-b/w 5.Forwards firm and commercial bank to exchange a specified amt of currency at the fwd. rate
on a specified future date -usually $1 million, and not used by ind. Consumers or small firms usually individualized contracts - Mostly settled by actual delivery (buy when expect to appreciate, sell app) F=S(1+p) If forward rate is less than spot rate, it's discount -Usually represent difference between home and foreign interest rates P=(F-S/S) * (360/n) if annualized use this part Swap Transactions -Spot and forward contracts used simultaneously that will reverse the spot transaction -Ex: Today you withdraw USD from account and convert to pesos in spot market and send to Mexican acct. And in one year you withdraw the million pesos and convert them to dollars at today's forward rate and then put them in your account. You receive fewer dollars in one year but avoid the risk of exchange rate movements NDFs -Net payments, no actual exchange -EX: Current spot rate is .002$/peso...this is on the contract as the reference rate, which is used to settle the contract. You agree to pay 100m pesos (200,000 dollars at .002$/peso) no matter what happens to the exchange rate. If rate goes up to .0023, u pay the supplier 230,000 but the bank gives u a refund of the extra 30,000. Opposite happens if the rate goes down to .0018 and u only have to pay 180,000. U owe the bank 20,000. Futures - Contracts specifying a standard volume of a particular currency to be exchanged at a specific settlement date-Used to hedge or speculate -Standardized, Traded on exchange, brokers or by firms. Typically commison charges-Liquidation mostly settled by offsetting and not actual delivery Guaranteed by exchange clearing house and margin requirements -Speculators sell futures when currency is expected to depreciate, buy depreciating currency at spot rate, which results in a profit at settlement date when they fulfill the contract. And vise versa. -MNCs purchase futures to hedge payable and sell to hedge recieveables -Can close out cotnracts by selling similar futures contracts and minimizing losses or sellers can close out by buying similar ones.. I-f you buy one and the currency depreciates, sell it and minimize your loss. Call Options -Grants holder the right to buy a specific currency at a specific price within a period of time -In the money (spot>strike) out of the money(spot<strike) -Premium higher if (spot-strike) is large, time to expiry is long, and variability of currency is great. -Can be used to hedge payables and bidding -purchase when expected to Appreciate -Profit=spot rate-premium-strike price -Sell or write when currency is excepted to Depreciate -Profit =premium-spot+strike -For purchasers, there are unlimited gains and a max loss of just the amount of the premium. Opposite is true for writers. Put Options -Ability to sell currency at strike price within time window -In the money (spot<strike), out of the money (spot>strike) -Used to hedge recievables -Purchase when currency is expected to depreciate -Profit= strike-spot-premium -Sell/Write when currency is expected to appreciate -Profit = premium +spot-strike -Straddle Purchase put and call at same time -Breakeven point = strike price+premium -For buyers, unlimited gains with max loss of premium. Opposite for writers. ( Conditional Currency Options -Premium is conditioned on actual currency movement over period -EX: exercise price is 1.70, trigger is 1.74, meaning premium will only be paid if the pound reaches 1.74. European style options are only available to be exercised on expiry date.
Locational arbitrage is possible when a bank's buying price (bid price) is higher than another bank's selling price (ask price) for the same currency. Ex: Bank C Bid Ask Bank D Bid Ask NZ$ $.635 $.640 NZ$ $.645 $.650 Buy NZ$ from Bank C @ $.640, and sell it to Bank D @ $.645. Profit = $.005/NZ$. Triangular arbitrage is possible when a cross exchange rate quote differs from the rate calculated from spot rate quotes. Ex: Bid Ask British pound () $1.60 $1.61 Malaysian ringgit (MYR)$.200 $.202 British pound () MYR8.10 MYR8.20 Buy at $1.61 ($10,000/$1.61)=6211.18. Then Sell at MYR 8.10 (6211.18*MYR8.1)=MYR50,310.56. Then Sell MYR at $.200 (50,310.56*.2)=10,062.11. Covered interest arbitrage is the process of capitalizing on the interest rate differential between two countries while covering for exchange rate risk.-Covered interest arbitrage tends to force a relationship between forward rate premiums and interest rate differentials. *Investors in Country A invest in Country B b/c interest rate is higher 1) use current ExRate to Exchange Currency 2) Invest @ i/r for term 3) use rate to lock in exchange rate for end date 4) calculate profit 5) compare final foreign return to domestic return Interest Rate Parity (IRP) -As a result of market forces, the forward rate differs from the spot rate by an amount that sufficiently offsets the interest rate differential between two currencies. (No more CIA) When IRP exists, the rate of return achieved from covered interest arbitrage should equal the rate of return available in the home country. CIA is no longer possible. i.e. forward = (1 + home interest rate) premium 1 (1 + foreign interest rate) Determining the Forward Premium Example Suppose 6-month ipeso = 6%, i$ = 5%. From the U.S. investor's perspective, forward premium = 1.05/1.06 1 - .0094 If S = $.10/peso, then 6-month forward rate = S (1 + p) .10 (1 _ .0094) $.09906/peso Transaction costs, political risk, and differential tax laws make IRP hold. A crisis in a country could cause its government to restrict any exchange of the local currency for other currencies. Investors may also perceive a higher default risk on foreign investments.
8. Purchasing Power Parity (PPP)
6. Fixed FX rate system rates are held constand and fluctuate narrowly
-Bretton woods and Smithsonian Agreement -ADV: MNCs know future FX rates, DIS: govt's revalue currencies, and each country is vulnerable to econ conditions in other countries Freely Floating FX rate system rates are determined by market forces without gov't intervention -Each country is more insulated from econ probs of others, central bank interventions not needed, govts not constrained by the need to maintain fx rates when setting new policies, less capital flow restrictions are needed, DIS: MNCs need to devote substantial respurces to managing exposure to FX rate fluctuations. Managed Float allowed to move freely on daily bassis and no offical boundaries exist, govts may interven to preven rates from moving too much in one direction. Pegged currencys value is pegged to a foreign currenct and moves in with that one against currencies -Mexico's Peso is pegged to USD Currency boards system for pegging currency to some other one Provides stability but interest rates must be aligned Dollarization replacement of a foreign currency with USD Equador has no local currency now Fiscal Policy taxes and govt spending. Monetary use of interest rates to keep inflation in check Euro - Central European bank based in Frankfurt responsible for setting monetary policy. Each country does its own fiscal policies. -Euro encourages more trade and capital flows, and easer to value frims across Europe as well as reduce risk and FX tran costs -Interest rates in Europe similar -Stock and bond prices more comparable -Not as much diversification for non-european investor Direct Intervention by the Central bank refers to the exchange of currencies that is held in reserves for other curreinces in FX market, usually most effective when it is coordinated among the banks and when there is high levels of reserves that they can use -EX: to strengthen dollar, Fed exchange for dollar and England exchanges for $ -When intervention is not adjusted for change in money supply, it is nonsterizlized intervention -In sterilized it simultaneously engages in offsetting transaction in treasury securities to maintain money supply( to strengthen dollar buy back t-bills) Can also use indirect intervention by influencing other factors (interest rates, govt controls) -EX: increase interest rates and boost dollar values by reducing money supply Target zones not too different from today's system(trying to reduce volatility) Weak home currency can stimulate foreign deman for goods and reduce unemployment but it can also lead to higher inflation Strong currency may cure inflation since it intensifies competion and forces domestic producers from increasing prices, however it may also lead to higher unemployment.
- When a country's inflation rate rises relative to that of another country, decreased exports and increased imports depress the high-inflation country's currency. The absolute form of PPP is an extension of the law of one price. It suggests that the prices of the same products in different countries should be equal when measured in a common currency. The relative form of PPP accounts for market imperfections like transportation costs, tariffs, and quotas. It states that the rate of price changes should be similar. PPP holds -- Solving for ef : ef = (1 + Ih ) 1 or ef = Ih-If (1 + If ) -relationship between inflation differentials and exchange rates is not perfect even in the long run PPP does not occur consistently due to: confounding effects -Exchange rates are also affected by differences in inflation, interest rates, income levels, government controls and expectations of future rates. a lack of substitutes for some traded goods PP can be tested by assessing a real exchange rate over time (rate adjusted for inflation) IFE nominal frisk free rates conatain a real rate of return and inflation, so differentials in rates may be due to inflation. This states that currencies with higher interest rates will depreciate because the higher nominal rates reflect expected inflation. No higher rates abroad this means. Ef=(1+ih/1+if) -1 or ef = ih-if -point is that on average the yield achieved would be similar using domestic and foreign investing -there is evidence that it holds during some time frames, but not consistently -since it is based on PPP, it will not hold if PPP does not hold
7.-Arbitrage is capitalizing on a discrepancy in quoted prices to make a riskless profit.
-The effect of arbitrage on demand and supply is to cause prices to realign, so no more aribitrage can exist and market become efficient again.