The document discusses foreign exchange markets and derivatives. It covers how exchange rates are quoted, factors that affect exchange rates like inflation and interest rates, techniques for forecasting exchange rates, and how derivatives like forwards, futures, and options can be used to hedge or speculate on currency movements. It also describes arbitrage opportunities between markets and how covered interest arbitrage equalizes forward rates and interest rate differentials.

1. Foreign
Exchange
Derivative
Market
© 2003 South-Western/Thomson Learning

2. Chapter Objectives
 Explain how various factors affect exchange
rates
 Describe how foreign exchange risk can be
hedged with foreign exchange derivatives
 Describe how to use foreign exchange
derivatives to capitalize (speculate) on
expected exchange rate movements

3. Background On Foreign Exchange
Markets
 Exchanging currencies is needed when:
 Trade (real) prompts need for forex
 Capital flows (financial) prompts need for forex
 Foreign exchange trading
 Via global telecommunications network between
mostly large banks
 Bid/ask spread

4. Foreign Exchange Rates
 Quoted two ways:
 Foreign currency per U.S. dollar
 Dollar cost of unit of foreign exchange
 Appreciation/depreciation of currency
 Appreciation = more forex to buy $
 Purchase more forex with $
 Depreciation = foreign goods cost more $
 Total return to foreign investor decreases

5. Background on Foreign Exchange
Markets
 Exchange rate quotations are available in the
financial press and on the Internet with spot
exchange rate quotes for immediate delivery
 Forward exchange rate is for delivery at some
specified future point in time
 Forward premium is the percent annualized
appreciation of a currency
 Forward discount is the percent annualized
depreciation of a currency

6. Background on Foreign Exchange
Markets
 Exchange rates involve different kinds of
quotes for comparing the value of the U.S.
dollar to various foreign currencies
 1 unit of foreign currency worth some amount of
U.S. dollars—e.g. $.70 U.S. per Canadian Dollar
 1 U.S. dollar’s value in terms of some amount of
foreign currency– e.g. CD$1.43 per U.S. dollar
 Note reciprocal relationship
 Cross-exchange rates express relative values
of two different foreign currencies per $1 U.S.

7. Background on Foreign Exchange
Markets
 Cross-exchange rates are foreign exchange
rates of two currencies relative to a currency.
 Value of one unit of currency A in units of
currency B = value of currency A in $ divided
by value of currency B in $
 British Pound = $1.4555; Euro = $.8983
 Value of Pound in Euros = $1.4555/$.8983
or…
 1.62 Pounds per Euro using the forex rates per
U.S. dollar

8. Background on Foreign Exchange
Markets
 Currency terminology
 Appreciation means a currency’s value increases
relative to another currency
 Depreciation means a currency’s value decreases
relative to another currency
 Supply and demand influences the values of
currencies
 Many factors can simultaneously affect supply
and demand

9. Background on Foreign Exchange
Markets
 1944–1971 known as the Bretton Woods Era
 Government maintained exchange rates within a
1% range
 Required government intervention and control
 By 1971 the U.S. dollar was clearly
overvalued
Background on Foreign Exchange Markets

10. Background on Foreign Exchange
Markets
 Smithsonian Agreement (1971) among major
countries allowed dollar devaluation and
widened boundaries around set values for each
currency
 No formal agreements since 1973 to fix
exchange rates for major currencies
 Freely floating exchange rates involve values set
by the market without government intervention
 Dirty float involves some government intervention

11. Classification of Exchange Rate
Arrangement
 There is a wide variation in how countries
approach managing or influencing their
currency’s value
 Float with periodic intervention
 Pegged to the dollar or some kind of composite
 Some countries have both controlled and floating
rates
 Some arrangements are temporary and others
more permanent

12. Factors Affecting Exchange Rates: Real
Sector
 Differential country inflation rates affect the
exchange rate for euros and dollars if inflation
is suddenly higher in Europe
 Theory of Purchasing Power Parity suggests
the exchange rate will change to reflect the
inflation differential—influence from real
sector of economy
 Currency of the higher inflation country (euro)
depreciates compared to the lower inflation
country ($)

13. Factors Affecting Exchange Rates:
Financial Sector
 Differential interest rates affect exchange rates
by influencing capital flows between countries
 For example, the interest rates are suddenly
higher in the United States than in Europe
 Investors want to buy dollar-denominated
securities and sell European securities
 Euros are sold, dollars bought to buy U.S.
securities
 Downward pressure on the euro, appreciation
of the dollar

14. Factors Affecting Exchange Rates
 Direct intervention occurs when a country’s
central bank buys/sells currency reserves
 For example, the U.S. central bank, the
Federal Reserve sells one currency and buys
another
 Sale by central bank creates excess supply and that
currency’s value drops relative to the one
purchased
 Market forces of supply and demand can
overwhelm the intervention

15. Factors Affecting Exchange Rates
 Indirect intervention involves influencing the
factors that affect exchange rates rather than
central bank purchases or sales of currencies
 Interest rates, money supply and inflationary
expectations affect exchange rates
 Historical perspective on indirect intervention
 Peso crisis in 1994
 Asian crisis in 1997
 Russian crisis in 1998

16. Factors Affecting Exchange Rates
 Some countries use foreign exchange controls
as a form of indirect intervention to maintain
their exchange rates
 Place restrictions on the exchange of currency
 May change based on market pressures on the
currency
 Venezuela in mid-1990s illustrates the issues
involved in controlling rates via intervention
and the affect of market forces

17. Movements in Exchange Rates
 Foreign exchange rate changes can have an
important effect on the performance of
multinational firms and economic conditions
 Many market participants forecast rates
 Market participants take positions in derivatives
based on their expectations of future rates
 Speculators attempt to anticipate the direction of
exchange rates
 There are several forecasting techniques

18. Forecasting Techniques
Technical Forecasting
Fundamental Forecasting
Market-based
Forecasting
Mixed Forecasting

19. Forecasting Exchange Rates: Technical
 Technical forecasting is a technique that uses
historical exchange rate data to predict the
future
 Uses statistics and develops rules about the
price patterns—depends on orderly cycles
 If price movements are random, this method
won’t work
 Models may work well some of the time and
not work other times

20. Forecasting Exchange Rates:
Fundamental
 Fundamental forecasting is based on
fundamental relationships between economic
variables and exchange rates
 May be statistical and based on quantitative
models or be based on subjective judgement
 Regression used to forecast if values of
influential factors have a lagged impact
 Not all factors are known and some have an
instant impact so sensitivity analysis is used to
deal with uncertainty

21. Forecasting Exchange Rates:
Fundamental
 Limitation of fundamental forecasting
methods:
 Some factors that are important to determining
exchange rates are not easily quantifiable
 Random events can and do affect exchange rates
 Predictor models may not account for these
unexpected events

22. Forecasting Exchange Rates: Market-
Based
 Market-based forecasting uses market
indicators like the spot and forward rates to
develop a forecast
 Spot rate: recognizes the current value of the
spot rate as based on expectations of
currency’s value in the near future
 Forward rate: used as the best estimate of the
future spot rate based on the expectations of
market participants

23. Forecasting Exchange Rates: Mixed
 Mixed forecasting is used because no one
method has been found superior to another
 Multinational corporations use a combination
of methods
 Assign a weight to each technique and the
forecast is a weighted average
 Perhaps a weighted combination of technical,
fundamental, and market-based forecasting

24. Forecasting Exchange Rate Volatility
 Market participants forecast not only exchange
rates but also volatility
 Volatility forecast
 Recognizes how difficult it is to forecast the actual
rate
 Provides a range around the forecast

25. Forecasting Exchange Rate Volatility
 Volatility of historical data
 Use a times series of volatility patterns in
previous periods
 Derive the exchange rate’s implied standard
deviation from the currency option pricing
model
Methods Used To Forecast Volatility

26. Speculation in Foreign Exchange Markets
 For example, a dealer takes a short position in
a foreign currency to profit from expected
depreciation
 Dealer forecasts currency 1 to depreciate
relative to foreign currency 2 so the first step
is to borrow currency 1 and then exchange
currency 1 for currency 2
 Invest in currency 2 and receive the investment
returns at maturity
 Convert back to foreign currency 1 and pay back
loan denominated in currency 1

27. Foreign Exchange Derivative Contracts
Currency Futures
Hedge or Speculate
Forward Contracts Currency Swaps
Currency Options

28. Foreign Exchange Derivatives-Hedge
 Forward contracts
 Negotiated with a counterparty
 Specify a maturity date, amount and which
currency to buy or sell
 Negotiated in over-the-counter market
 Used to lock in the price paid or price received for
a future currency transaction
 Classic hedging contract

29. Foreign Exchange Derivatives-Hedge
 Forward contracts can be used to hedge if a
corporation must pay a foreign currency
invoice in the future
 Purchase foreign currency for amount/date of
invoice
 Locks in cost of invoice
 Hedges foreign exchange risk of transaction
 Forward contracts are also used by hedgers
who have a foreign currency inflow on some
future date

30. Foreign Exchange Derivatives
 Forward rate premium or discount
P = % annualized premium or discount
FR = Forward exchange rate
S = Spot exchange rate
n = number of days forward
Where:
x
FR - S
S
360
n
p =

31. Foreign Exchange Derivatives-Hedge
 Currency futures contracts trade on exchanges,
are standardized in terms of the maturity and
amount
 Currency swaps allow one currency to be
periodically swapped for another at a specified
exchange rate
 Currency options contracts offer one-way
insurance to buy (call) or sell (put) a currency

32. Foreign Exchange Derivatives-Hedge
 Buying a call option on a foreign currency is
the right to purchase a specified amount of
currency at the strike price within the specified
time period
 Exercise the option if the spot rate rises above the
strike price
 Do not exercise if the spot rate does not reach or
exceed the strike price
 U.S. business that owes Canadian in 60 days buys
currency call options to hedge spot forex risk

33. Foreign Exchange Derivatives-Hedge
 Buying a put option on a foreign currency is the right
to sell a specified amount of currency at the strike
price within the specified time period
 Exercise the option if the spot rate falls below the strike
price
 Do not exercise if the spot rate does not decline below the
strike price
 U.S. business hedges Canadian dollar payment it will
receive in 30 days by buying CD currency put options—if
CD depreciates against U.S., gain will offset spot loss

34. Foreign Exchange Derivatives-Speculate
 Business or person has no spot interest in
underlying asset—takes position based on
forecast of currency movements
 Forward contracts
 Buy/sell foreign currency forward
 When received, sell in the spot market
 Purchase/sell futures contracts
 Purchase call/put options

35. Foreign Exchange Derivatives-
Speculation
 For example, what position in derivates would
a speculator take if he/she anticipates a
depreciation in a currency?
 Forward contracts
 Sell foreign currency forward
 At maturity, buy in the spot market
 Sell futures contracts
 Purchase put options

36. International Arbitrage
 Arbitrage takes advantage of a temporary
price difference in two locations to make
profits buying at a lower price than you can
receive via the simultaneous sale of an asset,
financial instrument or currency
 Risk free because the purchase and sale price
are locked in simultaneously
 As arbitrage occurs, prices in both locations
change until equilibrium (one price) returns

37. International Arbitrage
 Covered interest arbitrage activity creates a
relationships between spot rates, interest rates and
forward rates
 Borrow in country 1
 Convert the funds to currency for country 2 using the
spot rate; buy forward contract for return
 Invest in country 2 and earn an investment rate of
return
 Convert back to country 1 currency using forward
contract, repay loan

38. International Arbitrage
 Covered interest arbitrage activity makes
forward premium approximately equal to the
differential in interest rates between two
countries
 If forward premium does not equal the interest
rate differential, covered interest arbitrage is
possible
 If the forward premium or discount equals the
interest rate differential, there are no
opportunities for arbitrage

39. International Arbitrage
 Equation for covered interest arbitrage
P = Forward premium or discount
ih = Home country interest rate
if = Foreign interest rate
Where:
–
( 1 + ih)
(1 + if )
1
P =

40. Explaining Price Movements of Foreign
Exchange Derivatives
 Indicators of foreign exchange derivatives are
closely monitored by market participants
 Hedgers and speculators continuously forecast
direction and degree of movement and
monitor
 Inflation rates between countries
 Interest rates
 Economic indicators

41. Foreign Exchange Markets
 Exchanging Currencies Is Needed When:
 Trade (real) prompts need For forex
 Capital flows (financial) prompts need for forex
 Foreign Exchange Trading
 Via global telecommunications network between
mostly large banks
 Bid/ask spread

42. Foreign Exchange Rates
 Quoted Two Ways:
 Foreign currency per U.S. Dollar
 Dollar cost Of unit Of foreign exchange
 Appreciation/Depreciation of Currency
 Appreciation = more forex To buy $
 Purchase more forex with $
 Depreciation = foreign goods cost more $
 Return To foreign investor decreases

43. Exchange Rate Systems
 Bretton Woods Era (1944-1971)
 Fixed Or pegged forex rates
 Central bank maintained rates
 Could not adjust To major economic change
 Smithsonian Agreement (1971)
 Devalued dollar
 Widened trading range Of forex
 First Step Toward Market-Determined Forex

44. Exchange Rate Systems
 Market-Determined Rates (1973)
 Dirty Float
 Exchange Rate Mechanisms:
Currencies pegged to another
European currency unit (ECU)
Central Bank involvement
ERM problems

45. Major Factors Affecting Forex
 Differential inflation rates between countries
 Goods and services impact demand/supply for
foreign exchange
 Inflating currency declines to provide….
 Purchasing power parity

46. Major Factors Affecting Forex
 Differential interest rates between countries
 Reflect expected differential inflation rates
 Global Fisher Effect
 Governmental Intervention
 Domestic Economic Policy
 Direct Intervention, e.g., Forex Controls
 Market Forces Reign!!!

47. Forecasting Foreign Exchange Rates
 Technical forecasting
 Fundamental forecasting
 Market-based forecasting
 Mixed forecasting

48. Forecasting Forex Volatility
 Forex prices difficult to forecast
 Forecasting volatility creates range of
probable forex rates
 Use best- and worst-case scenarios in planning
 Define future period
 Consider historical volatility
 Time series of previous volatility

49. Speculation In Forex Market
 Take position based on forex expectations
 Expect To appreciate
 Take long position (buy)
 Forward contract to buy
 Buy forex currency futures contract
 Buy forex call options
 Action taken if depreciation expected??

50. Foreign Exchange Derivatives
 Speculate vs. Hedging
 Forward contracts
 Contract To buy/sell forex at specified price on
specified date
 OTC market characteristics
 Reflects expected future spot rate
 Premium vs. Discount from spot
 Interest rate parity concept

51. Other Forex Derivatives
 Currency futures contracts
 Currency swaps
 Currency option contracts

52. International Arbitrage
 Arbitrage defined
 Locational arbitrage
 Covered interest arbitrage
 Maintains interest rate parity
 Forward/spot differential =
Differential inflation rates
Interest rate differentials
Expected future spot rate

53. Institutional Use Of Forex Market
 Intermediary or dealer of forwards or other
derivative contracts
 Speculating/hedging
 Future investment flows (loans, interest)
 Future financing flows (principal and interest)