Session3 - Notes Session 3 > > Chapter 5 Currency...

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Notes - Session 3 >>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>> >>>>>>> Chapter 5: Currency Derivatives Chapter 6: Government Influence on Exchange Rates >>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>> >>>>>>> Lecture 3 expands upon some of the key points in Chapters 5 and 6, and provides some exercises and problems, with solutions provided. CHAPTER 5 FOREIGN EXCHANGE MARKETS AND CURRENCY DERIVATIVES The foreign exchange market serves two main functions. The first is to convert the currency of one country into the currency of another. The second is to provide some insurance against foreign exchange risk, by which is meant the adverse consequences of unpredictable changes in exchange rates. Forward Exchange A forward contract specifies a standard volume of a particular currency to be exchanged on a particular date. Rates for forward currency exchange are typically quoted for 30, 90, or 180 days into the future. Corporations that have payables in a foreign currency and wish to hedge against the possible appreciation of that currency can purchase futures contracts. Conversely, corporations with receivables in a foreign currency can sell futures contracts to hedge against the possible depreciation of that currency. Speculators can use currency futures contracts in a similar fashion, purchasing them when they expect the currency to appreciate and selling them when they expect that currency to depreciate. The terms "forward" and "future" both refer to the same type of transaction, buying or selling currencies for delivery at a specified future date. They differ in that a futures contract comes with standard terms for units and maturity. (For example, a contract for Deutsche marks will always be for a certain number of units--say 62,500 Deutsche marks in each contract--and will always have specified maturity dates (one month, three months, six months, etc.) There is no ability to customize. A forward contact allows the buyer to negotiate the size of the contract and the maturity date (two months and three days from now, for example.) Currency Futures Contracts Here is an example of a forward transaction: A U.S. company has made a sale worth Yen 100,000,000 to a Japanese customer, with payment to be made in three months. Today's spot rate is Yen 116/US$, but there is no way of knowing what the rate will be three months hence when the U.S. company will
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receive payment and will need to convert the yen to dollars. If they had the yen today and converted at today's spot rate, they would receive about $862,069. But, of course, they do not have the yen yet. If the exchange rate weakens between now and the payment date, say to Yen 130/US$, they would receive only $769,321. The U.S. company is afraid that the yen might weaken to Yen130/US$. However, the general market is less pessimistic about the yen. The forward rate quoted for yen today is Yen 120/US$. If the company buys a forward contract and promises to exchange their yen at Yen120/US$ three months from now, they will know exactly what they will receive in three months, $833,333. If their pessimistic forecast about the yen is correct, they will feel very happy that they bought the forward.
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