The expected return on the asset in excess of the

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Unformatted text preview: the spot exchange rate in 1 year: Dollar proceeds in 1 year - £7M * S(t+1,$/£) Excess return (t+1) = S(t+1) * (£7M/$10M) – 1.08 7.1 SpeculaFng in the Foreign Exchange Market •  SpeculaFng with forward contracts –  –  –  –  ! !1 + i ($ )" $ S BE = S (t )× # !1 + i (£ )" # $ Break- even spot rate: Kevin’s breakeven rate would be: SBE = 1.08/0.7 = $1.5429/£ If future exchange rate < forward, Kevin has a negaFve return If future exchange rate > forward, Kevin has a posiFve return •  Comparing forward market and foreign money market investments –  Forward Market return (per $) =fmr (t+1) = [S(t+1) – F(t)]/S(t) –  fmr(t+1) * [1+i(£)] = [S(t+1)/S(t)]*[1+i(£)]- [1+i($)] Exhibit 7.1 Profits and Losses from Forward Market SpeculaFon 7.1 SpeculaFng in the Foreign Exchange Market •  Currency speculaFon and profits and losses –  QuanFfying expected losses and profits •  Use the condiFonal expectaFon of the future exchange rate •  Kevin expects the £ to depreciate against the $ by 3.57% over next year –  $1.60/£ * (1- 0.0357) = $1.5429/£ à༎ £7M * $1.5429/£ = $10.8003M –  At what forex rate will Kevin just get his $10M back? £7M * S = $10M à༎ $1.4286/£ –  Probability that he will lose with 10% standard deviaFon of appreciaFon of £ would be [S(t+1/$/£ ) - $1.5429/£ ]/$0.16/£. Exhibit 7.2 Standard Normal DistribuFon 7.1 SpeculaFng in the Foreign Exchange Market •  Lessons from history: the variability of currency changes and forward market returns Exhibit 7.3 Standard DeviaFons of Monthly Exchange Rate Changes and Forward Market Returns 7.2 Uncovered Interest Rate Parity and the Unbiasedness Hypothesis •  Covered interest rate parity: doesn’t maEer where you invest – you’ll have the same domesFc currency return as long as the foreign exchange risk is covered using a forward contract...
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This note was uploaded on 07/17/2013 for the course FINS 3616 at University of New South Wales.

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