I. Overview of The Foreign Exchange Market
1. Definition
- The foreign exchange (FX) market is the place where currencies are traded and its primary function is to facilitate international trade and investment.
- The FX market has no physical location where traders get together to exchange currencies. It is an electronically linked networks of banks, foreign exchange brokers and dealers whose function is to bring together buyers and sellers of foreign exchange.
- The purpose of the FX market is to permit transfers of purchasing power denominated in one currency to another - to permit trading of one currency for another currency.
- The FX market is the largest financial market in the world. The average foreign exchange daily trading volume is $1.5 trillion, or $375 trillion a year in 1998. London is the largest currency trading market in the world with daily turnover in 1998 estimated at $637 billion. The United States is second, at about $351 billion in 1998. In contrast, average daily trading volume on the New York Stock Exchange is only about $7 billion.
2. Types of Transactions
- Three general types of transactions take place in the FX market: spot, forward and swap.
- Spot transactions involve an agreement on price today with settlement day usually two business days later. Spot transactions account for about 40% of the market.
- Forward transactions involve an agreement on price today for settlement at some date in the future. Frequently traded forward maturities are for one or two weeks, or one through twelve months. Forward contracts account for 9% of foreign exchange transactions.
- A swap is the sale (purchase) of a foreign currency with a simultaneous agreement to repurchase (resell) it at some date in the future. Swap transactions represent 51% of foreign exchange transactions.
3. Foreign Exchange Rates and Quotations
A foreign exchange rate is the price of one currency expressed in terms of another currency.
a. Direct and Indirect Quotes
Foreign exchange quotations are either direct or indirect.
Direct quote - the home currency price of one unit of foreign currency. e.g., $0.8914/euro
Indirect quote - the foreign currency price of one unit of home currency. e.g., euro 1.1218/$
c. Bid and Offer Quotations
- Foreign exchange quotations are expressed as a bid and an offer (ask).
Bid price - the price at which a dealer is willing to buy a currency.
Offer price - the price at which a dealer is willing to sell a currency.
e.g., euro 1.1218 -1.1220 per $
d. Cross Rates
Exchange rates of almost all currencies are quoted against the U.S. dollars. For example, both the British pound and euros will be traded with prices quoted against the U.S. dollar. If a commercial customer asked for a euro price in terms of the British pound, this cross rate will be determined from the two dollar rates.
Example: A bank is currently quoting the following exchange rates with respect to the dollar:
Euro 1.1218/$; $1.4374/L
What euro per British pound cross rate would the bank quote, it asked?
e. Measuring a Change in Spot Exchange Rates
Suppose the yen value of the dollar dropped from Y106/$ to Y102/$. What is the percent decrease in the yen value of the dollar? What is the percent increase in the dollar value of the
yen?
II. Foreign Exchange Parity Conditions and Forecasting
1. Parity Conditions
In the competitive and efficient foreign exchange market, the following economic relationships, called parity conditions, among foreign exchange rates, inflation and interest rates.
A. Purchasing Power Parity
B. Fisher Effect
C International Fisher Effect
D. Interest Rate Parity
E. Forward Rate as an Unbiased Predictor of Future Spot Rates
A. Purchasing Power Parity (PPP)
(a) The Absolute Version
Exchange-adjusted price levels should be identical worldwide. In other words, a unit of home currency should have the same purchasing power around world.
1
The absolute PPP ignores the effects on free trade of transportation costs, tariffs, quotas and other restrictions.
(b) The Relative Version
The Exchange rate change during a period should equal the inflation differential for that same period. Or currencies with high rates of inflation should devalue relative to currencies with lower rates of inflation.
fh
2
B. The Fisher Effect (FE)
Nominal interest rates in each country are equal to the real rate of return plus the expected inflation rate.
i = + E(
3
C. The International Fisher Effect (IFE)
The expected future spot exchange rate should change in an equal amount but in the opposite direction to the difference in interest rates between two countries.
4
In short, the IFE says that currencies with low interest rates are expected to appreciate relative to currencies with high interest rates.
D. Interest Rate Parity
The difference in the national interest rates for securities of similar risk and maturity should be equal to, but opposite in sign to, the forward rate discount or premium for the foreign currency. Algebraically,
5
or, in approximation,
6
- According to the interest rate parity theorem, if interest rates are higher (lower) in the domestic country than in the foreign country, then the foreign country's currency will be selling at a premium (discount) in the forward market.
- In short, interest rate parity says that high interest rates on a currency are offset by forward discounts and that low interest rates are offset by forward premiums.
- Consider a trader with access to the interbank market in foreign exchange and eurocurrency.
Strategy A
- At time 0, deposit one unit of domestic currency
- At time 1, withdraw 1 + ih units of domestic currency.
Strategy B
- At time 0, purchase S0 units of foreign currency; deposit them at the interest rate of 1 + if; sell forward S0(1 + if) units of foreign currency at forward rate F1.
- At time 1, deposit matures and pays S0(1 + if) units of foreign currency; deliver this amount of foreign currency in fulfillment of forward contract receiving S0(1 + if)/ F1 units of domestic currency.
With no arbitrage opportunities, we must have equality between the rate of return on domestic assets and covered foreign assets:
1 + ih = S0(1 + if)/ F1
or
7
Example 1: Let the spot rate S0 = euro 1.4/$ and the one-year forward rate F1 = euro1.3/$. Let the rates on eurodollar deposits and euro deposits be, respectively, ih = 4% and if = 3.714%. Compare the return on domestic lending with the return on covered foreign lending.
Example 2: Suppose an interbank trader noticed the following market prices:
S0 = L0.7/$, F1= L0.8/$; ih = 10% and if = 6%.
Is there an arbitrage opportunity?
E. Forward Rate as an Unbiased Predictor of the Future Spot Rate
If the foreign exchange market is efficient, the expected value of the future spot rate at time 2 equals the present forward rate for time 2 delivery, available at time 1 (now).
E(S1) = F1
3. Exchange Rate Forecasting
A. Fundamental Versus Technical Analysis
- Fundamental analysis is to construct forecasts on the basis of financial and economic theories.
- Technical analysis is to derive forecasts from the trend of the data series itself.
(a) Fundamental Analysis
Fundamental analysis is split into two schools of thought: the balance of payments approach and the asset market approach.
- The balance of payments approach emphasizes analysis of a country's balance of payments as an indicator of pressure on a managed exchange rate.
- The asset market approach postulates that the relative attractiveness of a currency for investment purpose is the main force driving exchange rates.
(b) Technical Analysis
Technical analysis is to attempt to forecast future foreign exchange rates through the analysis of past price and volume data. One advantage of the technical analysis is to be able to assess the market psychology.
B. Forecasting Exchange Rates in the Short Run
The two primary alternatives for forecasting exchange rates in the short run are time series techniques which emphasize trend and the use of the forward rate itself as a prediction.
C. Forecasting Exchange Rates in the Long Run
Forecasting methods for the long run include computerized time series analysis and the econometric analysis using fundamental analysis.
III. Foreign Exchange Risk Management
(1) There are three main types of foreign exchange exposure: Operating, Transaction, and Accounting.
(2) Exposure refers to the degree to which a company is affected by foreign exchange changes.
(3) Operating exposure, or economic exposure, measures a change in the present value of firm that results from changes in future operating cash flows caused by an unexpected change in exchange rates.
(4) Transaction exposure measures changes in the value of outstanding financial obligations due to an unexpected change in exchange rates.
(5) Accounting exposure, or translation exposure, measures potential accounting-derived changes in owners' equity that result from the need to translate foreign currency financial statements to into a single reporting home currency.
1. Operating Exposure
(1) The Nominal vs. Real Exchange Rates
- The real exchange rate is defined as the nominal exchange rate adjusted for changes in the relative purchasing power of each currency since some base period, i.e.,
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- A change in the nominal exchange rate accompanied by an equal change in the price level would have no effect on the relative prices of domestic and foreign goods. In contrast, a change in the real exchange rate will cause relative price changes - changes in the ratio of domestic goods' prices to prices of foreign goods.
(2) Inflation and the Nominal Exchange Risk
- Without relative price changes, a multinational company has no operating exposure. A multinational firm's foreign cash flows vary with the foreign rate of inflation. But the exchange rate also depends on the difference between the foreign and the domestic rates of inflation. Therefore, the movement of the exchange rate exactly cancels the change in the foreign price
level, leaving real dollar cash flows unaffected.
(3) Real Exchange Rate Changes and Exchange Risk
- The economic impact of a currency change on a firm depends on whether the exchange rate is fully offset by the difference in inflation rates or whether the real exchange rate and, hence, relative prices change. It is these relative price changes that ultimately determine a firm's long-run operating exposure.
- Example
(4) Economic Effects of Exchange Rate Changes on MNCs
Example: Sunbeam Inc. considers selling its product to Mexico. Two alternative ways of selling the product overseas is to export or to construct production facilities in Mexico and sell the product locally. Sunbeam Inc. plans to set the export price at $180 per product if it decides to export and the local sales price at 630 pesos if it chooses to manufacture and sell in Mexico. The unit production cost is $70 if the product is manufactured in the U.S. and 245 pesos if it is manufactured in Mexico. The current exchange rate is Peso 3.5/$. At this current exchange rate, Sunbeam forecasts the export volume of 1,200 units. Sunbeam also forecasts that if the peso value revalues to peso 3.0/$, the export volume will increase to 1,500 units, and if the peso devalues to peso 4.0/$, the export volume will decrease to 900 units. If Sunbeam chooses the second alternative of constructing production facilities in Mexico, the local sales volume will remain to be 1,200 units. Calculate the profit margin (= sales revenue - production cost) for the three cases (i.e., at the current exchange rate, the case of revaluation and the case of devaluation) under each of the two alternatives (i.e., export and foreign direct investment), respectively. You must fill all the entries in dollar terms.
(1) Export
At currentAfter re-After de-
exchange ratevaluationvaluation
Sales Rev.
Production
cost
Profit
Margin
(2) Foreign direct investment
At currentAfter re-After de-
exchange ratevaluationvaluation
Sales Rev.
Production
cost
Profit
Margin
- Observation
(a) Domestic facilities that supply foreign markets entail much greater exchange risk than do foreign facilities supply local markets. e.g., Nissan Motors
(b) A firm producing solely for the domestic market and using only domestic sources of inputs can be strongly affected by currency changes, even though its accounting exposure is zero. e.g., American automobile companies.
(5) Managing Operating Exposure
a. Match any change in the inflow on assets due to a currency change with a corresponding change in the outflow on the liabilities used to fund those assets.
b. Reduce the price elasticity of demand
The less price elastistic the demand, the more price flexibility a company will have to respond to exchange rate changes. Price elasticity, in turn, depends on the degree of competition and the location of key competitors
c. Enhance the ability to shift production and sourcing of inputs among countries
The greater a company's flexibility to substitute between home-country and foreign-country inputs or production, the less exchange risk the company will face. Other things being equal, firms with worldwide production system can cope with currency changes by increasing production in a nation whose currency has undergone a real devaluation and decreasing production in a nation whose currency has revalued in real terms.
2. Transaction Exposure
(1) Causes
Transaction exposure measures gains or losses that arise from the settlement of financial obligations whose terms are stated in a foreign currency. Transaction exposure arises from
a. purchasing or selling on credit goods or services whose prices are stated in foreign currencies,
b. borrowing or lending funds when repayment is to be made in a foreign currency.
(2) Examples
a. Suppose that a U.S. firm sells merchandise on open account to a French buyer for FF1,000,000, payment to be made in 60 days. The current exchange rate is FF5.7/$, and the U.S. seller expects to exchange FF1,000,000 for $175,439 when payment is received.
b. Britain's Beecham Group borrowed SF100 million in 1971 at a time when that amount of Swiss francs was worth L10.13 million. When the loan came due five years later the cost of repayment of principal was L22.73 million-more than double the amount borrowed.
(3) Managing Transaction Exposure
Transaction exposure can be managed by hedges in the forward, money, futures, options markets, as well as swap agreements.
Example: Dow Chemical, imports a chemical processor from VEBA Group, a German firm, in March for euro1,000,000. Payment is due three months later, in June. The following quotes are available.
Spot exchange rate: euro 0.70/$
Three-month forward rate: euro0.80/$
Germany borrowing interest rate: 6% per annum
Germany investment interest rate: 5% per annum
U.S. borrowing interest rate: 8% per annum
U.S. investment interest rate: 6.8% per annum
Dow Chemical's International Finance Division forecasts that the spot rate in three months will be euro0.78/$.
Four alternatives are available to Dow Chemical:
. Remain unhedged
. Hedge in the forward market
. Hedge in the money market
. Hedge in the options market
. Hedge in the swap market
a. Unhedged Position
b. Forward Market Hedge
c. Money Market Hedge
3. Foreign Currency Futures
A. Definition
A futures contract obligates you to sell or purchase a specific amount of a commodity at a specific time in the future.
B. Purpose of Futures Markets
to meet the needs of the following three groups of futures market users.
- Those who wish to transfer unwanted risk to some other party.
- Those who wish to speculate
- Those who wish to discover information about futures spot prices of commodities.
C. Futures vs. Forward Markets
Futures MarketsForward Markets
(a) Futures contracts are always tradedLoosely organized.
on an organized exchangeDo not have physical location devoted
to trading
(b) Futures contracts are highly Not standardized
standardized and well specified
commitments for a carefully
described goods to be delivered
at a certain time and in a certain
manner
(c) The buyer and seller hold formalThe buyer and seller hold formal
contracts with the clearingcontracts with each other.
house of the futures exchange.Contracts are ordinarily satisfied by actual
Thus, either party can liquidatedelivery of specified items on the specific
its futures obligation to buy (ordate.
sell) by "offsetting" it with a sale
(or purchase) of the same contract prior
to the scheduled delivery date. In the
futures market, almost all contracts are
"offset" prior to delivery.
(d) Initial margin requirement and daily resettlement features.
D. FX Futures Contracts
(a) The two most important places where FX futures contracts can be traded are at the International Money Market (IMM) of the Chicago Mercantile Exchange and at the London International Financial Futures Exchange (LIFFE).
(b) The most active currency futures contracts are Canadian dollar, Deutsche mark, French franc, Japanese yen, British pound, and Swiss franc.
(c) Delivery takes place on the third Wednesday of the spot month or if that is not a business day, the next business day. Trading in a contract ends two business days prior to the delivery day.
4. Foreign Currency Options
A. Definition
An option is a contract giving its owner the right to buy or sell an underlying asset at a fixed price on or before a given date. There are two types of options: call and put options. A call option gives the owner the right to buy an asset and a put option the right to sell an asset.
B. Some jargons
(a) Exercising the option: The act of buying or selling the underlying asset via the option contract.
(b) Striking price or exercise price: The fixed price in the option contract at which the holder can buy or sell the underlying asset.
(c) Expiration date: The maturity date of the option.
(d) American and European options: An American option may be exercised any time up to the expiration date. A European option differs from an American option in that it can be exercised only on the expiration date. Nearly all options now traded in the U.S. are of the American type.
C. The foreign currency options market
The market for foreign currency options consists of an interbank market centered in London and New York, and exchange-based markets in Philadelphia (the PHLX), Chicago (the CME and CBOE), and London (LIFFE and LSE).
D. Hedging with foreign currency options
(a) Foreign currency put options on spot can be used as insurance to establish a floor price on the domestic currency value of foreign exchange. This floor price is approximately
Floor price = Exercise price of put - Put premium
(b) Foreign currency call options can be used as insurance to establish a ceiling price on the domestic currency cost of foreign exchange. The ceiling price is approximately