Foreign Exchange Rate, Hedging and Arbitrage

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# Foreign Exchange Rate, Hedging and Arbitrage - PowerPoint PPT Presentation

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

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.
• Traded currency appear in pairs, the most popular currency pairs are: USD/EUR, USD/JPY, USD/GBP and USD/AUD
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/\$)
Foreign Exchange Rates 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.
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.
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)

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/€

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

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?
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.
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

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
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.
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/₤

• If the spot exchange rate at maturity is more than \$1.62/₤,

not exercise and sell in the spot market

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

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.

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