This slide set is a work in progress and is embedded in my Principles of Finance course, which is also a work in progress, that I teach to computer scientists and engineers http://awesomefinance.weebly.com/

1. Foreign
Exchange
Risk

2. Geneva:
6
May
2010
2
Buy
Sell
1.06993
1.14009
Is
AMEX
buying
and
selling
Swiss
francs
or
dollars
at
these
rates?
When
you
arrive
you
sell
$1
for
1.07
SFr
When
you
depart
you
buy
$1
for
1.14SFr
AMEX
is
buying
and
selling
USD
in
terms
of
CHF
USD / CHF Bid
1.06993
Ask
1.14009
Buy
1 USD for
1.14009 CHF
Sell
1 USD for
1.06993 CHF
Buy
1 CHF for
0.93464 USD
Sell
1
CHF for
0.87712 USD

3. Geneva:
20
May
2011
3
Buy
Sell
.85305
0.90899
When
you
arrive
you
sell
$1
for
.85
SFr
When
you
depart
you
buy
$1
for
.91
SFr
Or
equivalently
When
you
arrive
you
buy
1
SFr
for
$1.17
When
you
depart
you
sell
1
SFr
for
$1.10
USD / CHF Bid
0.85305
Ask
0.90899
Buy
1 USD for
0.90899 CHF
Sell
1 USD for
0.85305 CHF
Buy
1 CHF for
1.17226 USD
Sell
1
CHF for
1.10012 USD

4. CHF
/
USD
Three
Year
Chart
4
May
2010
0.897666
August
2011
May
2011
1.133196
Did
I
have
exchange
rate
(FX)
risk
between
1.374079
the
me
I
booked
the
trip
and
the
me
I
arrived
and
incurred
expenses
in
francs?
How
about
U.S.
businesses
that
buy
or
sell
products
in
Switzerland?

5. FX
Notaon
EUR
/
USD
1.4021
Terms or quote
currency
1
EUR = =
Buy
the
commodity
currency
using
(selling)
the
terms
currency
(1
Bbl)
WTI
Crude
Oil
/
USD
82
(1
oz)
Gold
/
USD
1700
5
Commodity or base
currency
1.4021
1
USD
1
EUR 1.4021
USD
Live
Quotes

6. USD
/
CHF
Three
Year
Chart
6

7. How
many
CHF
for
1
USD
?
7

8. FX
Bid
and
Offer
(Ask)
¨ EUR
/
USD
1.4480
-­‐
1.4485
¨ or
without
the
‘big
numbers’
or
‘handle’
in
the
offer
rate
EUR/USD
1.4480
–
85
¨ Smallest
increment
is
.0001
=
1
pip
¤ One
ck
in
rate
in
terms
currency
in
least
significant
figure
¨ Example
¤ If
€125,000
is
being
bought
and
sold
in
matched
trades,
the
dealer
makes
a
profit
of
5
pips
at
$12.50
per
pip
or
$62.5
¤ The
AMEX
dealer
at
the
Geneva
airport
made
575
pips
on
a
matched
trade
8
Bid Offer (Ask)
Live
Bid
–
Offer
Rates

9. FX
Bid
and
Offer
(Ask)
9
Interbank
rates
Bid
/
Ask
(Offer)
You
Sell
/
You
Buy
Dealer
buys
/
Dealer
Sells
You
get
the
worse
of
the
two
rates
ISO
Currency
Codes

10. Reciprocal
FX
Rates
EUR/USD
SB
–
SO
EUR/USD
1.3447
–
1.3464
1
USD/EUR
0.7427
-­‐
0.7437
10
Spot
Spot
Bid
Ask
(Offer)
O B S
S
USD/EUR
1 −
EUR / USD Bid
1.3447
Ask
1.3464
Buy
1 EUR for
1.3464 USD
Sell
1 EUR for
1.3447 USD
Buy
1 USD for
0.7437 EUR
Sell
1
USD for
0.7427 EUR
USD / EUR Bid
0.7427
Ask
0.7437
Buy
1 USD for
0.7437 EUR
Sell
1 USD for
0.7427 EUR
Buy
1 EUR for
1.3464 USD
Sell
1
EUR for
1.3447 USD

11. Buy
and
Sell
Round
Trip
At
A
FX
Kiosk
11
$
100.00 Sell
USD
Fr.
85.31 Receive
Fr.
5.00 Selling
commission
Fr.
80.31 Actual
Receipt
Fr.
5.00 Buying
commission
Fr.
75.31 Actual
sale
$
82.84 Receipt
USD / CHF Bid
0.8531
Ask
0.9090
Buy
1 USD for
0.9090 CHF
Sell
1 USD for
0.8531 CHF
Buy
1 CHF for
1.1723 USD
Sell
1
CHF for
1.1001 USD
559
pips
and
a
6.349%
spread
The
interbank
rate
is
5
pips

12. Long
Term
FX
Rate:
USD/
CHF
12

13. Japanese
Yen
¥
USD
/
JPY
13
Yen
News

14. Long
Term
FX
Rate:
USD/
JPY
14
JPY / USD Bid
0.007660
Ask
0.007665
Buy
1 JPY for
0.007665 USD
Sell
1 JPY for
0.007660 USD
Buy
1 USD for
130.5483 JPY
Sell
1
USD for
130.4631 JPY

15. Euro
€
EUR
/
USD
15

16. Hong
Kong
Dollar
HK$
USD
/
HKD
16

17. Chinese
Yuan
¥
USD
/
CNY
17

18. Zimbabwe
Dollar
$
USD
/
ZWD
18

19. Personal
FX
Tips
¨ Foreign
Travel
¤ FX
kiosks
at
airports
n Banks
n Travel
agents
n Amex
Travel
,
Thomas
Cook,
Travelex
¤ ATM
¤ Credit
cards
¤ Traveler’s
Checks
19
Foreign
Exchange
Markets
or
Securies
• OTC
currency
contracts
• Spot,
forwards
• FX
Futures
and
opons
• CME
• ETF
• Wisdomtree
• CurrencyShares
• Mutual
Funds
• MERK
Funds
• Hedge
Funds

20. US
Dollar
Index
DXY
20
Currency Weight
Euro 57.7%
Japanese
Yen 13.7%
British
Pound 12.0%
Canadian
Dollar 9.2%
Swedish
Krona 4.3%
Swiss
Franc 3.7%

21. Singapore
Dollar
USD
/
SGD
21

22. 400
350
300
250
200
150
100
50
0
r f f
− −
i i 1
i f
-­‐4.0%-­‐3.5%-­‐3.0%-­‐2.5%-­‐2.0%-­‐1.5%-­‐1.0%-­‐0.5% 0.0% 0.5% 1.0% 1.5% 2.0% 2.5% 3.0% 3.5% 4.0%
Frequency
Daily
Rate
of
Change
Stascal
Analysis
22
3,823
daily
rates,
ri,
of
change
from
1996
to
2011
USD
/
SGD
Mean:
-­‐.007
Standard
deviaon:
0.376%
(remove
the
bad
cks)
i −
1
=

23. Stascal
Analysis
-­‐4.0% -­‐3.5% -­‐3.0% -­‐2.5% -­‐2.0% -­‐1.5% -­‐1.0% -­‐0.5% 0.0% 0.5% 1.0% 1.5% 2.0% 2.5% 3.0% 3.5% 4.0%
Daily
Rate
of
Change
23
The
daily
change
rates
are
not
normal,
but
are
uni-­‐modal
and
leptokurc.
Qualitavely
un-­‐
skewed
with
exponenally
decreasing
tails.
Very
important
in
stascs
is
whether
a
random
variable
is
independent,
idencally
distributed
and
has
finite
variance.

24. Autocorrelaon
of
Change
Rates
24
1
0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0
-­‐0.1
-­‐0.2
-­‐0.3
Independence
is
oren
checked
by
non-­‐auto-­‐
correlaon
of
rates
and
variance
of
rates.
Autocorrelaon
of
simple
rates
of
return
0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 32 34 36
Autocorrelation
Lag
[Days]

25. Autocorrelaon
of
Change
Rate
Variance
25
1.0
0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0.0
Autocorrelaon
of
de-­‐trended
squared
rates
of
return
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36
Autocorrelation
Lag
[Days]

26. Correlaon
Visualizaon
26
Developed
by
Erich
Neuwirth
ρ
=
-­‐.2
ρ
=
.3

27. Financial
Risk
-­‐
Frank
Knight’s
Insight
¨ University
of
Chicago
,
1921
¨ Disnguished
between
risk
and
uncertainty
¨ Risk
–
future
financial
outcomes
can
be
quanfied
and
managed
via
probabilies
due
to
sufficient
frequency
of
relevant
historical
events
¤ Risk
is
quanfied
and
managed
via
mathemacal
models
¨ Uncertainty
–
future
financial
outcomes
cannot
be
quanfied
and
managed
with
probabilies
due
to
infrequency
of
relevant
historical
events
¤ Uncertainty
is
managed
via
n risk
reducing
contracts
n global
operaons

28. Money
28
Federal
Reserve
Balance
Sheet
Assets
Gold
US
Treasuries
US
Agencies
MBS
Bear
Stearns
assets
Etc
Liabiles
Bank
deposits
Currency
Etc
Capital
The
main
funcons
of
money
are:
a
medium
of
exchange;
a
unit
of
account;
a
store
of
value;

29. Currency
29

30. Currency
30

31. China
Trade
and
Currency
Flows
31
USD CNY
Bank
of
China
Balance
Sheet
Assets
Liabilies
UST
Yuan
currency
and
deposits
US
consumers
businesses
Chinese
Company
Products
US Treas
UST
USD
Bank
of
China
$
US
Fed
UST
US Fed
Primary
Dealers
Bond
Market
UST $

32. Purchasing
Power
Parity
32
An economic
theory that
estimates the
adjustment
needed in the
exchange rate
between countries
in order for the
exchange to be
equivalent to each
currency's
purchasing power.
investopedia

33. Purchasing
Power
Parity
33

34. Essenal
Concepts
¨ FX
rate
notaon
¤ Direct
and
reciprocal
¨ Exchanged
traded
and
pegged
currencies
¨ Bid
and
offer
spreads
on
FX
and
securies
¨ Time
series
analysis
¤ FX
trend
and
volality
¤ Independence
and
auto-­‐correlaon
¨ Risk
and
uncertainty
¨ Money
¨ Foreign
Trade
34

35. Discussion
Links
¨ New
Fee
to
Bank
Cash
¨ Swissy
Plummets
On
Rumor
Swiss
Banks
To
Charge
For
CHF
Deposits
¨ Live
Interbank
Rates
¨ Financial
Repression
¨ CME
FX
¤ Note
CHF
futures
contract
at
CME
is
reciprocal
of
that
at
the
Geneva
kiosk
¨ Franc,
Yen,
Dollar
Tumble
as
Stock
Rally
Curbs
Haven
Demand;
Rand
Climbs
35

36. FX
Risk
Management
¨ Manage
uncertainty
¤ Unknown
future
FX
rate
¤ Long
term
contracts
¤ Lock
in
future
rates
¤ Next
chapter
n Full
hedge
with
forwards
¨ Manage
risk
¤ Stascal
models
of
FX
rate
of
change
¤ Fluctuaons
or
volality
n Standard
deviaon
of
rate
of
change
36