FINA 4810 Test 2 [Moore]

IRP formula actual

(F$/y) / (S$/y) = (1 + i$) /(1 + iy)

standardizing features of futures contracts

-Contract size -Delivery date -Daily resettlement ("marked to market")

non-deliverable forward contract

-Due to government-initiated capital controls, the currencies of some emerging market countries are not freely traded. -settled in cash (usually US dollars) -Settlement = difference between the forward price agreed to in the contract and the spot price at maturity of the contract multiplied by the CONTRACT SIZE

performance of the forecasters summary

-Forecasting is difficult, especially with regard to the future. -As a whole, forecasters cannot do a better job of forecasting future exchange rates than the forward rate. -The founder of Forbes magazine once said: "You can make more money selling financial advice than following it."

Money market hedge

-This is the same idea as covered interest arbitrage. -To hedge a foreign currency payable, buy a bunch of that foreign currency today and sit on it. -Buy the present value of the foreign currency payable today. -Invest that amount at the foreign interest rate. -At maturity your investment will have grown enough to cover your foreign currency payable. *To construct a MM hedge for a foreign currency-denominated payable (receivable), lend (borrow) in the foreign currency*

interest rate parity

-a no arbitrage equilibrium state in which the forward rate differs from the spot rate sufficiently to offset the interest rate differential between two currencies. -If IRP were violated, an astute trader could make unlimited profits exploiting the arbitrage opportunity. -IRP usually holds

at option expiration time value =

0

what causes IRP to not hold

1. Transactions Costs (Exhibit 6.5) -The interest rate available to an arbitrageur for borrowing, ia , may exceed the rate she can lend at, ib. -There may be bid-ask spreads to overcome, Fb/Sa < F/S -Thus (Fb/Sa)(1 + i¥b) - (1 + i$ a) £ 0 2. Capital Controls: Governments sometimes restrict import and export of money through taxes or outright bans.

2 types of PPP

1. absolute 2. relative

approaches to forecast exchange rates

1. efficient markets approach 2. fundamental approach 3. technical approach

outright forward trades are _____% of interbank FX trading

11%

swap transactions are ____% of interbank FX trading

56%

how is a futures contract different from a forward contract

A futures contract is different from a forward contract in that futures are standardized contracts trading on organized exchanges with daily resettlement through a clearinghouse

how is a futures contract similar to a forward contract

A futures contract is like a forward contract in that it specifies that a certain currency will be exchanged for another at a specified time in the future at a price specified today.

______ is the world's largest currency future's market

CME (Chicago Mercantile Exchange) Group

exchange traded currency funds

ETF's in a currency -Currency is now recognized as a distinct asset class, like stocks and bonds. Currency ETFs facilitate investing in the euro, the British pound, the Chinese yuan, the Japanese yen, and other currencies. -You're essentially buying "shares" in a currency •Ex: entering an ETF in the euro; the amount of shares you have is how much the euro is worth, so if the euro appreciates your shares are worth more

T/F: PPP tends to hold

FALSE; it does not tend to hold

T/F: out of the money options have no value

FALSE; they can still have value (immediate exercise just isn't profitable)

efficient markets approach

Financial markets are efficient if prices reflect all available and relevant information (I). -If this is so, exchange rates will only change when new information arrives. Thus: the best prediction of the forward rate IS the spot rate -random walk idea -using this approach is AFFORDABLE and HARD TO BEAT -developed by Eugene Fama

call options

Holder has the right, but not the obligation, to buy a given quantity of some asset at some time in the future at prices agreed upon today.

put options

Holder has the right, but not the obligation, to sell a given quantity of some asset at some time in the future at prices agreed upon today

purchasing power parity

In theory, price levels should be equal worldwide when expressed in a common currency. That is, a unit of home currency should have the same purchasing power around the world. More formally, the exchange rate between two currencies should equal the ratio of the countries' price levels:

fundamental approach

Involves econometrics to develop models that use a variety of explanatory variables. This involves three steps: Step 1: Estimate the structural model to determine parameter values. Step 2: Estimate future values of the independent variables. Step 3: Use the model to develop forecasts. -The downside is that fundamental models do not consistently work any better than the forward rate model or the random walk model

forward contracts are sold ____

OTC

options are sold ____

OTC and exchange traded

currency options are traded ______

OTC or exchange exchanges: PHLX, HKFE (Hong Kong Futures Exchange), European Options Exchange (Amsterdam), Chicago Mercantile Exchange, and Montreal Stock Exchange

T/F: American options are usually worth more than European options, other things equal.

TRUE

T/F: American options can be exercised at any time up to and including the expiration date.

TRUE

T/F: European options can only be exercised on the expiration date.

TRUE

T/F: If IRP is holding, the forward hedge and the money market hedge result in the same outcome for the firm.

TRUE

T/F: With a futures contract, there is daily resettlement of gains and losses, rather than one big settlement at maturity.

TRUE

T/F: absolute PPP almost never holds

TRUE

T/F: the long position payoff equals the negative of the short position payoff.

TRUE

T/F: §Exchange traded options or listed options are standardized with predetermined exercise prices and standard expiration months

TRUE

derivative security

a financial instrument whose value depends on the value of some other, more basic underlying variable(s) -The variable underlying derivatives is often the price of a traded asset, but does not have to be. ex: stock options, forward contract, weather derivatives -Stock option: value dependent on the price of a stock -Forward contract: value dependent on the spot exchange rate -Weather derivative: payoff is determined by the average temperature at a particular location

big mac index measures ______ PPP and it typically ______ hold

absolute; does not

forward contract

an agreement to buy (long position) or sell (short position) foreign exchange at a certain future time for a specified delivery price.

swap

an agreement to provide a counterparty with something he wants in exchange for something that you want. -series of forward contracts -ex: you need pounds every six months for 5 years, you can set the whole thing up today instead of entering into separate contracts as you need them

currency futures option

an option on a currency futures contract. -Exercise of a currency futures option results in a long futures position for the owner of a call or the writer of a put. -Exercise of a currency futures option results in a short futures position for the writer of a call or the owner of a put. -If the futures position is not offset prior to its expiration, foreign currency will change hands.

a firm may _______ in foreign currency to hedge its foreign currency receivables

borrow

covered interest arbitrage

capitalizing on the interest rate differential between two currencies while covering exchange rate risk with a forward contract. -covered because you're entering into a forward contract

Open interest typically ________ with term to maturity of most futures contracts

decreases

open interest is a good proxy for the _____ of a contract

demand

Assuming IRP, the forward exchange rate is ________ from the spot exchange rate, the domestic and foreign interest rates, and the time to maturity.

derived

if the dollar is expected to depreciate in the future, then it is trading at a ________ in the forward market

discount

arbitrage examples

ex: if pound is overvalued you want to: -borrow dollars -convert to pounds -invest in UK market -enter forward contract to sell pounds -convert back to dollars -pay back dollar interest -you'll have a profit ex: if dollar is overvalued you want to: -borrow pounds -convert to dollars -invest in US market -enter forward contract to sell dollars -convert back to pounds only amount that you owe to pay off interest -pay back pound interest -keep profit of dollars (if you want profit in dollars aka american perspective)

futures contracts are sold ___

exchange traded

why do managers often use a "quick and dirty" approximation differential for inflation?

expected inflation is difficult to measure

currency future contract is used for _______ and _______

hedging and speculating

derivatives are used for _____

hedging, speculating, arbitrage

usually interest rates are higher/lower/equal to inflation

higher; usually at least the amount of inflation

IRP formula approximate

i$ - i¥ = (F -S)/S -Right hand side of approximated term: equation for the premium or discount on forward rate •Positive number means that the forward is trading at a premium •Negative number means that the forward is trading at a discount If left hand side of equation is positive: •US interest rate is higher than that of japan, but this doesn't necessarily mean that investing in the US is better •If dollar depreciates, then Japanese investors should not invest in the US because it'll take more dollars to convert it back to yen and then at that point they should have just kept their money in Japanese markets

How supply/demand moves exchange rate back to equilibrium

in this example, you would make a profit by investing pounds in the UK market effects of arbitrage: •Demand for pounds in spot market increases, S$/pound increases •UK banks reserves increases •If banks have excess reserves, they try to lend them •This leads to a decreased interest rate Supply of pounds in 3-month forward market increase (people are selling their pounds), 3 month forward rate decreases

interest rate differential is roughly equal to the _______ rate differential

inflation

market value =

intrinsic value + time value

a firm may _______ in foreign currency to hedge its foreign currency payables

lend

buyer/holder/owner has the _____ position in a call or put option

long

at the end of each trading day there is price resettlement in futures If the price goes down, the _____ pays the ______

long pays the short

technical approach

looks for patterns in the past behavior of exchange rates. -Clearly, it is based upon the premise that history repeats itself. -Thus, it is at odds with the efficient markets approach. -also known as chartist approach

After the daily resettlement, each party effectively has a new contract at the new price with _______-day-shorter maturity.

one -Prevents build up of large losses; avoids defaults

(futures) the long position payoff is the _____ of the short position payoff

opposite

if the pound is expected to appreciate in the future, then it is trading at a _________ in the forward market

premium

seller/writer has the ______ position in a call or put option

short

at the end of each trading day, a settlement price is determined If the price goes up, the _____ pays the ______

short pays the long

relative PPP

states that the rate of change in the exchange rate is equal to differences in the rates of inflation

arbitrage

the act of simultaneously buying and selling the same or equivalent assets or commodities for the purpose of making certain, guaranteed profits

economic exposure

the affect of unanticipated exchange rate changes on the firm's value. Economic exposure can impact the firm's competitive position in the market, its future operating cash flows or the value of its assets/liabilities.

transaction exposure

the affect of unanticipated exchange rate changes on the value of foreign currency denominated transactions (payables or receivables) that the firm has already entered.

option premium

the amount paid for the option.

intrinsic value

the amount that the option is "in-the-money," or the amount you would receive if you exercise the option. Call's IV = Either (St - E) or 0 Put's IV = Either (E - St) or 0 (depending on whether it's in or out of the money)

forward premium/discount

the annualized percentage deviation of forward rate from spot rate

time value

the difference between the option price and its intrinsic value. TV represents the "speculative" value of an option Call's TV = Call's Market Price - Call's IV Put's TV = Put's Market Price - Put's IV

exercise or strike price (for a currency option)

the exchange rate at which the option holder can buy or sell the contracted currency.

economic exposure (book definition)

the extent to which the value of the firm would be affected by unanticipated changes in exchange rates

open interest

the number of contracts outstanding for a particular delivery month

translation exposure

the potential that the firm's consolidated financial statements an be affected by changes in exchange rates

law of one price

the requirement that similar commodities or securities should be trading at the same or similar prices

transaction exposure (book definition)

the sensitivity of "realized" domestic currency values of the firm's contractual cash flows denominated in foreign currencies to unexpected exchange rate changes can be called short term economic exposure

an out of the money option has ____ value

time

speculating

trying to profit from a favorable, but uncertain, price change in an asset by acquiring a position in it

PPP determined exchange rates still provide a valuable/invaluable benchmark

valuable