1 / 28

Fi8000 Exchange Rates Forwards, Futures

Fi8000 Exchange Rates Forwards, Futures. Milind Shrikhande. Final Exam. 30% of your grade The exam is comprehensive – covers everything on the syllabus 1.5-2 hours, 4-5 questions Bring your calculator and a formula sheet ( one page, letter, you may write on both sides)

oliver-myers
Download Presentation

Fi8000 Exchange Rates Forwards, Futures

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. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  1. Fi8000Exchange RatesForwards, Futures Milind Shrikhande

  2. Final Exam • 30% of your grade • The exam is comprehensive – covers everything on the syllabus • 1.5-2 hours, 4-5 questions • Bring your calculator and a formula sheet (one page, letter, you may write on both sides) • StockTrak written assignment – type and bring with you to the exam.

  3. Tonight and Next Week • Currency exchange rate • Spot • Forward • Debt instruments • Types • Ratings (default risk) • Spot and forward interest rate • The yield curve • Duration

  4. Currency Exchange Rate (Spot) • A spot currency transaction is an exchange of one currency for another. • The currency exchange rate is a simple conversion factor: • The direct exchange rate is the number of $US to be paid for 1 unit of foreign currency (usually for the £UK and the Euro); • The indirect exchange rate is the number of foreign currency units paid for 1 $US (usually for the Swiss franc and Japanese yen).

  5. Currency Exchange Rate Numeric Example: The exchange rate between the $US and £UK is 1.6757 $US/ £UK - i.e. one has to pay $1.6757 for £1 (direct). The same exchange rate can be presented as 1/1.6757 = 0.5968 £UK /$US - i.e. one has to pay £0.5968 for $1 (indirect).

  6. Currency Exchange Rate Example continued: The exchange rate between the $US and £UK is 1.6757 $US/ £UK. The exchange rate between the $US and J¥ is 0.007331 $US/J¥. What should be the exchange rate between the £UK and the J¥?

  7. Currency Arbitrage • There are at least two ways to convert pounds to yen: • Direct conversion of £UK toJ¥ • Conversion using an intermediary currency: • Convert £UK to $US • Convert $US toJ¥ • If there is no opportunity to make arbitrage profits, both conversion methods must imply the same pound to yen exchange rate .

  8. Currency Exchange Rate Example (data): 1.6757 $US/£UK or 0.5968 £UK/$US. 0.007331 $US/J¥ or 136.40 J¥/$US. We will use the no-arbitrage argument to calculate the £UK/J¥ (or J¥/£UK) exchange rate.

  9. Currency Exchange Rate Conversion using an intermediary currency: Convert £UK to $US: the cost of 1 $US is 0.5968 £UK Convert $US to J¥: the cost of 1 J¥ is 0.007331 $US The £UK cost of 1 J¥: 0.5968 £UK/$US * 0.007331 $US/J¥ = 0.004375 £UK/J¥

  10. Currency Exchange Rate The Pound-Yen no-arbitrage exchange rate: The £UK/J¥ exchange rate is 0.004375, i.e. the cost of 1 J¥ is 0.004375 £UK. The J¥/£UK exchange rate is 1/0.004375 = 228.5641, i.e. the cost of 1 £UK is 228.5641J¥.

  11. Currency Exchange Arbitrage Example continued: The $US/ £UK exchange rate is 1.6757. The $US/J¥ exchange rate is 0.007331. Is there an arbitrage opportunity if the £UK/J¥ exchange rate is 0.004494? Yes! The £UK/J¥ exchange rate in the market is different from the no-arbitrage rate (two-stage currency exchange): Market: 0.004494 £UK/J¥ > 0.004375 £UK/J¥ :No-arbitrage How can we make an arbitrage profit?

  12. Currency Exchange Arbitrage Cross currency (triangle) arbitrage strategy: Sell the expensive J¥ – convert J¥ to £UK in one step: 1. Sell J¥ for £UK (i.e., Buy £UK with J¥ or convert £UK to J¥) Buy the cheap J¥ - convert £UK to J¥ in two steps, using the $US as an intermediary: 2. Buy $US with £UK (convert £UK to $US) 3. Buy J¥ with $US (convert $US to J¥) Note: this is a round trip transaction. You start with J¥ (before step 1) and you end up with J¥ (after step 3).

  13. Currency Exchange Arbitrage Cross currency (triangle) arbitrage strategy: Sell the expensive J¥ - conversion using the direct £UK to J¥ exchange rate: 1. Sell 1 J¥ for 0.004494 £UK (i.e., Buy 0.004494 £UK for 1 J¥) Buy the cheap J¥ - conversion from £UK to J¥ in two stages, using the $US as an intermediary: 2. Buy $US for 0.004494 £UK (you can buy 0.004494 £UK * 1.6757 $US/£UK = 0.00753 $US) 3. Buy J¥ for 0.00753 $US (you can buy 0.00753 $US * 136.40 J¥/$US = 1.02717 J¥) Arbitrage profit: you start with 1 J¥ and end up with 1.02717 J¥.

  14. Currency Exchange Arbitrage Cross currency arbitrage strategy (end up with $US): 2. Sell 136.40 J¥ for £UK (you can buy 136.40 J¥ * 0.004494 £UK/J¥ = 0.6130 £UK) 3. Buy $US for 0.6130 £UK (you can buy 0.6130 £UK * 1.6757 $US/£UK = 1.02717 $US) 1. Buy J¥ for 1 $US (you can buy 1 $US * 136.40 J¥/$US = 136.40 J¥) Arbitrage profit: you start with 1 $US and end up with 1.02717 $US. An arbitrage profit of 0.02717 $US.

  15. Currency Exchange Rate (Forward) • Forward or Futures Contracts • An agreement between a buyer and a seller, to trade at a specific date in the future, a specific quantity of a specific currency for an agreed exchange rate. • Forward – tailored OTC market contracts for creditworthy traders and large trades. • Futures – formal markets of standardized contracts (International Monetary Market in Chicago, London International Financial Futures Exchange).

  16. Covered Interest Arbitrage • There are at least two ways to invest money without risk for one year: • Domestic risk-free investment • Buy US Treasury Bills • Foreign risk-free investment • Convert $US for foreign currency • Buy foreign risk-free bonds for 1 year • Convert the foreign currency back to $US (forward contract) • If there is no opportunity to make arbitrage profits, both investment strategies should have the same dollar denominated percentage return.

  17. Covered Interest Arbitrage Numeric Example: Suppose you would like to invest $100,000 in a risk-free instrument. In the US the annual risk free rate is 5.00%, while in the UK the annual risk free rate is 5.20%. Is there an arbitrage opportunity? – Compare the domestic and foreign investment strategies.

  18. Covered Interest Arbitrage Numeric Example Continued: We need the spot and forward (one year) $US/£UK exchange rates to answer that question. Note that if we do not use a forward contract to “lock in” the exchange rate, the foreign alternative becomes a risky (exchange rate risk) rather than a risk-free investment strategy. Is there an opportunity to make arbitrage profits, if the spot rate is 1.6750 $US/£UK and the (one year) forward exchange rate is 1.6500 $US/£UK?

  19. Comparing the Two Strategies Domestic risk-free investment: 1. Buy US Treasury Bills

  20. Comparing the Two Strategies Foreign risk-free investment: 1. Convert $US for foreign currency 2. Buy foreign risk-free bonds for 1 year 3. Convert the foreign currency back to $US (forward contract)

  21. Arbitrage Strategy Buy Cheap: Domestic risk-free investment Buy US Treasury Bills  get 5% dollar denominated risk free rate Sell Expensive: Foreign risk-free investment Convert £UK to $US Short sell UK risk-free bonds for 1 year Convert $US back to £UK (forward contract)  pay 3.63% dollar denominated risk free rate

  22. Covered Interest Arbitrage

  23. Covered Interest Arbitrage What is the no-arbitrage UK risk free rate? (r = 6.5909%)

  24. Interest Rate Parity(Covered Interest Arbitrage) Intuition: If two investments are risk-free they must have the same rate of return. Therefore, any difference in the domestic and foreign risk-free rates must be offset by a difference in the spot and forward exchange rates. Formula:

  25. Interest Rate Parity(Covered Interest Arbitrage) Notation: E0 = spot exchange rate ($US/£UK) or (£UK/$US) F0 = forward exchange rate ($US/£UK) or (£UK/$US) * Note that if you use the £UK/$US (indirect) exchange rate you will also have to reverse the ratio of interest rates. Formula:

  26. Practice Problems Practice Problem #1 The annual risk-free rate in the US is 5.00% while in Japan it is 3.20%. What should be the spot J¥/$US exchange rate, if the (one year) forward J¥/$US exchange rate is 107.875? Answer: E0(J¥/$US) = 109.7565

  27. Practice Problems Practice Problem #2 The annual risk-free rate in the US is 4.60% while in Japan it is 3.50%. The spot J¥/£UK exchange rate is 205.00, the spot $US/£UK exchange rate is 1.8825, the (one year) forward J¥/£UK exchange rate is 204.00 and the forward $US/£UK exchange rate is 1.8900. Describe an arbitrage transaction. Write down the same stages and use the table format presented in the lecture notes.

  28. Practice Problems BKM Ch. 23: 10, 12-14. Practice problems: Forward and futures contracts 1-5; Currency exchange rates 6-9.

More Related