dollar5. Zena Bank can borrow €10 millionDescribe the steps Zena should take to profit from shorting euros and going long on dollars.20Speculating on Expected Exchange Rate Movements (cont’d)Zena Bank should take the following steps:1. Borrow €10 million and convert to $11,111,1112. Invest the $11,111,111 million for ten days at 6 percent annualized (or .1667 percent over ten days), which will generate $11,129,6303. After ten days, convert the $11,129,630 into euros at the existing spot rate, which converts to €10,573,1484. Pay back the loan of €10 million plus interest of 5 percent annualized (.1389 percent over ten days), which equals €10,013,889 Thus, Zena earns €559,259 over a ten-day period.21Foreign Exchange DerivativesForeign exchange derivatives can be used to:Speculate on future exchange rate movementsHedge anticipated cash inflows or outflows in a given foreign currencyInstitutional investors have increased their international investments, which has increased their exposure to exchange rate risk22Foreign Exchange Derivatives (cont’d)Forward contractsForward contracts are contracts typically negotiated with a commercial bank that allow the purchase or sale of a specified amount of a particular foreign currency at a specified exchange rate on a specified future dateThe forward market facilitates the trading of forward contractsCommercial banks profit from the difference between the bid price and the ask price and are exposed to exchange rate risk if their purchases do not match their sales of a foreign currencyForward purchases can hedge the corporation’s risk that the currency’s value may appreciateForward sales can hedge the corporation’s risk that the currency’s value may depreciate23Foreign Exchange Derivatives (cont’d)Forward contracts (cont’d)The forward rate may sometimes exhibit a premium or discount relative to the existing spot rate:The forward premium reflects the percentage by which the forward rate exceeds the spot rate on an annualized basis24Computing A Forward Rate Premium or DiscountAssume that the spot rate for the euro is $1.20, while the 180-day forward rate for the euro is $1.22. What is the forward rate premium?25Foreign Exchange Derivatives (cont’d)Currency futures contractsA currency futures contract is a standardized contract that specifies an amount of a particular currency to be exchanged on a specified date and at a specified exchange rateFirms purchase futures to hedge payablesFirms sell futures to hedge receivablesFutures contracts have specified settlement dates Currency swapsA currency swap is an agreement that allows one currency to be periodically swapped for another at specified exchange ratesEssentially a series of forward contracts26Foreign Exchange Derivatives (cont’d)Currency options contractsA currency call option provides the right to purchase a particular currency at a specified price (the exercise price) within a specified periodUsed to hedge payables in a foreign currencyThe option will not be exercised if the spot rate remains below the exercise priceA currency put option provides the right to sell a particular currency at the exercise price within a specified periodUsed to hedge receivables in a foreign currencyThe option will not be exercised if the spot rate remains above the exercise price27Foreign Exchange Derivatives (cont’d)Currency options contracts (cont’d)Conditional currency optionsThe premium is conditioned on the actual movement in the currency’s value over the period of concernThe choice of a basic option versus a conditional option is dependent on the firm’s expectations of the currency’s exchange rate over the period of concern28Foreign Exchange Derivatives (cont’d)Use of foreign exchange derivatives for speculatingSpeculators who expect the euro to appreciate could:Purchase euros forward and sell them in the spot market when receivedPurchase futures contracts on euros and sell euros in the spot market when receivedPurchase call options on euros and sell the euros in the spot market if the option is exercised29Foreign Exchange Derivatives (cont’d)Use of foreign exchange derivatives for speculating (cont’d)Speculators who expect the euro to depreciate could:Sell euros forward and purchase them in the spot market to fulfill the obligationSell futures contracts on euros and purchase euros in the spot market by the settlement datePurchase put options on euros and purchase the euros in the spot market if the option is exercised30Speculating with Currency FuturesAssume the following:1. The spot rate for the euro is $1.152. The price of a futures contract is $1.17 3. Expectation of euro’s spot rate as of the settlement date is $1.20What could you do to profit from your expectations?You could buy euro futures. You would receive euros on the settlement date for $1.17 and could sell euros at $1.20 if your expectations were correct. To account for uncertainty, you could also develop a probability distribution for the future spot rate.31Speculating with Currency OptionsAssume the following:1. The spot rate for the euro is $1.152. A call option is available with an exercise price of $1.17 and a premium of $0.02 per unit. 3. Expectation of euro’s spot rate as of the settlement date is $1.20What could you do to profit from your expectations?You could euro call options. If your expectations are correct, you will net $1.20 – $1.17 – $0.02 = $0.01 per unit. 32International ArbitrageIf exchange rates become misaligned, arbitrage will occur, forcing realignmentLocational arbitrage is the act of capitalizing on a discrepancy between the spot rate at two different locations by purchasing the currency where it is priced low and selling it where it is priced highSome financial institutions watch for locational arbitrage opportunities, so any discrepancy in exchange rates is quickly corrected33Conducting Locational ArbitrageAssume the following information:What actions could an arbitrageur take to benefit from these quotes?An arbitrageur could conduct locational arbitrage by purchasing euros from Blythe Bank for $1.19 and selling them to Slythe Bank for $1.20.Bid Rate on EurosAsk Rate on EurosBlythe Bank$1.18$1.19Slythe Bank$1.20$1.2134International Arbitrage (cont’d)Covered interest arbitrageInterest rate parity refers to the relationship between a forward rate premium and the interest rate differential of two countries:If the interest rate is lower in the foreign country than in the home country, the forward rate of the foreign currency should exhibit a premiumThe forward rate premium or discount should be about equal to the differential in interest rates between the countries of concern35Computing A Forward Premium Using Interest Rate ParityAssume that the spot rate of the British pound is $1.50, the one-year U.S. interest rate is 7 percent, and the one-year British interest rate is 8 percent. What should the forward rate premium or discount of the British pound be?The forward rate reflects a 0.93% discount below the spot rate, or $1.49.36International Arbitrage (cont’d)Covered interest arbitrage (cont’d)If interest rate parity does not hold, covered interest arbitrage is possibleE.g., if the spot rate and forward rate for a foreign currency are equal and the foreign interest rate is higher, arbitrageurs would buy the currency now, invest in the foreign country, and sell the currency forwardInterest rate parity prevents investors from earning higher returns from covered interest arbitrage than can be earned in the U.S.Impact of the September 11 CrisisThe interest rate differential between the U.S. and other countries increased, resulting in increased forward rate discounts37Explaining Price Movements of Foreign Exchange DerivativesIndicators of foreign exchange derivative pricesThe spot rate influences the forward rate and currency futuresIndicators that may signal a change in economic conditions that will affect the supply and demand for a particular currency and the spot rate are monitored:Relative inflationRelative interest ratesEconomic growth indicatorsRelative budget deficits38