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Foreign Exchange Rate, Hedging and Arbitrage

Foreign Exchange Rate, Hedging and Arbitrage. Na Yang. Foreign exchange rate. A foreign exchange rate is the price of one country's currency in units of another country's currency and it refers to as the value of a country's currency in terms of another country's currency .

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Foreign Exchange Rate, Hedging and Arbitrage

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  1. Foreign Exchange Rate, Hedging and Arbitrage Na Yang

  2. Foreign exchange rate • A foreign exchange rate is the price of one country's currency in units of another country's currency and it refers to as the value of a country's currency in terms of another country's currency. • Traded currency appear in pairs, the most popular currency pairs are: USD/EUR, USD/JPY, USD/GBP and USD/AUD

  3. Foreign Exchange Rates Quotations • Any two currencies: Direct vs. Indirect • Direct: HC/FC • eg. $1.4287/€ is a direct quotation for a US investor • Indirect: FC/HC • eg. $1.4287/€ is anindirect quotation for an Irish investor • Dollar: American vs. European • American: $/FC (e.g.1.62 $/pound) • European: FC/$ (e.g. 82 yen/$)

  4. Foreign Exchange Rates Quotations Bid and Ask Quotations • Interbank quotes are given as a bid and ask • The bid is the price at which a dealer is willing buy another currency • The ask is the price at which a dealer will sell another currency • Example: USD/EUR 1.4286/88 is the bid/ask for Euro. Exchange rate is usually quoted in mid rates ($1.4287/€), which is the average of the bid-ask.

  5. Foreign Exchange Rates Quotations • Spot Exchange Rates: • current exchange rate, quotes for spot transactions (actually settled within 1 or 2 business days) • Forward Exchange Rates: • an exchange rate quoted today for settlement at some future date. • Quotes for specified future transactions (3 business days and longer settlement). • Forward exchange rate allows businesses and investors to “lock” in an exchange rate for some future period of time.

  6. Forward exchange rate • Forwardexchange rate is calculated from three observable numbers: • The (current) spot rate • The foreign currency interest rate • The home currency interest rate • Forward exchange rate formulas is: FFC/USD=SFC/USD*(1+IFC)/(1+IUS)

  7. Foreign Exchange Rates Quotations Cross Rates • Exchange rate is determined through their relationship with third currency • Example: Citibank, Japan quotes ￥83.30/C$ Bank of Canada quotes € 0.72 /C$ Cross Rate JPY/EUR = ￥83.30/C$/ € 0.72 /C$=￥115.69/€

  8. Triangular Arbitrage Example: Citibank, Japan quotes ￥83.30/C$ Bank of Canada quotes € 0.72 /C$ Bank of Finland quotes ￥115.45/€ Begin:€ 1 million End:€1.002M € ￥115.45/€ € 0.72 /C$ ￥ C$ ￥115.694 M • ￥83.30/C$ C$ 1.39 M

  9. Hedging • Hedging is the practice of taking a position, either through acquiring a cash flow, an asses, or a contract(a forward contract, a future contract), to offset and balance against the value in an existing position • Why Hedging?

  10. Hedging with a Forward Contract • A currency forward contract is an agreement that two parties agree to buy and sell a certain amount of a foreign currency at a specific price and predetermined future date. • Forward contracts are traded in the over-the-counter market • Forward contractsallow businesses and investors to “lock” in an exchange rate for some future period of time.

  11. Hedging with a Forward Contract • USD/GBP Country/Currency Wed Tues UK pound 1.6231 1.6158 1-mos forward 1.6225 1.6152 3-mos forward 1.6211 1.6138 6-mos forward 1.6187 1.6115

  12. Hedging with a Future Contract • A currency future contract is very similar to a forward contract • Currency future contracts are traded on organized exchanges. Chicago Mercantile Exchange • Currency future contracts are standardized, settled through exchange's clearinghouse and the contracts are marked to market each day according to their market value • Maturities are based on a quarterly cycle of March, June, September and December

  13. Hedging with a Future Contract

  14. Currency Futures and Forward Compared

  15. Hedging with a Currency Option • A currency option contract gives buyers the right, not the obligation, to buy or sell a given amount of foreign currency at a fixed price for a specific time period • Currency options are traded both on organized exchanges and over-the-counter market. • It provides opportunities for buyer to benefit from favorable exchange rate movement and has maximum loss of option premium.

  16. Put Option Contract • Put Option Contract to sell ₤1 million pound in six months • The strike price is $1.62/₤ • the premium is 1.7 cent/₤ in the contract. • Cost of Option: $17,000 • If spot exchange rate at maturity is less than or equal to $1.62/₤ exercise and receive $1.62 million • If the spot exchange rate at maturity is more than $1.62/₤, not exercise and sell in the spot market

  17. Hedging with Currency Swap • A currency swap is an agreement between two parties to exchange a given amount of one currency for equivalent amount of another • In a currency swap both the principle and interests are exchanged • Three stages: 1)the principals are exchange at the spot exchange rate 2) interest payments are exchanged on each coupon date 3)the principalsare re-exchanged at the swap's maturity

  18. Take-aways • Hedging can reduce uncertainty and risks, but reduce risk doesn't mean add value • Two criteria help a market participant to choose strategy 1.the risk tolerance the participant can assume 2.anticipation for the direction and distance of the exchange rate.

  19. Questions

  20. Reference • 5/10/2011, Foreign exchange market, http://en.wikipedia.org/wiki/Foreign_exchange_market • Moffett, Michael, Arthur Stonehill, and David Eiteman.Fundamentals of multinational finance. 2nd. Addison-Wesley, 2005. Print. • 5/10/2011, Hedging(Finance), http://en.wikipedia.org/wiki/Hedge_(finance) • 4/28/2011, Foreign exchange Forwards and Futures, • http://thismatter.com/money/forex/fx_forwards.htm • 5/18/2011, Exchange Rates: New York Closing Snapshot, http://online.wsj.com/mdc/public/page/2_3021-forex-20110518.html?mod=mdc_pastcalendar • 5/10/2011, Currency Futures, http://en.wikipedia.org/wiki/Currency_future • 5/18/2011, Currency futures, http://online.wsj.com/mdc/public/page/2_3023-fut_currency-futures-20110518.html?mod=mdc_pastcalendar • 5/18/2011, Arbitrage, http://en.wikipedia.org/wiki/Arbitrage • 5/18/2011, Foreign exchange rate, http://www.citibank.co.jp/en/index.html • 5/18/2011, Daily currency converter, http://www.bankofcanada.ca/rates/exchange/daily-converter/ • 5/18/2011, Exchange rate, http://www.suomenpankki.fi/en/Pages/default.aspx • 5/41/2011, Exchange rate, http:www.xe.com

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