Lecture 2 (Chapters 3 & 5)
FINS5516 Jared Staneld
FORWARD MARKETS AND TRANSACTION EXCHANGE RISK
Chapter 3
3.1 Transac@on Exchange Risk
Transac@on exchange risk possibility of taking a loss in foreign exchange transac@ons
Who incurs transac@on exchange risk? Corpora@ons Ins@tu@onal investors Individuals
How to avoid? Hedging protect against losses; get rid of
uncertainty
Uwe Boll is a German lm director who challenges to lm cri@cs to st ghts. He also created the classic movie In the Name of the King: A Dungeon Siege Tale starring Jason Statham as a farmer named Farmer, Burt Reynolds as king, Ray Lio^a as a wizard, and for reasons only known to Uwe Boll, lots and lots of ninjas.
Example
Example
Because the German tax loop-hole that allows Bolls investors to make more money when the lm does badly is closing, Boll is planning to do a sequel in six months and lming it in Sydney. He has commitments from German investors of 38 million to make the movie and needs A$48.6 million to make the movie. Boll has two op@ons to transfer the German investor money to Australian Dollars. The spot rate is currently A$1.23/ and Boll expects the to appreciate by 4% in 6 months (180 days). Boll can: 1) wait and sell s on the market or 2) hedge.
1) No hedge: Realized A$ amount= S(t+180, A$/)*(38,000,000)
=(A$1.28/ )*(38,000,000)=A$48,609,600 2) Hedge: purchase a forward contract and lock in rate. No uncertainty.
A Forward is the markets best guess as to what the spot will be in
180 days so if the market is right, youre only out the bid/ask spread. If the market is wrong, hedging could be good or bad! If A$ appreciates (takes more s to buy an A$), hedging would have
been be^er, if it depreciates (takes fewer s to buy a A$), then hedging would have been worse.
3.2 Describing Uncertain Future Exchange Rates
Assessing exchange rate uncertainty using historical prices
Percentage change: s(t) = [S(t) S(t-1)]/S(t-1) Apprecia@on if (+) Deprecia@on if (-)
Mean and standard devia@on Normal distribu@on for major currencies Skewed distribu@on for emerging markets
Exhibit 3.1 Dollar/Pound Monthly Exchange Rate: 19752010
Exhibit 3.2 Peso/Dollar Monthly Exchange Rate: 19942010
3.2 Describing Uncertain Future Exchange Rates
The probability distribu@on of future exchange rates Depends on all of the informa@on available at @me t
so we say it is condi@onal
Condi@onal mean/expecta@on at @me t of the future spot exchange rate: S(t) * (1+) A$1.23/ * (1+0.04) = A$1.28/
Condi@onal vola@lity: S(t) * A$1.23/ * 0.06 = A$0.07/
Range (within + or - 1 ) is: A$1.21/ - A$1.35/
Exhibit 3.3 Probability Distribu@on of S(t+180)
Within 1
Probability of 68.26%
Within 2
Probability of 95.45%
1.28 1.21 1.35 1.42 1.49 1.14 1.07
Possible A$/ Exchange Rates
3.2 Describing Uncertain Future Exchange Rates
Assessing the likelihood of par@cular future exchange rate ranges - how likely is it that the will appreciate in 180 days to A$1.40/?
A$0.12/ greater than condi@onal mean of A$1.28/ 0.12/0.07 = 1.714 standard devia@ons away, or 8.66%
for normal distribu@on
3.3 Hedging Transac@on Exchange Risk
Forward contracts and hedging
Forward rate - specied in a forward contract Eliminates risk/uncertainty Usually a large sum of money With bank
3.3 Hedging Transac@on Exchange Risk
Example Uwe Boll has a liability in A$ and assets in .
Uwe can sell 38,000,000 at A$1.28/ (selling Euros forward), which gives him an asset (A$48,609,600) to match his liabili@es but no exchange risk.
Exhibit 3.4 Panel A Gains and Losses Associated with Hedged Versus Unhedged Strategies
If revenue, unhedged position is preferable If cost, hedged position is preferable
If revenue, hedged position is preferable If cost, unhedged position is preferable
Exhibit 3.4 Panel B Gains and Losses Associated with Hedged Versus Unhedged Strategies
1.28
1.28
1.40
1.40
3.3 Hedging Transac@on Exchange Risk
The cost and benets of a forward hedge What is the appropriate way to view the cost of a forward hedge?
Ex ante (before) Ex post (aver) To hedge or not to hedge?
Exhibit 3.5 Costs and Benets of Hedging
Cost of 1 foreign currency unit
3.3 Hedging Transac@on Exchange Risk
Hedging import payments Example: Hedge a 4M payment due in 90 days Spot: $1.10/; 90-day forward: $1.08/ Hedged you will pay 4 M * $1.08/ = $4,320,000 If dollar strengthens, you could lose money rela@ve to remaining unhedged though
Hedging export receipts Example: Hedge a 500M receivable to arrive in 30 days Spot: 176/; 30-day forward: 180/ Hedged you will receive 500M/(180/) = 2,777,778 If the yen strengthens, you could lose money rela@ve to remaining unhedged though
3.4 The Forward Foreign Exchange Market
Market organiza@on
Outright forward contracts Only 12% of all transac@ons
Swap Simultaneous purchase and sale of a certain amount
of foreign currency for two dierent dates in the future
More than 44% of forex transac@ons are swaps
3.4 The Forward Foreign Exchange Market
Forward contract maturi@es and value dates Forward value or se^lement date
Most ac@ve dates are 30, 60, 90, 180 days Highly customizable Exchange takes place on the forward value date
Forward bid/ask spreads Larger than in spot market Spreads higher for greater maturi@es 0.10% for major currencies 90 day: 15% greater than spot contracts
Exhibit 3.6 Risks in Forward Contracts
Forward contract @ $0.90/C$
1 day later the C$ Appreciates to $0.92! BofA needs to go long C$ to cover the posi@on
Hedging from The beginning
3.4 The Forward Foreign Exchange Market
Net se^lement
Se^ling a contract by paying or receiving a net se^lement that depends on the value of the contract
Can be used in a case where the situa@on changes from original scenario
Oven used in forex futures market (Ch. 20)
3.4 The Forward Foreign Exchange Market
Foreign exchange swap types The purchase of foreign currency spot against the sale
of foreign currency forward The sale of foreign currency spot against the purchase
of foreign currency forward The purchase of foreign currency short-term forward
against the sale of foreign currency long-term forward
The sale of foreign currency short-term forward against the purchase of foreign currency long-term forward
Most common
3.4 The Forward Foreign Exchange Market
How swap prices are quoted Spot: /$ 104.30 (bid) 40 (ask) 30-day swap points: 80 (bid)/85 (ask) basis points that must be added/subtracted to/from the current spot bid/ask price to yield the actual 30-day bid/ask forward prices
A rule for using swap points If rst number in swap quote is smaller than the second, you add the points to the bid and ask prices to get the forward quotes; if larger - subtract
Cash ows in a swap (next slide)
Swap Example
What we would see in a quote:
Cashows: Swapping out of $10,000,000 and into yen for 30 days.
Spot 30-Days
/$ 104.3040 80/85
Today (from Companys POV) 30-Days (from Companys POV)
3.5 Forward Premiums and Discounts
Forward premium - occurs when the price of the currency contract is higher then the spot rate
F$/ > S$/ (the price of a is higher for Forward) Forward discount - occurs when the price of the currency
contract is lower then the spot rate
F$/ < S$/ (the price of a is lower for Forward)
Ndaysspot
spotforwardPercentAnnualized 360=
Exhibit 3.8 Historical Means of Forward Premiums or Discounts
3.5 Forward Premiums and Discounts
Forward premiums and swap points
Because forward contracts typically trade as part of a swap, the swap points indicate the premium or discount for the denominator currency
1st2nd (swap points subtracted) currency in denominator is at a discount
3.6 Changes in Exchange Rate Vola@lity
Vola@lity clustering Understanding how forex rates move involves more than
just means and standard devia@ons Vola@lity clustering when standard devia@ons (vola@lity)
in forex rate demonstrate a pa^ern i.e., has been high & remains high
GARCH model Developed by Tim Bollerslev (1986) V(t) = a + b v(t-1) + c e(t)2
A=minimum variance if past vola@lity and news terms = 0 B=sensi@vity of current condi@onal variance to past vola@lity C=sensi@vity to current news
Other models: implied vola@lity, shivs, jump, and regime-switching models, none of which have received as much a^en@on
Exhibit 3.9 Monthly Standard Devia@ons of Daily Rates of Apprecia@on
EXCHANGE RATE SYSTEMS Chapter 5
5.1 Alterna@ve Exchange Rate Arrangements and Currency Risk Exchange rate systems around the world
Floa@ng currencies - determined by the market forces of supply and demand (i.e., U.S., Japan, European Union, Australia, and Sweden)
Managed oa@ng countries whose Central Banks intervene enough that the IMF cant classify them as freely oa@ng (i.e., Argen@na, Brazil, Columbia, Indonesia, Israel, Mexico and South Africa)
Fixed/pegged currencies pegging a currency to another or a basket of currencies (i.e., IMFs SDR and the Chinese yuan)
Oven implemented using a currency board
No separate legal tender adopt a currency (i.e., Ecuador, El Salvador and Panama have adopted the U.S. dollar
Target zone forex rate is kept within band Crawling pegs changes are kept lower than preset limits that are adjusted
regularly (w/ ina@on)
Exhibit 5.1 Exchange Rate Systems Around the World
Exhibit 5.1 Exchange Rate Systems Around the World (cont.)
5.1 Alterna@ve Exchange Rate Arrangements and Currency Risk
Special arrangements Where a regional central bank controls the forex rate system
for several countries Euro CFA franc zone
Currency risks Floa@ng rate systems generally symmetric Target zones less than oa@ng but can be big due to devalua@ons/
revalua@ons
Pegged latent vola@lity Currency board/Monetary unions currency boards frequently collapse
5.1 Alterna@ve Exchange Rate Arrangements and Currency Risk
Bo^om line currency risk of exchange rate regimes other than freely oa@ng is NOT summed up accurately through historic exchange rate vola@lity
Exhibit 5.2 Currency Risk in Alterna@ve Exchange Rate Systems
Exhibit 5.3 Contras@ng the FRF/DEM and CAD/USD Exchange Rates
Exhibit 5.3 Contras@ng the FRF/DEM and CAD/USD Exchange Rates (cont)
Exhibit 5.4 Exchange Rate Arrangements
5.2 Central Banks
To understand how exchange rate systems operate, you must rst understand how central banks func@on.
The central banks balance sheet (Exhibit 5.5)
Sum of these two is called The monetary base or base money Inuences money supply
Through open market opera@ons
Exhibit 5.5 Central Bank Balance Sheet
5.2 Central Banks
Ocial Reserves Foreign exchange reserves (86%)
Usually t-bills of other countries but recently more adventurous!
Chinas has reached $1 trillion! Gold reserves (10%) IMF-related reserve assets (4%)
Money crea@on and ina@on Seigniorage the value of the real resources that the central bank obtains
through the crea@on of base money
Seng money supply growth has implica@ons on GDP growth, unemployment, etc.
Exhibit 5.6 Foreign Exchange Reserves
5.2 Central Banks
The impossible trinity only two of the following three are possible Perfect capital mobility (no capital controls) Fixed exchange rates Domes@c monetary autonomy
Foreign Exchange Interven@ons Non-sterilized Sterilized
Exhibit 5.7 Sterilized and Non-Sterilized Foreign Exchange Interven@on
Fed buys ForEx from Bank, which is an asset and a liability for the Fed and an Asset for the bank
Steriliza@on part
Pegging the exchange rate Exhibit 5.8 Fixing the $/ Exchange Rate
peg
In order to peg, the Central Bank has to supply this excess demand. This is where reserves come in.
5.3 Flexible Exchange Rate Systems
Interven@on Money supply/interest rates A^empt to restrict capital movements Tax/subsidize interna@onal trade to inuence demand for foreign
currency
The eects of central bank interven@ons Debate increased vola@lity or calming of markets? Direct eects of interven@ons supply/demand of currency
Eect is argued negligible due to small amount (i.e., $20 billion versus $4 trillion overall trade in a day)
Changes in porolio composi@on bond porolio eect
5.3 Flexible Exchange Rate Systems
Indirect Eects of Interven@ons Aect the exchange rate through expecta@ons
Empirical evidence on the eec@veness of interven@on
Coordinated eorts are more eec@ve than unilateral Not eec@ve in the long-run Has not overall done a great job at decreasing exchange rate vola@lity
There is conic@ng evidence on whether or not the interven@on is protable
Exhibit 5.9 The Eects of Foreign Exchange Interven@ons
5.4 Fixed Exchange Rate Systems
The Interna@onal Monetary System before 1971 The Gold Standard WWI, hyperina@on (Germany) and the Interwar Period
Gold Standard was suspended by many Interwar some countries allowed oat
The Bre^on Woods System (1944) par@cipa@ng countries agreed to link their currency to $ (which was pegged to gold)
5.4 Fixed Exchange Rate Systems
Individual incen@ves versus aggregate incen@ves Poten@al problems with a bank run on gold in U.S. with no solu@on; not
sustainable
Special Drawing Rights (1968) An alterna@ve reserve asset created by IMF with the same gold value as
the dollar Stayed pegged to gold un@l 1976, when it was then pegged to a basket of
currencies
Due to incessant BOP decits, U.S. abolished gold standard in 1971 1973 Bre^on Woods system collapsed and major currencies
transi@oned into freely-oa@ng currencies
Exhibit 5.10 Pegging an Exchange Rate in a Developing Country
Peg>market rate; there is an excess supply of ringgit. Everyone wants to sell ringgits and buy dollars to invest abroad (capital ight)
5.4 Fixed Exchange Rate Systems
Why not simply oat? Economists dont agree some believe that pegged forex regimes
oers stability Many economists believe, however, that pegged regimes are not
ul@mately sustainable the average dura@on is only 4.67 years! Currency Boards
Have money-making capabili@es independent of government but the money is fully backed by a
foreign reserve currency and fully conver@ble into the reserve currency at a xed rate
Touted as a miracle cure for cung ina@on without high cost to the economy (e.g., Hong Kong)
Cannot mone@ze scal decits; cannot rescue banks! Dollariza@on
Exhibit 5.11 The Balance Sheet of a Currency Board
5.5 Limited-Flexibility Systems: Target Zones and Crawling Pegs
Target zones Specula@ve a^acks Defending the target zone
Intervene through open market opera@ons (i.e., buy/sell) Raise interest rates (discourages specula@on) Limit foreign exchange transac@ons through capital controls
Lead-lag opera@ons Lag opera@on: postpones the inow of foreign currency to increase the
value of their receivable (which is stronger once the local currency is devalued)
Lead opera@on: domes@c importers prepay for goods to beat an increase in cost when devalua@on goes into eect
These put pressure on central banks of small economies because foreign reserves are small rela@ve to the volume of foreign trade
Crawling peg
Exhibit 5.12 An Example of a Target Zone
Exhibit 5.13 A Tight Target Zone
Exhibit 5.14 An Example of a Crawling Peg
Crawl usually adjusts for the inflation differential between the domestic inflation and the inflation of the currency to which they are pegged so the domestic firms dont lose competitiveness
Monetary Unions: What are they good for?
Pros and cons of a monetary union Is Europe an op@mum currency area (Mundell, 1961) one that balances
the microeconomic benets of perfect exchange rate certainty against the costs of macroeconomic adjustment problems
Poten@al pros: enhanced price transparency, lower transac@on costs, no exchange rate uncertainty, enhanced compe@@on could promote trade and economic growth
Poten@al cons: loss of independent monetary policy (BAD if country is in a bad place and none of the other countries are)
Greece in global recession, 2010 Research does not agree on whether or not the EU is par@cularly well suited
to be a monetary union but in the end, the verdict is s@ll out
Next Time
Chapter 3: Problems 3-6 Chapter 5: Ques@ons 1, 2, 7, 9, 11, 13
Read Chapters 6 & 7 (probably one of the most central set of chapters in the book)