FINS3616 Lecture 2

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


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


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


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


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


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


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


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)


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


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)


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)


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)

FINS3616 Lecture 2

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