FIN 5605 Exam 1

If the real effective exchange rate index were above 100, the currency would be considered _________ (overvalued/undervalued) from a competitive perspective, and vice versa.

"overvalued"

Disequilibrium: Emerging Markets - Casual Complexities

- The Asian economic crisis—for it was more than just a currency collapse—had many roots besides traditional balance of payments difficulties. - *Although the causes of crisis were a bit different in each country, all countries shared three common contributors*: 1. corporate socialism 2. corporate governance cronyism 3. banking instability.

3. Banking instability

- The central role played by banks in the conduct of business had largely been ignored. - As firms across Asia collapsed, government coffers were emptied and banks failed.

forward-forward swap

- The difference between the buying price and the selling price is equivalent to the interest rate differential between the two currencies. - Combination of 2 forward contracts - Technique for borrowing another currency on a fully collateralized basis

Law of One Price

If identical products or services can be sold in two different markets, and no restrictions exist on the sale or transportation of product between markets, the price should be the same in both markets.

NDF example

1. Contract Value x Current FX Rate = Base Value If the value of the currency bought appreciates: - The value of the contract increases - Bank pays the firm the difference - Supplies cost more for the firm (dollar worth less) If the value of the currency bought depreciates: - The value of the contract decreases - The firm pays the bank the difference (bank wants this) - Supplies cost less for the firm (dollar worth more)

3 Currency Market Intervention Methods

1. Direct Intervention 2. Indirect Intervention 3. Capital Controls

Six sensitivities of option values (premiums):

1. Forward rates 2. Spot rates (delta) 3. Time to maturity (theta) 4. Volatility (lambda) 5. Interest differentials (rho & phi) 6. Alternative option strike prices

FX Markets (in order of importance):

1. London 2. New York 3. Tokyo

Theories that make up the parity conditions approach:

1. the Law of One Price 2. Absolute Purchasing Power Parity 3. Relative Purchasing Power Parity 4. Interest Rate Parity

Parity Conditions Approach

Relative Purchasing Power Parity - changes in relative prices between countries drive the change in exchange rates over time. - most used approach

Interest Rate Parity (IRP)

The difference in the national interest rates for securities of similar risk and maturity should be equal to, but opposite in sign to, the forward rate discount or premium for the foreign currency, except for transaction costs.

International Parity Conditions

The economic theories that link exchange rates, price levels, and interest rates together

________ options are more the territory of individuals and financial institutions than of business firms.

Exchange-traded

Interest arbitrage is _________, when the investor does not sell the higher yielding currency proceeds forward, choosing to remain uncovered and accept the currency risk of exchanging the higher yield currency into the lower yielding currency at the end of the period.

"uncovered"

Market efficiency assumes that

(1) All relevant information is quickly reflected in both the spot and forward exchange markets (2) Transaction costs are low (3) Instruments denominated in different currencies are perfect substitutes for one another.

Empirical Tests of PPP Theory

(1) PPP holds up well over the very long run but poorly for shorter time periods (2) The theory holds better for countries with relatively high rates of inflation and underdeveloped capital markets.

5 Institutional Participants of the Market:

(1) bank and non-bank foreign dealers; (2) private individuals and firms conducting commercial or investment transactions; (3) speculators and arbitragers; (4) central banks and treasuries; and (5) foreign exchange brokers.

Exchange rate movements can be subdivided into three time horizons:

(1) day-to-day movement, which is seemingly random; (2) short-term movements, ranging from several days to trends lasting several months (3) long-term movements

Mid-rate Formula

(Bid rate + Ask rate)/2

Forward Premium Formula

(Forward rate - Spot rate)/Spot rate x (360/Days) multiply by 100 for percent

Percentage under/over valuation against the dollar is calculated as

(Implied-Actual)/(Actual), for Britain and Euro it is (Actual-Implied)/(Implied)

Foreign Exchange Brokers

- Agents who facilitate trading between dealers without themselves becoming principals in the transaction. - Charge a small commission for this service

On the date of maturity, an option will have a value equal to only

its intrinsic value, as zero time remaining means zero time value (literally no hope remains).

Forecasting services normally undertake fundamental economic analysis for _______ forecasts.

long-term

Traditionally, many countries have pursued policies of pushing the value of their currencies down in an effort to

maintain the price competitiveness of their exports. (exports are more attractive when cheaper)

In the _________ market—options offered by banks, premiums are quoted as a percentage of the transaction amount.

over-the-counter (OTC)

forward rates are, depending on the currency, typically quoted in terms of

points or pips

Exchange Rate Dynamics: Making Sense of Market Movements

- Although the various theories surrounding exchange rate determination are clear and sound, it may appear on a day-to-day basis that the currency markets do not pay much attention to the theories - Overshooting: a behavior in which major market adjustment in price changes "overshoots" the likely value that it will settle after a longer adjustment period

1. Forward Rate Sensitivity

- Standard foreign currency options are priced around the forward rate because the current spot rate and both the domestic and foreign interest rates are included in the option premium calculation. - The forward rate is central to valuation. - The option-pricing formula calculates a subjective probability distribution centered on the forward rate.

spot transaction

- The purchase of foreign exchange with delivery and payment between banks taking place normally on the second following business day. - Ex: exchanging dollars for pounds for a trip to London

When carrying out uncovered interest arbitrage, you want:

1. The difference between interest rates to be high 2. Stable interest rates

The two major groups of market participants are:

1. liquidity seekers 2. profit seekers

The three functions of the foreign exchange market are:

1. transfer purchasing power 2. provide credit 3. minimize foreign exchange risk.

If purchasing power parity holds—all the real effective exchange rate indices would stay at _____.

100

forward rates for longer than one-year are called

swap rates

The time value of an option exists because

the price of the underlying currency, the spot rate, can potentially move further and further into the money before the option's expiration.

_______-term forecasts rely less on long-run economic fundamentals and more on technical factors in the marketplace, government intervention, news, and the passing whims of traders and investors.

Short

For the law of one price, the spot rate can be calculated by:

Spot Rate (Yen per USD) = Price of product in Japanese Yen / Price of product in USD

covered interest arbitrage (CIA)

The arbitrager who recognizes an imbalance will move to take advantage of the disequilibrium by investing in whichever currency offers the higher return on a covered basis.

Futures standardized features:

Contract size Method of stating exchange rates Maturity date Last trading day Collateral and maintenance margins Settlement Commissions Use of clearinghouse as a counterparty

Delta

Definition: Expected change in the option premium for a small change in the *spot rate* Interpretation: The higher the delta, the more likely the option will move in-the-money

Theta

Definition: Expected change in the option premium for a small change in the *time to expiration* Interpretation: Premiums are relatively insensitive until the final 30 or so days

Lambda

Definition: Expected change in the option premium for a small change in the *volatility* Interpretation: Premiums rise with increases in volatility

6. Alternative Strike Prices and Option Premiums

OTC options may be tailored with regard to strike prices. Intrinsic value differs based on the moneyness of the option. - in-the-money will have both intrinsic and time value elements - out-of-the-money will have only a time value component (intrinsic value = 0)

price elasticity of demand

a measure of the sensitivity of demand to changes in price

A fixed, or pegged, rate is

a rate the government (central bank) sets and maintains as the official exchange rate

A speculator who ______ a futures contract is locking in the price at which she must buy that currency on the specified future date.

buys

CHIPS (New York)

calculates net balances owed by any one bank to another and which facilitates payment of those balances on the value date

In the case of a ______ option, as the spot price of the underlying currency moves up, the holder has the possibility of unlimited profit. On the down side, however, the holder can abandon the option and walk away, losing only the premium paid.

call

The buyer of a ____ option wants to be able to sell the underlying currency at the exercise price when the market price of that currency rises.

call

Strike Price = Spot Rate

call option is at-the-money (ATM)

Strike Price < Spot Rate

call option is in-the-money (ITM)

Strike Price > Spot Rate

call option is out-of-the-money (OTM)

A ______ is an option to buy foreign currency, and a _____ is an option to sell foreign currency.

call, put

American Option

can be exercised on or before its expiration

European Option

can be exercised only on the expiration date

Higher real rates of interest attract ________.

capital

Nominal Effective Exchange Rate Index

uses *actual* exchange rates to create an index, on a weighted average basis, of the value of the subject currency over time. - does not really indicate anything about the "true value" of the currency or anything related to PPP - simply calculates how the currency value relates to some arbitrarily chosen base period, but it is used in the formation of the real effective exchange rate index

American terms

usually the pound and euro, the quoting of the U.S. dollar per one unit of a specific currency (e.g. USD/EUR)

Derivatives

value is derived from an "underlying" asset like a stock or a currency, powerful tools used in business today for two very distinct management objectives, speculation and hedging

The writer of a call option gains

what the holder loses. (such as the premium)

Basis Risk

you will have unhedged CF's unless your CF is an exact multiple of the lot

Intrinsic value will be _______ when the option is out-of-the money—that is, when the strike price > the spot rate—as no gain can be derived from exercising the option.

zero

forward premium using mid rate formula

check phone

Retail aggregators

collect and consolidate a multitude of small orders for large order execution. (reduces small customer transaction costs)

Time Value

component of the premium representing the present value of the possibility that the option will expire in-the-money.

The process of covered interest arbitrage (CIA) pushes the foreign exchange and money markets back toward __________.

equilibrium

To neutralize a _________ contract, buyers and sellers will offset their position by taking the opposite action.

futures

Individual investors find ________ contracts useful for speculation because they usually do not have access to _______ contracts.

futures, forward

Contract specifications are established by the exchange on which ________ are traded, however ________ are traded between individuals and banks.

futures, forwards

For businesses, ______ contracts are often considered inefficient and burdensome because the ________ position is marked to market on a daily basis over the life of the contract.

futures, futures

If a product is relatively price-inelastic—meaning that the quantity demanded is relatively unresponsive to price changes—may often demonstrate a _____ (high/low) degree of pass-through.

high

The buyer of an option is termed the _______, while the seller of an option is referred to as the __________.

holder, writer or grantor

Asset Market Approach and additional variables that contribute to exchange rate determination:

illiquid capital markets weak economic and social infrastructure political instability weak corporate governance laws and practices susceptibility to contagion effects widespread speculation

The owner (buyer/holder) will exercise the option only when doing so is profitable, which means only when the option is _________.

in the money

The intrinsic value of put options behave

in the opposite manner of call options.

If the economy is going too fast, the Fed will ______ (increase/decrease) interest rates.

increase

When prices are expected to increase from inflation, central banks __________ (increase/decrease) interest rates to combat price increases.

increase

Real Effective Exchange Rate Index

indicates how the weighted average purchasing power of the currency has changed relative to some arbitrarily selected base period

Technical Analysis : time series techniques

infer no theory or causality but simply predict future values from the recent past

Overly stimulating economic activity, or increasing money supply growth beyond real economic activity, may prove _________.

inflationary

All that is required to make a covered interest arbitrage profit is for _____________ not to hold.

interest rate parity

Uncovered Interest Arbitrage

investors borrow in countries and currencies exhibiting relatively low interest rates and convert the proceeds into currencies that offer much higher interest rates. - idea of trying to profit off of investing abroad - no forward contract -> no locked in rate -> more risk

Justification for the international Fisher effect is that

investors must be rewarded or penalized to offset the expected change in exchange rates.

Both the International Fisher Effect and Interest Rate Parity suggest:

investors should be indifferent between investing at home or abroad.

proprietary trading

large international banks operate foreign exchange trading rooms in each major geographic trading center in order to serve both their customers and themselves on a 24-hour-a-day basis

The _____ efficient the foreign exchange market is, the better the chance that forecasters may get lucky.

less

The writers of a call or put option have _____ profit and ______ loss.

limited, unlimited

Profit seekers generally profit from:

liquidity seekers

If Amber McClain expected the peso to rise in value versus the dollar in the near term, she could take a _____ position by buying a March future on the Mexican peso.

long

The ______ the time horizon of the forecast, the more inaccurate, but also the less critical the forecast is likely to be.

longer

When the spot rate rises above the strike price, the intrinsic value becomes _________—meaning the option is in-the-money—because the option is always worth at least this value if exercised.

positive

The financial manager of an MNE may purchase financial derivatives in order to take positions in the expectation of profit—____________—or may use these instruments to reduce the risks associated with the everyday management of corporate cash flow—____________.

speculation, hedging

Exchange-traded contracts are particularly appealing to

speculators and individuals who do not normally have access to the over-the-counter market. - Banks also trade on the exchanges because it is one of several ways they can offset the risk of options they may have transacted with clients or other banks.

The single most important element of _________ is that future exchange rates are based on the current exchange rate.

technical analysis

Forward Rate as an Unbiased Predictor relates

the 1-year forward rate on the Japanese yen, F, if assumed to be an unbiased predictor of the future spot rate, also forecasts ¥100/$.

Direct Intervention

the active buying and selling of the domestic currency against foreign currencies (not commonly used)

Foreign currency intervention

the active management, manipulation, or intervention in the market's valuation of a country's currency

Indirect Intervention

the alteration of economic or financial fundamentals that are thought to be drivers of capital to flow into and out of specific currencies. (raising/lowering interest rates)

Option Premium (Price)

the cost of the option, and is usually paid in advance by the buyer to the seller.

What does it mean for a currency to float?

the currency price of a nation is set by the forex market based on supply and demand relative to other currencies. This is in contrast to a fixed exchange rate, in which the government entirely or predominantly determines the rate.

Value Date

the date of settlement

Exchange Rate Pass-Through

the degree to which the prices of imported and exported goods change as a result of exchange rate changes

A forward quotation expressed in points is not a foreign exchange rate as such. Rather it is

the difference between the forward rate and the spot rate.

Interest Rate Parity (IRP) relates

the difference in nominal interest rates is equal to, but opposite in sign to, the forward premium. - For this numerical example, the nominal yen interest rate (4%) is 4% less than the nominal dollar interest rate (8%) = -4% and the forward premium is 4%

Balance of Payments Approach

the equilibrium exchange rate is found when the net inflow (or outflow) of foreign exchange arising from current account activities matches the net outflow (or inflow) of foreign exchange arising from financial account activities. - trade surplus should lead to appreciation of currency - trade deficit should lead to depreciation of currency - second most used approach

Intrinsic value

the financial gain if the option is exercised immediately.

forward premium or discount

the percentage difference between the spot and forward exchange rate, stated in annual percentage terms.

ask

the price (i.e., exchange rate) at which a dealer will sell the other currency

bid

the price (i.e., exchange rate) in one currency at which a dealer will buy another currency

direct quote

the price of a foreign currency in domestic currency units (e.g. for New York USD/EUR)

foreign exchange rate

the price of one currency expressed in terms of another currency

indirect quote

the price of the domestic currency in foreign currency units (e.g. for New York EUR/USD)

swap transaction

the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates

The forward rate is calculated from three observable data items:

the spot rate, the foreign currency deposit rate, and the home currency deposit rate

Technical Analysis

the study of past price behavior (for example trends and formations of price movements) in an effort to gain insights into future price movements.

Some forecasters believe that foreign exchange markets for the major floating currencies are "efficient" and forward exchange rates are _________ predictors of future spot exchange rates.

unbiased

Buyers of call and put option have ______ profit potential and ______ loss.

unlimited, limited

The longer the time horizon of the forecast, the more _________ the forecast is likely to be.

inaccurate

London Fix

Traders were alleged to be exchanging emails, using social networking sites, and even phone calls, to collaborate on market movements and price quotes at key times.

foreign currency option

a contract that gives the option purchaser (the buyer) the right, but not the obligation, to buy or sell a given amount of foreign exchange at a fixed price per unit for a specified time period (until the maturity date)

Indication

a currency quote containing a bid-ask spread—on a foreign currency pair

Forward contracts

allow you to hedge EXACTLY what you need since it is just between you and your bank (no unhedged CFs)

American and European options are priced _________ because the option holder would normally sell the option itself before maturity.

almost the same

at-the-money (ATM)

an option whose exercise price is the same as the spot price of the underlying currency

Difference over spot=

forward proceeds - spot proceeds

Disequilibrium: Emerging Markets - Argentine Crisis of 2002

- Argentina had been wracked by hyperinflation, international indebtedness, and economic collapse in the 1980s - In 1991, the Argentine peso had been pegged to the U.S. dollar at a one-to-one rate of exchange - Argentina adopted a currency board to limit the growth of money in the economy - Under a currency board, the central bank may increase the money supply in the banking system only with increases in its holdings of USD - By removing the ability of government to expand the rate of growth of the money supply, Argentina believed it was eliminating the source of inflation - The real GDP growth rate settled into recession in late 1998, and the economy continued to shrink Crisis: Economic crisis revealed three very important underlying problems with Argentina's economy: (1) The Argentine peso was overvalued (2) The currency board regime had eliminated monetary policy alternatives for macroeconomic policy (3) The Argentine government budget deficit was out of control. Devaluation: - President Eduardo Duhalde devalued the peso from 1.00 Argentine peso per U.S. dollar to 1.40 - In 2002, the Argentine government announced that the peso would be floated

1. Corporate socialism

- Because of the influence of government and politics in the business arena, even in the event of failure, it was believed that government would not allow firms to fail, workers to lose their jobs, or banks to close. - Practices that had persisted for decades without challenge, such as lifetime employment, were now no longer sustainable.

Arbitrage Rule of Thumb

- If the difference in interest rates is greater than the forward premium (or expected change in the spot rate), invest in the higher interest yielding currency. - If the difference in interest rates is less than the forward premium (or expected change in the spot rate), invest in the lower interest yielding currency.

When Foreign Currency Intervention Fails: Japan 2010

- In September 2010, the Bank of Japan intervened in the foreign exchange market in an attempt to slow the appreciating yen - Japan reportedly bought nearly 20 billion U.S. dollars in exchange. - resulted in public outcry from Beijing to Washington to London over the "new era of currency intervention." - Although the yen spiked downward (more yen per dollar) for a few days, it returned once again to an appreciating path within a week.

Cross-Rate Consistency in Forecasting

- International financial managers must often forecast their home currency exchange rates for the set of countries in which the firm operates - Checking cross-rate consistency—the reasonableness of the cross rates implicit in individual forecasts—acts as a reality check.

Forecasting: What to Think?

- It appears, from decades of theoretical and empirical studies, that exchange rates do adhere to fundamental principles and theories - Fundamentals do apply in the long term. - in the short term, a variety of random factors may cause currency values to deviate significantly from their long-term fundamental path.

2. Corporate governance cronyism

- Many firms operating within the Far Eastern business environments were largely controlled either by families or by groups related to the governing party or body of the country. - This tendency has been labeled cronyism - Cronyism means that the interests of minority stockholders and creditors are often secondary at best to the primary motivations of corporate management.

forward transaction

- More formally, an outright forward transaction, requires delivery at a future value date of a specified amount of one currency for a specified amount of another currency (like spot transaction but takes longer) - The exchange rate is established at the time of the agreement, but payment and delivery are not required until maturity - Tailored to the company, they dictate exact amount & duration, mitigates risk - Normally quoted for value dates of one, two, three, six, and twelve months

spot against forward swap

- Most common type of swap - Combination of swap & forward contract - The dealer buys a currency in the spot market (at the spot rate) and simultaneously sells the same amount back to the same bank in the forward market (at the forward exchange rate) - Single transaction with just one counterparty, the dealer incurs no unexpected foreign exchange risk

SWIFT

- Network that allows financial institutions all over the world to send and receive information about financial transactions in a secure, standardized, and reliable manner - Sends payment orders, but it does not facilitate the actual transfer of funds—settlement.

3. Time to Maturity Sensitivity (theta)

- Option values increase with the length of time to maturity. The expected change in the option premium from a small change in the time to expiration is termed theta - Option premiums deteriorate at an increasing rate as they approach expiration. Rule of Thumb: Longer maturity options are better values, since it is possible to alter an option position without suffering significant time value deterioration.

4. Sensitivity to Volatility (lambda)

- Option volatility is defined as the standard deviation of daily percentage changes in the underlying exchange rate. - If the exchange rate's volatility is rising, and therefore the risk of the option being exercised is increasing, the option premium would be increasing. - The primary problem with volatility is that it is unobservable; it is the only input into the option pricing formula that is determined subjectively by the trader pricing the option. - Volatility is viewed in 3 ways: historic, foward-looking, & implied Rule of Thumb: Traders who think volatilities will fall significantly can sell (write) options and buy them back for a profit when option premiums fall

Nondeliverable Forwards (NDFs)

- Possess the same characteristics and documentation requirements as traditional forward contracts, except that they are settled only in U.S. dollars; the foreign currency being sold forward or bought forward is not delivered - Used primarily for emerging market currencies or currencies subject to significant exchange controls - Without true interest rates, traders may price NDFs based on what they believe spot rates may be in the future

Speculators and Arbitragers

- Seek to profit from trading within the market itself - Operate in their own interest, without a need or obligation to serve clients or to ensure a continuous market - Try to profit from simultaneous exchange rate differences in different markets

Market-Based Forecasting

A process of formulating exchange rate forecasts from market indicators, which is based on either the (1) the spot rate (2) the forward rate - for long-term, interest rates can be used under conditions of IRP

When Foreign Currency Intervention Fails: Turkey 2014

- Turkey suffered a widening current account deficit and rising inflation - The US Fed announced it would be slowing its bond purchases from Turkey - Rates were expected to rise in the US and Turkey needed capital - To defend its currency, Turkey needed to raise interest rates - Instead, the Turkish president lowered interest rates to stimulate the economy - Lower interest rates provided no capital for Turkey - Turkish central bank had little choice but to increase the Turkish one-week bank repurchase interest rate (or repo rate) from 4.5% to 10.0% in an effort to stop the outflow of capital

Central Banks and Treasuries

- Use the market to acquire or spend their country's foreign exchange reserves as well as to influence the price at which their own currency is traded, a practice known as *foreign exchange intervention*. - The motive is not to earn a profit as such, but rather to influence the foreign exchange value of their currency in a manner that will benefit domestic interests.

Disequilibrium: Emerging Markets - The Asian Crisis of 1997

- currency crisis arose from a fundamental change in the economics of the region, the transition of many Asian nations from being net exporters to net importers. - The most visible roots of the crisis were in the excesses of capital inflows into Thailand - Thai banks continued to raise capital internationally, extending credit to a variety of domestic investments and enterprises beyond what the Thai economy could support. - As the investment "bubble" expanded, some participants raised questions about the economy's ability to repay the rising debt. The baht came under attack. Crisis: - the Thai government repeatedly intervened in the foreign exchange markets directly (using up much of its foreign exchange reserves) and indirectly (by raising interest rates) - Thai central bank finally allowed the baht to float - By November, the baht had fallen from 25 to 40 baht per dollar, a fall of about 38% - neighboring Asian nations came under speculative attack by currency traders and capital markets - The only currency that had not fallen besides the Hong Kong dollar was the Chinese renminbi, which was not freely convertible at the time.

Criticisms of the Balance of Payments Approach

- focuses on flows of currency and capital rather than on stocks of money or financial assets. - Relative stocks of money or financial assets play no role in exchange rate determination

Criticisms of Parity Conditions Approach

- proven to be quite poor at forecasting exchange rates (at least in the short to medium term) - basic assumption that the only thing that matters is relative price changes. - have to decide which measures or indexes of prices to use across countries, in addition to providing a "predicted change in prices" with the chosen indexes.

Criticisms of Monetary Approach

- real economic activity is relegated to a role in which it only influences exchange rates through changes in the demand for money - criticized for its omission of a number of factors that are generally agreed upon by area experts as important to exchange rate determination, including (1) the failure of PPP to hold in the short to medium term (2) money demand appears to be relatively unstable over time (3) the level of economic activity and the money supply appear to be interdependent, not independent.

Technical forecasting is limited by:

- the reliance that future values are predictable using subjective patterns of historical data - generally only useful for predicting day to day movements - models rarely provide point or range estimates and are of limited use to multinational corporations - semi-strong form of efficiency of markets suggest that its usefulness should be model

Fundamental forecasting is limited by:

- the uncertain timing of the impact of factors - the need to forecast factors that have an immediate impact on exchange rates - the omission of factors that are not easily quantifiable - changes in the sensitivity of currency movements to each factor over time

Every option has three different price elements:

1) the exercise price or strike price—which is the exchange rate at which the foreign currency can be purchased (call) or sold (put); 2) the premium, which is the cost, price, or value of the option itself; and 3) the underlying or actual spot exchange rate in the market.

3 components of foreign exchange trades:

1) the foreign exchange trade transaction agreement—the interaction of dealers, brokers, and aggregators as just described; 2) electronic communication and notification for payment and settlement; and 3) final settlement of the currency trade.

3 Major Determinants of Foreign Exchange Rates

1. Parity Conditions Approach 2. Balance of Payment Approach 3. Monetary Approach & Asset Market Approach

4 International Parity Conditions:

1. Purchasing Power Parity (Big Mac Index) 2. Fisher Effect 3. International Fisher Effect 4. Interest Rate Parity

relative form of PPP

Accounts for such market imperfections as transportation costs, tariffs, and quotas. The prices should be similar, not exact. (more realistic)

absolute form of PPP

An extension of the law of one price that suggests prices of the same products in different countries should be equal when measured in a common currency ex: If you take $4.79 (Price of Big Mac in USD) and convert it to another currency, you will get the *exact* amount you need to buy the Big Mac in that other country.

Phi

Definition: Expected change in the option premium for a small change in the *foreign interest rate* Interpretation: Increases in foreign interest rates cause decreasing call option premiums

bid-ask spread

Dealers bid (buy) at one price and ask (sell) at a slightly higher price, making their profit from the spread between the prices

Rho

Definition: Expected change in the option premium for a small change in the *domestic interest rate* Interpretation: Increases in domestic interest rates cause increasing call option premiums

CLS

Eliminates settlement risk by using a payment versus payment (PvP) settlement service where both sides' payment instructions for an FX transaction are settled simultaneously

Cross Rate Calculation

Example: a Mexican importer needs Japanese yen to pay for purchases in Tokyo Currency per USD: USD/JPY = 101.29 USD/MXN = 18.2692 101.29/18.2692 = 5.5443 Yen/Peso

_________ options are settled through a clearinghouse, which means that buyers do not deal directly with sellers.

Exchange-traded

Triangular Arbitrage

Exchanging currency A for currency B for currency C back to currency A to exploit slight disequilibrium in exchange rates

Ignoring transaction costs, if the returns in dollars are equal between the two alternative money market investments, the spot and forward rates are considered to be at ______.

IRP

International Fisher Effect

For any two countries, the spot exchange rate should change in an equal amount but in the opposite direction to the difference in nominal interest rates between countries

_________ contracts are commitments - they are generally held until delivery. Since it is tailored to a company, no one will want to take it over.

Forward

_______ contracts allow you to get out if you change your mind.

Futures

________ have fixed maturities. (e.g. 30, 60, 90, 180, 360 days)

Futures

Partial Pass-Through

If the price in U.S. dollars rises by less than the percentage change in exchange rates (as is often the case in international trade) Ex: If Volvo worried that a price increase of this magnitude in the U.S. market would severely decrease sales volumes, it might work to prevent the dollar price of this model from rising the full amount in the U.S. market. If the price of this same Volvo model rose to only $58,000 in the U.S. market, the percentage increase would be less than the 20% appreciation of the euro versus the dollar. $58,000/$50,000 = 1.16 or 16% increase

Complete Pass-Through

If the price in dollars increases by the same percentage change as the exchange rate Ex: The price of a specific Volvo is €50,000. When the firm exports the auto to the United States, the price of the Volvo in the U.S. market should simply be the euro value converted to U.S. dollars at the spot exchange rate: Price of Volvo in USD = Price of Volvo in Euros x Spot Rate in $/euro If the euro were to appreciate 20% versus the U.S. dollar—from $1.00/€ to $1.20/€—the price of the Volvo in the U.S. market should theoretically rise to $60,000. $60,000/$50,000 = 1.2 or 20% increase

The Law of One Price & Inflation (Relative PPP)

If the spot exchange rate between two countries starts in equilibrium, any change in the differential rate of inflation between them tends to be offset over the long run by an equal but opposite change in the spot exchange rate. - Even if the price of the Big Mac started off the same, as time passes, the price will diverge because of each country's inflation rates - The exchange rate should adjust to bring the price back to equilibrium

Commercial and Investment Transactors

Importers and exporters, international portfolio investors, multinational corporations, tourists, and others use the foreign exchange market to facilitate execution of commercial or investment transactions.

Relative Inflation Rates

Increase in U.S. inflation leads to: - Increase in price of U.S. goods (bad) - Increase in U.S. demand for foreign goods - Increase in U.S. demand for foreign currency - Increase in the exchange rate for the foreign currency - Decrease in the value of the USD

Relative Interest Rates

Increase in U.S. rates leads to: - Increased return for U.S. investors - Increase in demand for U.S. deposits - Decrease in demand for foreign deposits - Increase in demand for dollars - Increased exchange rate for the dollar.

Cross Rates

Many currency pairs are only inactively traded, so their exchange rate is determined through their relationship to a widely traded third currency

Counter-party risk is a problem in ______ markets.

OTC

The main advantage of ____ options is that they are tailored to the specific needs of the firm in terms of notional principal, strike price, and maturity.

OTC

The implied *purchasing power parity rate of exchange* using the actual price of the Big Mac in China (Yuan18.6) over the price of the Big Mac in the United States in U.S. dollars ($5.04):

Price of Big Mac in China (Yuan) / Price of Big Mac in US (USD) = Implied Price

The price of a Big Mac in China in U.S. dollar terms

Price of Big Mac in China (Yuan) / Yuan/$ Spot rate

For the law of one price, comparing prices would require only a conversion from one currency to the other. For example:

Price of product in USD x Spot Rate (Yen per USD) = Price of product in Japanese Yen

In many ways, buying an option is like buying a ticket to a benefit concert.

The buyer has the right to attend the concert, but is not obliged to. The buyer of the concert ticket risks nothing more than what she pays for the ticket. Similarly, the buyer of an option cannot lose more than what he pays for the option. If the buyer of the ticket decides later not to attend the concert, prior to the day of the concert, the ticket can be sold to someone else who wishes to go.

price currency (quote currency)

The currency on the right of the slash - The quotation always indicates the number of units of the price currency

5. Sensitivity to Changing Interest Rate Differentials (rho and phi)

The expected change in the option premium from a small change in the - domestic interest rate (home currency) is term rho. - foreign interest rate (foreign currency) is termed phi. Rule of Thumb: Buy a call option on foreign currency before the domestic interest rate rises (and its price increases)

International Fisher Effect relates

The forecast change in the spot exchange rate, is equal to, but opposite in sign to, the differential between nominal interest rates

Exchange Rate Indices: Real & Nominal

The objective is to discover whether a country's exchange rate is "overvalued" or "undervalued" -by weighting the bilateral exchange rates between the home country and its trading partners.

The Fisher Effect relates

The real rate of return is the nominal rate of interest less the expected rate of inflation. Assuming efficient and open markets, the real rates of return should be equal across currencies. - Here, the real rate is 3% in U.S. dollar markets (r = i - pie = 8% - 5%) and in Japanese Yen markets (4%-1%)

2. Spot Rate Sensitivity (delta)

The sensitivity of the option premium to a small change in the spot exchange rate is called the delta. - delta varies between +1 to 0 for a call option & -1 to 0 for a put - As an option moves further in-the-money, delta rises toward 1.0. - As an option moves further out-of-the-money, delta falls toward zero. Rule of Thumb: The higher the delta, the greater the probability of the option expiring in-the-money (this is when the option will be exercised)

Purchasing Power Parity (PPP)

The theory that the price of internationally traded commodities should be the same in every country, and hence the exchange rate between the two countries should be the ratio of prices in the two countries.

Prime Brokerage

a dealer-customer structure that allows customers such as hedge funds to deal directly in the interdealer market.

foreign exchange quotation (or quote)

a statement of willingness to buy or sell at an announced rate

Derivatives are used by firms to:

achieve certain payoffs hedge risks make underlying markets more efficient reduce volatility minimize earnings volatility reduce tax liabilities motivate management (agency theory effect)

foreign exchange transaction

an agreement between a buyer and seller that a fixed amount of one currency will be delivered for some other currency at a specified rate

foreign currency futures contract

an alternative to a forward contract that calls for future delivery of a standard amount of foreign exchange at a fixed time, place, and price

in-the-money (ITM)

an option that would be profitable, excluding the cost of the premium, if exercised immediately

out-of-the-money (OTM)

an option that would not be profitable, excluding the cost of the premium, if exercised immediately

Profit seekers

are typically much better informed about the market, looking to profit from its future movements

The chances of these forecasts being consistently useful or profitable depend on whether one believes the foreign exchange market is _______.

efficient

The transaction is _________, if the exchange rate back to dollars is guaranteed at the end of the period.

covered

base currency (unit currency)

currency on the left of the slash - Always a single unit

A country wishing for its currency to fall in value, may _______(increase/decrease) interest rates.

decrease

If the economy is going too slow, the Fed will _______ (increase/decrease) interest rates.

decrease

Financial _________ are powerful tools in the hands of careful and competent financial managers or they can be destructive devices when used recklessly and carelessly.

derivatives

The currency with the higher interest rate —will sell forward at a _________, and the currency with the lower interest rate will sell forward at a ________.

discount, premium

Monetary Approach

exchange rate is determined by the supply and demand for national monetary stocks, as well as the expected future levels and rates of growth of monetary stocks. - Other financial assets, such as bonds, are not considered relevant for exchange rate determination, as both domestic and foreign bonds are viewed as perfect substitutes. - It is all about money stocks - focuses on changes in the supply and demand for money as the primary determinant of inflation.

The more efficient the market is, the more likely it is that

exchange rates are "random walks," with past price behavior providing no clues to the future.

Asset Market Approach

exchange rates are determined by the supply and demand for financial assets of a wide variety, including bonds. - Changes in monetary and fiscal policy alter expected returns and perceived relative risks of financial assets, which in turn alter rates.

Premiums on __________ options are quoted as a domestic currency amount per unit of foreign currency.

exchange-traded

Technical analysts (chartists)

focus on price and volume data to determine past trends that are expected to continue into the future.

European terms

for most currencies, the quoting of the quantity of a specific currency per one U.S. dollar (e.g. EUR/USD)

Purchasing Power Parity relates

forecast change in spot exchange rates and forecast difference in rates of inflation - the change in spot rate will be equal to the difference in inflation, but opposite signs (spot rate = 4%, inflation rate = -4%)

A _________________ between currencies states the rate of exchange at which a foreign currency will be "bought forward" or "sold forward" at a specific date in the future (typically after 30, 60, 90, 180, 270, or 360 days).

forward exchange agreement

________ contracts are typically >$1M whereas __________ contracts are much smaller.

forward, futures

________ contracts have no basis risk whereas _________ contracts do.

forward, futures

The forward rate may never actually equal the ____________.

future spot rate.

One of the defining characteristics of _______ is the requirement that the purchaser deposit a sum as an initial margin or collateral.

futures

Liquidity seekers

simply wish to secure currency for transactions

The Fisher Effect

nominal interest rates in each country are equal to the required real rate of return plus compensation for expected inflation.

Unbiased prediction simply means that the forward rate will, on average,

overestimate and underestimate the actual future spot rate in equal frequency and degree.

When that pass-through is __________, meaning the full percentage change in the exchange rate is not reflected in prices, a country's real effective exchange rate index can deviate from its PPP equilibrium level of 100.

partial

The foreign exchange market is the mechanism by which:

participants transfer purchasing power between countries by exchanging money, obtaining or providing credit for international trade transactions, and minimizing exposure to the risks of exchange rate changes.

The concept of price elasticity of demand is useful when determining the desired degree of ___________.

pass-through

Bank and Nonbank Dealers

profit from buying foreign exchange at a bid price and reselling it at a slightly higher ask (also called an offer) price.

Foreign Exchange Market

provides the physical and institutional structure through which the money of one country is exchanged for that of another country.

If the goal were to increase the value of the domestic currency, the central bank would

purchase its own currency using its foreign exchange reserves

If the law of one price were true for all goods and services, the _________ exchange rate could be found from any individual set of prices.

purchasing power parity (PPP)

The buyer of a ____ option wants to be able to sell the underlying currency at the exercise price when the market price of that currency drops.

put

A country's central bank may either fight inflation or fight slow economic growth, but

rarely can they do both.

Capital Controls

restriction of access to foreign currency by the government.

If the goal were to decrease the value of its currency it would

sell its own currency in exchange for foreign currency, typically a major hard currency like the dollar and euro.

A speculator who _____ a futures contract is locking in the price at which she must sell that currency on that future date.

sells

If Amber McClain believes that the Mexican peso will fall in value versus the U.S. dollar by March, she could sell a March futures contract, taking a _______ position.

short

The Fisher effect usually exists for ___________, such as Treasury bills and notes.

short-maturity government securities