FIN 4920 Chapter 5, 6, and 7

offsetting a forward position

A forward contract can be effectively cancelled bytaking the opposite position at the same volume, with the same expiration date.

Currency Board

A government institution that exchanges domestic currency for foreign currency at a fixed rate of exchange. They achieve a credible fixed exchange rate by holding a stock of the foreign currency = 100% of the outstanding currency supply of the nation (largely short-term securities denominated in the foreign currency). In the case of a developing country facing a skeptical public due to past policy mistakes, a __________is a reasonable way to restore credibility; but is no guarantee of success. A _____________compels the government to follow a responsible fiscal policy, since it does not have a central bank to monetize its debt.

Revaluation

A move to increase the value of a currency is called a

Call Price

Amount that must be paid to call and retire a callable preferred stock or a callable bond.

Forward Contracts

An agreement formed that obliges that position taker to buy or sell an underlying currency at the contract's expiration, using the forward price at the time of contact's

Direct Government Intervention

Deliberately changing currency values. If non-strelizied, it is not adjusted for change in money supply.

Exchange Rate Target Zones

Exchange rate arrangements where there is limited flexibility around some central fixed value. The exchange rate is allowed to change with changes in fundamental determinants like money supply, incomes, and prices, but the amount of the change is limited by the width of the bands permitted by the target zone arrangements. A target zone backed by credible government policies helps to stabilize the exchange rate relative to a floating exchange rate.

Pegged Exchange Rate System

Fixed → the exchange rate is fixed against a major currency or some basket of currencies. Active intervention may be required to maintain the target pegged rate. Crawling → The exchange rate is adjusted periodically in small amounts at a fixed, preannounced rate or in response to certain indicators (such as inflation differentials) against major trading partners.

Swap Agreement

Involves the exchange of currencies at specified date, and a reverse exchange of the same two currencies at a date further in the future, at rates agreed upon at the time of contract initiation.

Floaters

Large size, closed economy, divergent inflation, and diversified trade

Free Floating Exchange Rates

Market forces of supply and demand determine exchange rates. Main Advantages: Countries have a relatively smaller tendency to 'export inflation'. With high inflation in the US, for example, the supply of pounds fall and the demand for pounds increases, causing an appreciation in the pound. The price of British goods to US consumers increases. British demand for US goods however, is unlikely to be affected by the rise in US prices (because of the appreciation of the pound). Main Disadvantages: High inflation in the US may cause a weaker dollar, which in turn causes more expensive imports. US Producers can thus impose high product prices on domestic consumers because of high foreign prices and lack of competition from foreign firms.

Currency Options

Offer the right, not the obligation, to buy (call option) or sell (put option) underyling foreign currency at options excise price (or strike) at expiration (European Options). American options allow before expiration. Buyer must pay for position with an option premium for such an opportunity. You can get immediate advantage here. An improvement on forward/future oppurtunity.

P = (F-S)/S

Permium equals (Forward Rate - Spot Rate)/ Spot Rate

Currency Futures

Similar to forward markets, but: Only a few currencies are traded Contracts are standardized, trading occurs only in a specific geographical location Futures Contracts are for smaller amounts of money than are forward contracts, and there serve as a useful hedging vehicle for small firms MNCs might find options don't meet their needs as forward contracts (which aren't standardized), but are tailored for a firm's specific needs

Peggers

Small size, open economy, harmonious inflation rate, and concentrated trade with few partners

Indirect Government Intervention

The FED focuses on factors that influences supply and demand for currency, usually just adjusting interest rates.

exercise price (strike price)

The predetermined price that an employee must pay to purchase a share of stock in a stock option plan.

Currency Arbitrage

The simultaneous and instantaneous purchase and sale of a currency for a profit. Basically taking advantage of price differences. Should be riskless.

Managed Float Rate Exchange System

This system reflects some desirable combination of government intervention in (and) a freely floating system. The monetary authority (usually the central bank) influences the exchange rate through active foreign exchange market intervention with no preannounced path for the exchange rate. Too much management can lead to perceptions of government policies being implemented at the expense of other countries.

Fixed Exchange Rates

Under this system, rates are either held constant (for example the Gold Standard, 1876-1914) or allowed to fluctuate within a narrow band (the Bretton Woods agreement (1944-1971)), for example). Main Advantages: MNCs don't have to be concerned about exchange rate fluctuations. Main Disadvantage: The government may decide to devalue or revalue the currency.

Swap Bank

Will arrange for each firm to borrow its domestic currency, then swap the domestic currency for the desired currency. The interest paid on the two currencies will reflect the forward premium in existence at the time the contract is executed.

Currency Derivatives

a contract with a price that is partially derived from the value of the underlying currency that it represents

Currency Swap

allows firms to obtain lower-cost long-term foreign currency than they can by borrowing directly simultaneous purchase and sale of a given amount of foreign exchange for two different value dates

Devaluation

cases a move to reduce the value of a currency is called

Covered Interest Arbitrage

involves investing in a foreign country and covering against exchange rate risk by using forward contracts • forces a relationship between interest rates of two countries and their forward premia or discounts if foreign interest rate is higher than local interest rate... • convert dollars to FC, sell FC forward, convert FC back to dollars at maturity • covered interest arbitrage would put upward pressure on spot rate of FC and downward pressure on forward rate — the forward rate will exhibit a discount in this case sometimes covered interest arbitrage may appear feasible before considering the bid/ask spread, but not after considering it

Interest Rate Parity (IRP)

is the equilibrium state reached once market forces have caused interest rates and exchange rates to be such that covered interest arbitrage is no longer feasible - interest rate differential is exactly offset by difference between forward and spot rates

Locational Arbitrage

opportunities exist when currencies are priced differently at different banks (locations) • one bank's bid price must be greater than another bank's ask price risk-free in the sense that selling price is known at purchase explains why prices among banks at different locations will not differ significantly

Triangular Arbitrage

opportunities exist when quoted cross exchange rate differs from cross exchange rate computed with the use of two other currencies • transactions are conducted in the spot market risk-free in the sense that purchase and selling prices are known transaction costs exist in the form of the bid/ask spread will probably not discover at one single bank