Foreign Exchange Rate, Hedging and Arbitrage Na Yang
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Foreign Exchange Rate, Hedging and Arbitrage
Na Yang
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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
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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/$)
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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 ($1.4287/€), which is the average of the bid-ask.
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Foreign Exchange Rates Quotations
Spot Exchange Rates:• current exchange rate, quotes for spot transactions
(actually settled within 1 or 2 business days)Forward Exchange Rates:
– an exchange rate quoted today for settlement at some future date.
– Quotes for specified future transactions (3 business days and longer settlement).
– Forward exchange rate allows businesses and investors to “lock” in an exchange rate for some future period of time.
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Forward exchange rate
Forward exchange rate is calculated from three observable numbers:
• The (current) spot rate
• The foreign currency interest rate
• The home currency interest rate
Forward exchange rate formulas is:
FFC/USD=SFC/USD*(1+IFC)/(1+IUS)
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Foreign Exchange Rates Quotations
Cross Rates– Exchange rate is determined through their relationship with third
currency
– Example:
Citibank, Japan quotes ￥ 83.30/C$
Bank of Canada quotes € 0.72 /C$
Cross Rate JPY/EUR = ￥ 83.30/C$/ € 0.72 /C$=￥ 115.69/€
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Triangular Arbitrage
Example:
Citibank, Japan quotes ￥ 83.30/C$
Bank of Canada quotes € 0.72 /C$
Bank of Finland quotes ￥ 115.45/€
€
￥ C$
€ 0.72 /C$
￥ 83.30/C$
￥ 115.45/€
Begin:€ 1 million
C$ 1.39 M￥ 115.694 M
End:€1.002M
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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?
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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 contracts allow businesses and investors to “lock” in an exchange rate for some future period of time.
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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 1.62111.6138
6-mos forward 1.6187 1.6115
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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
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Hedging with a Future Contract
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Currency Futures and Forward ComparedCharacteristic 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
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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.
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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
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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 principals are re-exchanged at the swap's maturity
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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.
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Questions
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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
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