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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)