Currency Futures

1. Currency Futures Professor Brooks BA 444 02/12/08

2. The Underlying Asset • FX is the abbreviation for foreign currency exchange • Foreign Currency is the underlying asset • Just think of the foreign currency as a commodity that you buy or sell • Currency relationship around the world • Purchasing Power Parity • Exchange rates set so that currency of one country should be able to buy the exact same goods of another country • Example: Shoes in US vs. Japan

3. Purchasing Power Parity • Shoe sells for $150 in USA • Same shoe sells for ¥18,750 • Where do you buy your shoes? • Note you can have them shipped directly to you and the shipping charge is included in the price • The current exchange rate is ¥125 for $1 • No advantage for where you buy the shoe • What about a year from now? • US inflation rate is 5% and Japanese inflation rate is 8% • US price will be $157.50 – Japanese will be ¥20,250 • Exchange rate in one year will be: ¥128.57 for $1 • Forward exchange rates reflect inflation differences

4. Foreign Exchange Rates • Change daily due to expected inflation rates in the various countries • Anticipated or Forward Rates reflect the impact of the expected inflation rate • Future Forward Rate Calculation: Forward Ratet≈ Spot Rate x (1 + (InfFor – InfUS))t • Example Forward Rate ≈ 125 x (1 + (0.08 – 0.05)) Forward Rate ≈ 125 x 1.03 = 128.75

5. Forward Rates • More Exact Model using the Indirect Quote:

6. Interest Rate Parity • Components of interest rate • The real rate – compensation for waiting • Inflation rate – the general rise in the prices of goods over time • Risk premium(s) – default, maturity, liquidity, etc. • The real rate is the same the world round • Example…investing in country with the highest nominal interest rate

7. Investing Around the World • Current risk-free rate in U.S. is 4% • Current risk-free rate in Japan is 7% • Convert U.S. dollars to Yen (say $100) • Invest in Japan (¥12,500) • Wait 1 Year (¥13,375) • Convert Yen back to U.S.dollars…($104) • Same place in wealth if you had left money in U.S. bank…except for transaction costs… • Proof…used ¥125 to $1 and then ¥128.60577 to $1 • US deposit at end of one year $104

8. Where is the Risk? • Weak Dollar • The term weak dollar usually means that the U.S. dollar is losing buying power in a foreign currency • Example, today the U.S. dollar can buy 125 yen…but if the dollar weakens next month it can only buy 115 yen • Strong Dollar is just the opposite • What does this mean for imports and exports?

9. Where is the Risk? • Weak U.S. Dollar and Imports/Exports • Imports become more expensive (for U.S. buyer), exports become cheaper (for foreign buyer) • Helps exporters (manufacturers) of U.S. goods – Hurts importers (consumers) of foreign goods • Strong U.S. Dollar and Imports/Exports • Imports become cheaper (for U.S. buyer), exports become more expensive (for foreign buyer) • Helps importers (consumers) of foreign goods – Hurts exporters (manufacturers) of U.S. goods • Balance of Trade Issues for U.S. economy

10. Where is the Risk? • Accounting Risks – Multinational Company based in U.S. • Transaction Risk • Company buys a good (on credit) in a foreign currency • Price of the good may go up or down due to changes in the exchange rate • Translation Risk • Company owns property in a foreign country • Must consolidate assets for U.S. reporting • Foreign asset value must be translated into U.S. dollars • Value may go up or down due to changes in the exchange rate

11. Where is the Risk? • Economic Exposure • Own foreign stock or foreign asset • Value will fluctuate with change in exchange rate • Example – Purchase Nestle stock five years ago at €45 when the exchange rate was €1 = $1 • In five years the stock has gone up 60% • In five years exchange rate has changed to €1=$0.75 • Gain on stock should be 60% (in Euros) • Translated gain is only 20% • €45 x (1.60) x 0.75 = $54 and • $54 / $45 – 1 = 20%

12. Dealing with the Risk • Ignore the exposure • Expectation is that FX will have small or very moderate changes • Eliminate the potential risk • Don’t hold foreign assets or securities • Hedge the risk • With forward market, enter into a forward exchange agreement (lock in the future exchange rate) • Hedge with futures contract – contracts large

13. Hedge Example • Wine Importer – Buys French Wines • Purchases wines at harvest but will not have shipment of wines until following year • Futures on FX for Euros – contract is for €125,000 • One year rate is 1.45 • It would take $181,250 to purchase €125,000 in one year • Assume Wine Importer has ordered $10,000,000 of wine (order is in Euros) • Current obligation (at €1.25 to $1) is for €8,000,000 • Needs 64 Futures Contracts to Buy Euros (long in Euros futures contract, short Euros) • Locks in exchange rate at 1.45 for one year from now and anticipates paying $11,600,000

14. Hedge Example Continued • Exchange Rate is higher at 1.60 • Needs $12,800,000 to buy the wine • With Futures…makes $1,200,000 on futures contract, • Net outflow is $11,600,000 • Exchange Rate is at anticipated 1.45 • Pays $11,600,000 for wine • No gain or loss on futures • Exchange Rate stays at 1.25 • Needs only $10,000,000 to pay for wine • Losses $1,600,000 on futures • Net outflow $11,600,000 • Locked in cost of wine…$11,600,000

15. What about French Winemaker? • Opposite Risk? • Wine will be purchased with Euros…no currency exposure • Price is €8,000,000 today…tomorrow… • Winemaker has a forward contract for sale of wine in one year…he has hedged wine with a forward contract