Chapter 10
This presentation is the property of its rightful owner.
Sponsored Links
1 / 45

Chapter 10 PowerPoint PPT Presentation


  • 55 Views
  • Uploaded on
  • Presentation posted in: General

Chapter 10. Foreign Exchange Futures. Outline. Introduction Foreign exchange risk Forward rates Foreign currency futures Dealing with the exposure. Introduction. The capital markets across the globe have become one giant playing field

Download Presentation

Chapter 10

An Image/Link below is provided (as is) to download presentation

Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author.While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server.


- - - - - - - - - - - - - - - - - - - - - - - - - - E N D - - - - - - - - - - - - - - - - - - - - - - - - - -

Presentation Transcript


Chapter 10

Chapter 10

Foreign Exchange Futures


Outline

Outline

  • Introduction

  • Foreign exchange risk

  • Forward rates

  • Foreign currency futures

  • Dealing with the exposure


Introduction

Introduction

  • The capital markets across the globe have become one giant playing field

    • The U.S. share of market capitalization is steadily declining as foreign markets develop


Foreign exchange risk

Foreign Exchange Risk

  • Introduction

  • FX risk and interest rates

  • The concept of exposure

  • FX risk from a business perspective

  • FX risk from an investment perspective


Introduction1

Introduction

  • Overseas investments and international business involve foreign exchange risk

  • A survey of corporate treasurers indicates that the primary corporate use of derivative assets is hedging foreign exchange exposure


Introduction cont d

Introduction (cont’d)

  • Foreign exchange risk is the risk of loss due to changes in the relative value of world currencies

    • Modest changes in exchange rates can result in significant dollar differences


Fx risk and interest rates

FX Risk and Interest Rates

  • Introduction

  • The real rate of interest

  • The inflation premium

  • The risk premium


Introduction2

Introduction

  • Events in one industrial country affect the rest of the world

    • Interest rates are often a good barometer of events like high unemployment, changes in economic policy, etc.


The real rate of interest

The Real Rate of Interest

  • The nominal interest rate (the stated rate) can be expressed as the sum of:

    • The real rate

    • An inflation premium and

    • A risk premium


The real rate of interest cont d

The Real Rate of Interest (cont’d)

  • The real rate reflects the rate of return investors demand for giving up the current use of funds

    • Indicates people’s willingness to postpone spending their money

    • Is not directly observable

    • Hovers in the 3% to 4% range


The inflation premium

The Inflation Premium

  • The inflation premium reflects how the general price level is changing

    • Measures how rapidly the money standard is losing its purchasing power

    • In the past 75 years, U.S. inflation has averaged about 3.2% annually


The risk premium

The Risk Premium

  • The risk premium is the component of interest rates that is most difficult to measure

    • Risk-averse investors expect to be compensated for risks they take

    • The price of a risky security must reflect a risk premium to entice someone to buy it

    • The magnitude of the risk premium depends on how much risk the security carries

    • The higher the risk premium, the lower the price


The concept of exposure

The Concept of Exposure

  • Introduction

  • Accounting exposure

  • Economic exposure


Introduction3

Introduction

  • Exposure is the extent to which you face foreign exchange risk

  • There are two general types of exposure:

    • Accounting exposure

    • Economic exposure


Accounting exposure

Accounting Exposure

  • Accounting exposure is the exchange rate exposure that results when consolidated financial statements are prepared in a single currency

  • Two types of accounting exposure:

    • Transaction exposure

    • Translation exposure


Accounting exposure cont d

Accounting Exposure (cont’d)

  • Transaction exposure results from transactions involving the purchase or sale of goods or services with the price stated in foreign currency

    • Exists until the payable or receivable is liquidated

    • E.g., a U.S. importer must pay a European supplier in Swiss francs


Accounting exposure cont d1

Accounting Exposure (cont’d)

  • Translation exposure results from translating foreign assets and liabilities into U.S. dollars on the consolidated balance sheet


Economic exposure

Economic Exposure

  • Economic exposure measures the risk that the value of a security or a firm will decline due to an unexpected change in relative foreign exchange rates

    • Would reduce the value of the security or firm

    • The most important type of exposure for security investors


Fx risk from a business perspective

FX Risk From A Business Perspective

A Business Example of Economic Exposure

An American importer agrees to purchase 400 Swiss overcoats at a price of CHF1,200 each, for a total of CHF480,000. The coats will take 3 months to produce, and the importer is to pay for them upon delivery.


Fx risk from a business perspective cont d

FX Risk From A Business Perspective (cont’d)

A Business Example of Economic Exposure (cont’d)

Assume the following exchange rates exist today:

  • $ per CHF = $0.5788 (direct quotation)

  • CHF per $ = CHF1.7276 (indirect quotation)


Fx risk from a business perspective cont d1

FX Risk From A Business Perspective (cont’d)

A Business Example of Economic Exposure (cont’d)

If the importer paid for the coats today, each coat would cost the importer:

CHF1,200 x $0.5788/CHF = $694.56

The importer is concerned that the U.S. dollar might weaken between now and coat delivery time.


Fx risk from a business perspective cont d2

FX Risk From A Business Perspective (cont’d)

A Business Example of Economic Exposure (cont’d)

If the dollar strengthens and the value of the Swiss franc falls to $0.5100, the cost of each coat will be:

CHF1,200 x $0.5100/CHF = $612.00

If the dollar weakens to an exchange rate of $0.6800, the cost of each coat will be:

CHF1,200 x $0.6800/CHF = $816.00


Fx risk from an investment perspective

FX Risk From An Investment Perspective

An Investment Example of Economic Exposure

You just placed an order with your broker to purchase 10,000 shares of Kangaroo Lager, trading on the Sydney Stock Exchange. You can currently purchase the shares for AUD1.45 apiece.

The current exchange rate is $0.5755/AUD. Thus, the shares cost you:

10,000 x AUD1.45 x $0.5755/AUD = $8,344.75


Fx risk from an investment perspective cont d

FX Risk From An Investment Perspective (cont’d)

An Investment Example of Economic Exposure (cont’d)

You hold the Kangaroo shares for six months, at which time the shares sell for AUD1.95. This is a return of

(1.95 – 1.45)/1.45 = 34.5%


Fx risk from an investment perspective cont d1

FX Risk From An Investment Perspective (cont’d)

An Investment Example of Economic Exposure (cont’d)

In six months, the exchange rate is $0.5500. If you were to sell the shares, you would receive:

10,000 x AUD1.95 x $0.5500/AUD = $10,725.00

This is a return on investment of

($10,725.00 - $8,344.75)/$8,344.75 = 28.52%


Forward rates

Forward Rates

  • Introduction

  • Purchasing power parity

  • Interest rate parity


Introduction4

Introduction

  • The spot exchange rate is the current exchange rate for two currencies

  • The forward exchange rate is a contractual rate between a commercial bank and a client for the future delivery of a specified quantity of foreign currency


Introduction cont d1

Introduction (cont’d)

  • Forward exchange rates are normally quoted on the basis of one, two, three, six, and twelve months


Introduction cont d2

Introduction (cont’d)

  • The forward rate is an unbiased estimate of the future spot rate for foreign exchange

    • E.g., if forward rates show that the dollar is expected to strengthen against the Swiss franc, it would make sense to delay paying Swiss francs as long as possible


Introduction cont d3

Introduction (cont’d)

  • The difference between the forward and spot rates can be quoted as an annual premium or discount:


Purchasing power parity

Purchasing Power Parity

  • Purchasing power parity is an arbitrage-based idea that in a world of perfect markets, the same good should sell for the same price in different countries

    • Assumes there are no trade barriers, no taxes, etc.


Purchasing power parity cont d

Purchasing Power Parity (cont’d)

  • Unexpected inflation causes the value of the home currency to fall

  • Differentials in international inflation rates can be a source of foreign exchange risk


Interest rate parity

Interest Rate Parity

  • Interest rate parity states that differences in national interest rates will be reflected in the currency forward market

    • Two securities of similar risk and maturity will show a difference in their interest rates equal to the forward premium or discount, but with the opposite sign


Interest rate parity cont d

Interest Rate Parity (cont’d)

  • According to interest rate parity:


Foreign currency futures

Foreign Currency Futures

  • Introduction

  • Pricing of foreign exchange futures contracts


Introduction5

Introduction

  • Foreign currency futures contracts were the first financial futures traded on exchanges in the U.S.

    • Began trading at the Chicago Mercantile Exchange in 1972

  • Foreign currency futures were quickly recognized as very effective ways to deal with foreign exchange risk


Pricing of foreign exchange futures contracts

Pricing of Foreign Exchange Futures Contracts

  • Futures prices are a function of

    • The spot price

    • The cost of carrying the particular asset or financial instrument

  • For foreign currency futures, the cost of holding one currency rather than another is an opportunity cost measured by differences in interest rates


Pricing of foreign exchange futures contracts cont d

Pricing of Foreign Exchange Futures Contracts (cont’d)

  • A basic pricing model:


Pricing of foreign exchange futures contracts cont d1

Pricing of Foreign Exchange Futures Contracts (cont’d)

Pricing A Foreign Currency Futures Contract Example

In the Land of Leptonia interest rates are 10.00%, and the current dollar price of a Lepton is $0.4817. The current Eurodollar deposit rate is 7.50%.

For how much should a 90-day futures contract on Lepton’s sell?


Pricing of foreign exchange futures contracts cont d2

Pricing of Foreign Exchange Futures Contracts (cont’d)

Pricing A Foreign Currency Futures Contract Example (cont’d)

Using the equation:

The futures price for Leptons should be less than their cost in the spot market. This is because Leptonia’s interest rates are 2.5% higher than the U.S. rate.


Dealing with the exposure

Dealing With the Exposure

  • Introduction

  • Ignore the exposure

  • Reduce or eliminate the exposure

  • Hedge the exposure


Introduction6

Introduction

  • The portfolio manager needs to decide whether to:

    • Ignore the exposure,

    • Eliminate the exposure, or

    • Hedge the exposure


Ignore the exposure

Ignore the Exposure

  • Investors may be aware of economic exposure but accept it as a fact of life

  • Ignoring the exposure may be appropriate if the dollar amount of the exposure is relatively small

  • Ignoring the exposure may be appropriate if the dollar is expected to depreciate


Reduce or eliminate the exposure

Reduce or Eliminate the Exposure

  • Amounts to selling the foreign security or reducing the size of the position

  • May be appropriate if the dollar is expected to appreciate dramatically


Hedge the exposure

Hedge the Exposure

  • Involves taking a position in the market that offsets another position

    • Hedging foreign exchange risk is also called covering the risk

    • Hedging can be done in the forward market or the futures market


  • Login