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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 .

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foreign exchange rate
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
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 quotations1
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.
foreign exchange rates quotations2
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
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 quotations3
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
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
  • 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
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 contract1
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
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
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
  • 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

hedging with currency swap
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
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
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