Transcript Chap31
Chapter 31 THE MARKET FOR FOREIGN EXCHANGE RATE RISK CONTROL INSTRUMENTS Foreign Exchange Rates The amount of one currency that can be exchanged for a unit of another currency Exchange Rate Quotation Conventions Direct quote Indirect quote Foreign Exchange Risk Foreign exchange risk refers to the risk of adverse movements in the exchange rate. Assets denominated in a foreign currency expose investors to exchange rate risk. Liabilities denominated in foreign currency expose borrowers to exchange rate risk. Spot Market The market for the settlement of foreign exchange transactions within two business days. Appreciation Depreciation American terms European terms Spot Exchange Rates Foreign exchange rates between major currencies are free to float, with market forces determining the relative value of a currency. Spot exchange rates adjust to compensate for the relative inflation rate between two countries. Cross rates The exchange rate between two countries except the U.S. Dollar price of currency X Dollar price of currency Y Cross rate mispricing leads to triangular arbitrage it involves positions in three currencies Foreign Exchange Dealers Large international banks act as dealers in the foreign exchange market Dealers are linked by telephone and cable and various information transfer services Revenue sources: Bid-ask spread Commissions Trading profits The Euro European Union 15 European member countries Treaty on European Union (1992) established monetary union Maastricht Treaty single currency and monetary policy European Central Bank (ECB) Economic and Monetary Union (EMU) Entry Requirements The annual fiscal deficit not to exceed 3% of GDP. Cumulative public debt not to exceed 60% of GDP. Other economic, political, and social requirements Approval by voters of a country seeking membership The Euro Adopted on January 1, 1999 fixed conversion rate against member country’s national currencies and relative to euro free to fluctuate against all other currencies January 1, 2002 physical replacement of member countries’ currencies with euro Outcomes Since Birth of Euro The euro has been viable and fairly stable. It has developed a very large public and cooperate capital market denominated in euros. Since its inception at $1.17, the euro has weakened considerably, reaching a low of $0.8229 on October 27, 2000. Potential participants include the U.K. and Sweden; Denmark voted against joining the EMU on September 28, 2000. Instruments for Hedging Foreign Exchange Risk Currency Currency Currency Currency Forward Contracts Futures Contracts Options Swaps Currency Forward Contracts Forward Contract Maturities maturity of less than two years longer dated forward contracts have large bid-ask spreads Pricing Currency Forward Contracts The forward exchange rate is determined from the spot exchange rate and the interest rates in the two countries. Interest rate parity implies that, by hedging in the forward market, an investor will receive the same domestic return whether investing domestically or in a foreign country. Interest Rate Parity Relationship between the spot exchange rate, the interest rates in two countries, and the forward rate. 1 iA F S 1 iB The arbitrage process which forces interest rate parity is called covered interest arbitrage. Currency Futures Contracts Trading Locations Underlying Currencies Contract Size Contract Maturity Currency Option Contracts Underlying Currencies spot currency currency futures Currency Options Trading organized exchange over-the-counter Trading Locations Contract Specifications Currency Swaps A package of currency forward contracts. Allows hedging of long-dated foreign exchange risk. More traditionally efficient than futures or forward contracts. Used to arbitrage opportunities in global financial markets for raising funds at lower cost than in the domestic market.