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Chapter 16 Foreign Exchange Derivative Markets Outline Foreign Exchange Markets Institutional Use of Foreign Exchange Markets Exchange Rate Quotations Types of Exchange Rate Systems Eurozone Arrangement Abandoning the Euro Factors Affecting Exchange Rates Differential Inflation Rates Differential Interest Rates Central Bank Intervention Forecasting Exchange Rates Technical Forecasting Fundamental Forecasting Market-Based Forecasting Mixed Forecasting Foreign Exchange Derivatives Forward Contracts Currency Futures Contracts Currency Swaps Currency Options Contracts Use of Foreign Exchange Derivatives for Speculating International Arbitrage Locational Arbitrage Triangular Arbitrage Covered Interest Arbitrage Key Concepts 1. Identify factors that influence exchange rates. 2. Explain how various foreign exchange derivatives can be used to hedge against exchange rate movements. 3. Explain how arbitrage can assure that currency values are not mispriced. POINT/COUNTER-POINT: Do Financial Institutions Need to Consider Foreign Exchange Market Conditions When Making Domestic Security Market Decisions? POINT: No. If there is no exchange of currencies, there is no need to monitor the foreign exchange market. COUNTER-POINT: Yes. Foreign exchange market conditions can affect an economy or an industry and therefore affect the valuation of securities. In addition, the valuation of a firm can be affected by currency movements because of its international business. WHO IS CORRECT? Use the Internet to learn more about this issue and then formulate your own opinion. ANSWER: The counter-point is correct. Students should not view the foreign exchange market as an isolated market. Questions 1. Exchange Rate Systems. Explain the exchange rate system that existed during the 1950s and 1960s. How did the Smithsonian Agreement in 1971 revise it? How does today’s exchange rate system differ? ANSWER: The 1950s and 1960s were part of the Bretton Woods era, in which currency values were maintained within 1 percent of a specified rate. In 1971, the Smithsonian Agreement called for a widening of the boundaries to 2-1/4 percent around each currency’s specified rate. These boundaries were eliminated in 1973. Today, there are no explicit boundaries. 2. Dirty Float. Explain the difference between a freely floating system and a dirty float. Which type is more representative of the United States system? ANSWER: A free float implies that currencies are market determined without government intervention. A dirty float implies that currency values can fluctuate but are subject to government intervention. The dirty float is more representative of the United States. 3. Impact of Quotas. Assume that European countries impose a quota on goods imported from the United States, and that the United States does not plan to retaliate. How could this affect the value of the euro? Explain. ANSWER: A quota on goods imported from the United States by Europe will reduce the supply of euros for sale (to be exchanged for dollars) and places upward pressure on the euro. 4. Impact of Capital Flows. Assume that stocks in the United Kingdom become very attractive to U.S. investors. How could this affect the value of the British pound? Explain. ANSWER: U.S. investors would convert dollars to pounds to purchase British stocks. Thus, the value of the pound may appreciate against the dollar in response to the increased U.S. demand for pounds. 5. Impact of Inflation. Assume that Mexico suddenly experiences high and unexpected inflation. How could this affect the value of the Mexican peso according to purchasing power parity (PPP) theory? ANSWER: High Mexican inflation would cause an increased Mexican demand for U.S. goods (increased supply of pesos for sale) and a reduced U.S. demand for Mexican goods (and therefore a reduced demand for Mexican pesos). Both forces place downward pressure on the value of the peso. 6. Impact of Economic Conditions. Assume that Switzerland has a very strong economy, placing upward pressure on both inflation and interest rates. Explain how these conditions could place pressure on the value of the Swiss franc, and determine whether the franc’s value will rise or fall. ANSWER: A stronger economy will cause an increased Swiss demand for U.S. goods, which places downward pressure on the value of the franc. A higher Swiss inflation rate will also increase the Swiss demand for U.S. goods, which places downward pressure on the franc’s value. Higher Swiss interest rates may attract U.S. funds and place upward pressure on the franc’s value. The first two factors relate to international trade while the third factor relates to capital flows. If trade flows are larger, the franc’s value is expected to depreciate. 7. Central Bank Intervention. The Bank of Japan desires to decrease the value of the Japanese yen against the U.S. dollar. How could it use direct intervention to do this? ANSWER: The Bank of Japan could flood the foreign exchange market with yen by selling yen in exchange for U.S. dollars, causing downward pressure on the yen’s value. 8. Conditions for Speculation. Explain the conditions under which a speculator would like to take a speculative position in which it will invest in a foreign currency today, even when it has no use for that currency in the future. ANSWER: A speculator may invest in a currency if it expects the currency to appreciate. 9. Risk from Speculating. Seattle Bank just took speculative positions by borrowing Canadian dollars and converting the funds to invest in Australian dollars. Explain a possible future scenario that could adversely affect the bank’s performance. ANSWER: If the Canadian dollar appreciates against the U.S. dollar, while the Australian dollar depreciates against the U.S. dollar, this implies that the Canadian dollar is appreciating against the Australian dollar. Seattle Bank would be adversely affected by this scenario. If the Australian dollar inflows from closing out the long position are used to cover the short position in Canadian dollars, they will be worth fewer Canadian dollars (because of the Australian dollar’s assumed depreciation). 10. Impact of a Weak Dollar. How does a weak dollar affect U.S. inflation? Explain. ANSWER: A weak dollar tends to cause higher prices paid by U.S. firms for foreign supplies and materials. It also reduces foreign competition and allows U.S. producers to raise prices more easily without concern about losing business. Both forces reflect upward pressure on U.S. inflation. 11. Speculating With Foreign Exchange Derivatives. Explain how foreign exchange derivatives could be used by U.S. speculators to speculate on the expected appreciation of the Japanese yen. ANSWER: U.S. speculators could attempt to lock in an exchange rate at which they could exchange dollars for yen at a future point in time. This could be accomplished by purchasing forward contracts or futures contracts on Japanese yen, negotiating a swap for yen, or purchasing yen call options. They could also sell yen put options to capitalize on their expectations. Advanced Questions 12. Interaction of Capital Flows and Yield Curve. Assume a horizontal yield curve exists. How do you think the yield curve would be affected if foreign investors in short-term securities and long-term securities suddenly anticipate that the value of the dollar will strengthen? (You may find it helpful to refer back to the discussion of the yield curve in Chapter 3.) ANSWER: Open-ended. Foreign investors may purchase more U.S. securities than before to benefit from their expectations. A stronger dollar tends to place downward pressure on inflation and therefore on future interest rates. Therefore, foreign investors could benefit more from purchase long-term bonds than from purchasing short-term securities. While there could be an increased demand for short-term and long-term U.S. securities, the demand for long-term securities should be greater. Thus, while both short-term and long-term rates should decline, long-term rates will decline by a greater degree. The result is a new yield curve that is lower than the previous yield curve and is sloped downward. 13. How the Euro’s Value May Respond to Prevailing Conditions. Consider the prevailing conditions for inflation (including oil prices), the economy, interest rates, and any other factors that could affect exchange rates. Based on prevailing conditions, do you think the euro’s value will likely appreciate or depreciate against the dollar for the remainder of this semester? Offer some logic to support your answer. Which factor do you think will have the biggest impact on the euro’s exchange rate? ANSWER: The value of the euro against the dollar may respond to prevailing conditions in various ways, as investors assess factors such as inflation, economic performance, interest rate differentials, and geopolitical developments. Let's analyze these factors and determine whether the euro is likely to appreciate or depreciate against the dollar for the remainder of this semester: 1. Inflation and Economic Conditions: • If prevailing conditions suggest higher inflation and stronger economic growth in the Eurozone compared to the United States, this could potentially lead to an appreciation of the euro against the dollar. Higher inflation may prompt expectations of tighter monetary policy by the European Central Bank (ECB), which could support the euro. • Conversely, if economic conditions in the Eurozone deteriorate relative to the United States, with lower inflation and weaker economic growth, the euro may depreciate against the dollar as investors seek safer assets denominated in the US currency. 2. Interest Rates: • Interest rate differentials between the Eurozone and the United States can influence the relative attractiveness of the euro and the dollar. If the ECB adopts a more hawkish stance by raising interest rates or signaling tighter monetary policy, this could lead to an appreciation of the euro. Conversely, if the Federal Reserve raises interest rates more aggressively than expected, the dollar may strengthen against the euro. 3. Geopolitical Developments: • Geopolitical tensions or uncertainties in Europe, such as Brexit negotiations, trade disputes, or political instability in member countries, could weigh on the euro's value. Negative developments may lead to risk aversion and capital outflows from the Eurozone, potentially depreciating the euro against the dollar. • Conversely, positive geopolitical developments or increased political stability in the Eurozone could support the euro's value against the dollar. Based on prevailing conditions, several factors suggest that the euro may appreciate or depreciate against the dollar for the remainder of this semester: • If economic data in the Eurozone continues to outperform expectations, leading to expectations of tighter monetary policy by the ECB, the euro may appreciate against the dollar. • Conversely, if economic conditions in the Eurozone deteriorate or geopolitical tensions escalate, leading to increased risk aversion, the euro may depreciate against the dollar. The factor that is likely to have the biggest impact on the euro's exchange rate is interest rate differentials between the Eurozone and the United States. Changes in monetary policy stance by the ECB and the Federal Reserve, as well as economic data releases and geopolitical developments, will be closely watched by investors for clues about future interest rate movements and their implications for the euro-dollar exchange rate. 14. Obtaining Credit from the European Central Bank. What are the consequences to a government in the Euroone when it obtains credit from the ECB? ANSWER: When the ECB provides credit to a country, it imposes austerity conditions that are intended to help the government resolve its budget deficit problems over time. These conditions may include a reduction in government spending and higher tax rates on citizens. 15. Impact of Abandoning the Euro on Eurozone Conditions. Explain the possible signal that would be transmitted to the market if a country abandoned use of the euro. ANSWER: If a country abandoned use of the euro, it might signal the possible abandonment by other countries that presently participate in the euro. If MNCs and large institutional investors outside of the Eurozone feared other countries would follow, they may not be willing to invest any more funds in the Eurozone, because they might fear the collapse of the euro. This might encourage them to sell their assets in the Eurozone now so that they could move their money into their home currency or another currency before the euro weakens. Interpreting Financial News Interpret the following comments made by Wall Street analysts and portfolio managers. a. “Our use of currency futures has completely changed our risk-return profile.” The use of currency futures to hedge reduces a firm’s risk, but also reduces its expected return. b. “Our use of currency options resulted in an upgrade in our credit rating.” The use of currency options resulted in lower exchange rate risk, so the firm’s credit rating was upgraded. c. “Our strategy to use forward contracts to hedge backfired on us.” The use of forward contracts can reduce overall profits by hedging the firm’s position that may have performed better if it was not hedged. Managing in Financial Markets You are the manager of a stock portfolio for a financial institution, and about 20 percent of the stock portfolio that you manage is in British stocks. You expect the British stock market to perform well over the next year, and you plan to sell the stocks one year from now (and will convert the British pounds received to dollars at that time). However, you are concerned that the British pound may depreciate against the dollar over the next year. a. Explain how you could use a forward contract to hedge the exchange rate risk associated with your position in British stocks. You could negotiate a forward contract to sell pounds one year from now. You would specify an amount of pounds in the forward contract that you expect to have in one year. b. If interest rate parity holds, does this limit the effectiveness of a forward rate contract as a hedge? Interest rate parity does not limit the effectiveness of a forward hedge on a portfolio of British stocks. It simply suggests that the forward premium, or discount, reflects the interest rate differential. c. Explain how you could use an options contract to hedge the exchange rate risk associated with your position in stocks. You could purchase put option contracts on pounds that would allow you to sell pounds at a specified price (the exercise price). This locks in the minimum exchange rate at which the pounds can be sold. If the spot rate of the pound exceeds this exercise price at the time the pounds are sold, you would not exercise the put option, but would instead sell the pounds at the prevailing spot rate. d. Assume that while you are concerned about the potential decline in the pound’s value, you also believe that the pound could appreciate against the dollar over the next year. You would like to benefit from the potential appreciation of the pound but wish to hedge against the possible depreciation of the pound. Should you use a forward contract or options contracts to hedge your position? Explain. You should purchase put options on pounds so that you have the flexibility to let the options expire if the pound appreciates over the year; the put options could be exercised if the pound depreciates over the year. Problems 1. Currency Futures. Use the following information to determine the probability distribution of per unit gains from selling Mexican peso futures. • Spot rate of peso is $.10. • Price of peso futures per unit is $.102 per unit. • Your expectation of peso spot rate at maturity of futures contract is: Possible Outcome for Future Spot Rate Probability .09 10% .095 70% .11 20% ANSWER: Possible Outcome Gain per Unit from for Future Spot Selling Futures Rate Contracts Probability $.09 $.102 – $.09 = $.012 10% .095 $.102 – $.095 = $.007 70 .11 $.102 – $.11 = –$.008 20 2. Currency Call Options. Use the following information to determine the probability distribution of net gains per unit from purchasing a call option on British pounds: • Spot rate of the British pound = $1.45 • Premium on the British pound option = $.04 per unit • Exercise price of British pound option = $1.46 • Your expectation of British pound spot rate prior to the expiration of option is: Possible Outcome for Future Spot Rate Probability $1.48 30% 1.49 40% 1.52 30% ANSWER: Gain per Unit from Possible Outcome Purchasing a Call Option for Future Spot (After Accounting for Rate Premium Paid) Probability $1.48 –$.02 30% 1.49 –$.01 40 1.52 $.02 30 3. Locational Arbitrage. Assume the following exchange rate quotes on British pounds: Bid Ask Orleans Bank $1.46 $1.47 Kansas Bank 1.48 1.49 Explain how locational arbitrage would occur. Also explain why this arbitrage will realign the exchange rates. ANSWER: One could purchase pounds at Orleans Bank for $1.47 and sell them to Kansas Bank for $1.48. As locational arbitrage occurs, Orleans Bank will increase its ask price while Kansas Bank reduces its bid price, causing a realignment of the exchange rates. 4. Covered Interest Arbitrage. Assume the following information: • British pound spot rate = $1.58 • British pound one-year forward rate = $1.58 • British one-year interest rate = 11% • U.S. one-year interest rate = 9% Explain how U.S. investors could use covered interest arbitrage to lock in a higher yield than 9 percent. What would be their yield? Explain how the spot and forward rates of the pound would change as covered interest arbitrage occurs. ANSWER: U.S. investors would purchase pounds for $1.58 in the spot market, invest the pounds at 11 percent, and simultaneously sell pounds forward at $1.58. The yield would be 11 percent. As covered interest arbitrage occurs, the spot rate of the pound will increase and the forward rate will decrease. 5. Covered Interest Arbitrage. Assume the following information: • Mexican one-year interest rate = 15% • U.S. one-year interest rate = 11% If interest rate parity exists, what would be the forward premium or discount on the Mexican peso’s forward rate? Would covered interest arbitrage be more profitable to U.S. investors than investing at home? Explain. ANSWER: If interest rate parity exists, the forward premium (discount) is: Covered interest arbitrage would not be feasible since the forward discount offsets the higher interest rate in Mexico. U.S. investors could earn 9 percent by investing in the United States, which is the same yield they would earn using covered interest arbitrage. Flow of Funds Exercise Hedging With Foreign Exchange Derivatives Carson Company expects that it will receive a large order from the government of Spain. If the order occurs, Carson will be paid about 3 million euros. Since all of its expenses are in dollars. Carson would like to hedge this position. Carson has contacted a bank, with brokerage subsidiaries that can help it hedge with foreign exchange derivatives. How could Carson use currency futures to hedge its position? Carson could sell currency futures, so that it could lock in the future sale of 3 million euros. What is the risk of hedging with currency futures? If Carson does not receive the order, it will still need to sell 3 million euros as of the settlement date at the exchange rate specified in the futures contract. It can offset this sale of a futures contract by buying an identical contract. Yet, it may incur a loss if the euro’s value increased by the time it created the offsetting position, as the price to be paid for euros on the settlement date exceeds the price at which it is contracted to sell euros as of the settlement date. c. How could Carson use currency options to hedge its position? Carson could purchase put options on euros, which allow it the option to sell euros at a specified exchange rate. d. Explain the advantage and disadvantage to Carson of using currency options instead of currency futures. Currency put options do not obligate Carson to sell euros in the future. Therefore, if Carson does not receive the order and the euro’s value declines over time, it can let the option contract expire. If it receives the order and the euro’s value is higher at the time it receives payment than the rate specified in the option contract, it can let the option expire and sell the euros in the spot market. The futures contract does not allow such flexibility, as it would obligate to sell euros on a specified settlement date at the rate specified in the futures contract. However, Carson has to pay a premium for put options, so the cost of the hedge is more expensive than selling futures contracts. Solution to Integrative Problem for Part V Choosing Among Derivative Securities 1. The scenario suggests that the United States will rebound from the recession, which should place upward pressure on interest rates (primarily because of an increase in the demand for loanable funds, as spending increases). If interest rates rise, the savings institution should hedge. Assuming that interest rates are expected to increase for at least a few years, the fixed-for-floating swap would be appropriate. While this may limit the return to the institution, it provides a proper hedge. The floating-for-fixed swap is not appropriate because it would expose the institution to even more interest rate risk. The put option on futures could be a useful hedge, but a premium must be paid for the option. The option offers more flexibility than the interest rate swap because it does not have to be exercised. Yet, if interest rates are almost definitely expected to rise, there is no reason to pay a premium for the extra flexibility. 2. Economic conditions will likely improve, so that stock prices will rise. While this is a subjective assessment, there is no reason to expect a major decline in stock prices. Therefore, a hedge (such as selling stock index futures) is not appropriate. The insurance company should remain unhedged. 3. Since interest rates will likely increase, there is reason to consider hedging the bond portfolio. The proper hedge would be to sell bond index futures. The pension fund would not wish to buy bond index futures because it would be even more exposed to interest rate risk. Some people might suggest that hedging the bond portfolio of a pension fund is not necessary because the income received will ultimately be transferred to participants. The situation is different than that of a savings institution, which attracts deposited funds (at a cost) to make investments that are exposed to interest rate risk. The pension fund receives its funds from contributions and therefore may not be as concerned about rising interest rates over time (since it does not pay an interest rate on incoming funds). Nevertheless, it could be better off by hedging in this situation if it is confident that interest rates will rise. The proper hedge is to sell bond index futures. 4. A short position (selling bond index futures) in a U.S. bond index will not necessarily be an effective hedge against the interest rate risk of non-U.S. bonds. Interest rates in the United Kingdom will not always move in tandem with U.S. interest rates. Therefore, prices of these bonds could decline even more than those of U.S. bonds, as the respective interest rates in the U.K. could possibly increase by a higher degree. A sale of a particular bond index futures contract would not be an effective hedge under such circumstances. Exchange rate risk is also an important risk to consider. If the British pound weakens against the dollar, the dollar value of the international mutual fund will decline, and the dollar value of each share will decline. According to the background information given, the dollar was weak. Yet, if U.S. interest rates begin to rise, there may be some upward pressure on the value of the dollar, which would reduce the fund’s value. To hedge against the risk of a stronger dollar (a weaker pound), the manager could sell currency futures contracts on the pound. If the pound’s value declines, there would be a gain on the currency futures position, which can offset the adverse effect on the value of the international mutual fund. If the manager desired a hedge with more flexibility, put options on the pound could be purchased. In the event that the pound strengthens, the options would not be exercised. The value of the international mutual fund would increase when the pound appreciates, since its value is measured in dollars. The currency options offer more flexibility than currency futures, but a premium must be paid for the options. Solution Manual for Financial Markets and Institutions Jeff Madura 9781133947875, 9781305257191, 9780538482172
