Foreign Exchange Rate Hedging and Arbitrage Na Yang

Foreign Exchange Rate, Hedging and Arbitrage Na Yang

Foreign exchange rate Ø 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. Ø Traded currency appear in pairs, the most popular currency pairs are: USD/EUR, USD/JPY, USD/GBP and USD/AUD Page 3 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 an indirect quotation for an Irish investor Dollar: American vs. European · American: $/FC (e. g. 1. 62 $/pound) · European: FC/$ (e. g. 82 yen/$) Page 4 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. Page 5 5

Foreign Exchange Rates Quotations ØSpot Exchange Rates: • current exchange rate, quotes for spot transactions (actually settled within 1 or 2 business days) ØForward 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. Page 6 6

Forward exchange rate Ø Forward exchange rate is calculated from three observable numbers: • The (current) spot rate • The foreign currency interest rate • The home currency interest rate ØForward exchange rate formulas is: FFC/USD=SFC/USD*(1+IFC)/(1+IUS) Page 7 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/€ Page 8 8

Triangular Arbitrage Example: Citibank, Japan quotes ￥ 83. 30/C$ Bank of Canada quotes € 0. 72 /C$ Bank of Finland quotes End: € 1. 002 M ￥ 115. 45/€ ￥ ￥ 115. 694 M Page 9 ￥ 115. 45/€ Begin: € 1 million € € 0. 72 /C$ C$ ￥ 83. 30/C$ C$ 1. 39 M 9

Hedging ØHedging 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 ØWhy Hedging? Page 10 10

Hedging with a Forward Contract ØA 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. ØForward contracts are traded in the over-the-counter market ØForward contracts allow businesses and investors to “lock” in an exchange rate for some future period of time. Page 11 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 Page 12 12

Hedging with a Future Contract ØA currency future contract is very similar to a forward contract ØCurrency future contracts are traded on organized exchanges. Chicago Mercantile Exchange ØCurrency future contracts are standardized, settled through exchange's clearinghouse and the contracts are marked to market each day according to their market value ØMaturities are based on a quarterly cycle of March, June, September and December Page 13 13

Hedging with a Future Contract Page 14 14

Currency Futures and Forward Compared Characteristic Currency Futures Currency Forward Size of Contract Standard contracts per currency Any size desired Pricing Open outcry process on the exchange floor Prices are determined by bid and ask quotes Margin/Collateral Initial margin is marked to market on a daily basis No explicit collateral, standard banking relationship needed. Settlement Rarely delivered upon; settlement normally takes place through purchasing of offsetting position Normally delivered upon Counterparties unknown to each other Parties are in direct contact Liquidity Liquid but relatively small in total sales volume and value Liquid but relatively large in total sales volume and value 15 Page 15

Hedging with a Currency Option ØA 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 ØCurrency options are traded both on organized exchanges and over-the-counter market. ØIt provides opportunities for buyer to benefit from favorable exchange rate movement and has maximum loss of option premium. Page 16 16

Put Option Contract ØPut Option Contract to sell ₤ 1 million pound in six months ØThe strike price is $1. 62/₤ Øthe 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 Page 17 17

Hedging with Currency Swap ØA currency swap is an agreement between two parties to exchange a given amount of one currency for equivalent amount of another ØIn a currency swap both the principle and interests are exchanged ØThree stages: 1)the principals are exchange at the spot exchange rate 2) interest payments are exchanged on each coupon date 3)the principals are re-exchanged at the swap's maturity Page 18 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. Page 19 19

Questions Page 20 20

Reference Ø 5/10/2011, Foreign exchange market, http: //en. wikipedia. org/wiki/Foreign_exchange_market Ø Moffett, Michael, Arthur Stonehill, and David Eiteman. Fundamentals of multinational finance. 2 nd. Addison-Wesley, 2005. Print. Ø 5/10/2011, Hedging(Finance), http: //en. wikipedia. org/wiki/Hedge_(finance) Ø 4/28/2011, Foreign exchange Forwards and Futures, Ø http: //thismatter. com/money/forex/fx_forwards. htm Ø 5/18/2011, Exchange Rates: New York Closing Snapshot, http: //online. wsj. com/mdc/public/page/2_3021 -forex 20110518. html? mod=mdc_pastcalendar Ø 5/10/2011, Currency Futures, http: //en. wikipedia. org/wiki/Currency_future Ø 5/18/2011, Currency futures, http: //online. wsj. com/mdc/public/page/2_3023 -fut_currency-futures-20110518. html? mod=mdc_pastcalendar Ø 5/18/2011, Arbitrage, http: //en. wikipedia. org/wiki/Arbitrage Ø 5/18/2011, Foreign exchange rate, http: //www. citibank. co. jp/en/index. html Ø 5/18/2011, Daily currency converter, http: //www. bankofcanada. ca/rates/exchange/daily-converter/ Ø 5/18/2011, Exchange rate, http: //www. suomenpankki. fi/en/Pages/default. aspx Ø 5/41/2011, Exchange rate, http: www. xe. com Page 21 21