Week 10- Forward currency exchange markets
How do you offset a forward contract
buying or selling (opposite transaction) an offsetting contract at prevailing market rates
How is the forward exchange rate calculated?
calculated by adjusting the current market rate (the spot rate) for "forward points", which take into account the difference in interest rates between the two currencies and the time of maturity
How can importers cover risk exposure?
(1) buy foreign currency now (spot market) (2) enter a forward contract to buy foreign currency (3) buy foreign currency when due (spot market)
How can exporters cover risk exposure?
(1) enter a forward contract to sell foreign currency and then sell foreign currency when due (spot market) (2) take a foreign currency loan, convert to local currency, and repay debt upon receipt of foreign currency.
How do you hedge with foreign currency receivables?
1. borrow foreign currency & convert to home currency 2. deposit in a domestic interest bearing bank account 3. buy foreign currency on transaction due date = If expectation is correct interest on borrowing is offset by domestic exchange rate appreciation.
What is the process of triangular arbitrage?
1. convert one currency to another 2. convert it again to a third currency 3. convert it back to the original currency WITHIN A SHORT TIME FRAME
What is a forward contract?
A forward contract is an agreement between a corporation and a bank to exchange a specified amount of foreign currency at a specific exchange rate (called the forward rate) on a specified date in the future.
What is offsetting a forward contract?
Closing out a contract before maturity
What does uncovered interest arbitrage involve?
Convert principal + interest to home currency at the end of investment term without having purchased a forward contract
Why do exporters want to hedge?
Exporters want to protect against foreign exchange depreciation (home currency appreciation) where contracts are nominated in foreign currency.
True or false? A forward contract is a standardised tradable financial instrument?
False
True or false? Interest rate arbitrage opportunities ignore the forward rate of exchange?
False- they use forward contracts, and look at forward premium to earn riskless profit
What are forward contracts?
Forward contracts are agreements between two parties to exchange two designated currencies, at a specified exchange rate, at a specific time in the future.
What is hedging?
Hedging is a risk management strategy used to limit or offset the probability of loss from fluctuations in the prices of commodities, currencies, or securities
When is interest rate arbitrage possible?
If interest rate abroad greater than interest rate at home & forward rate is equal to the spot rate
When isn't interest rate arbitrage possible?
If interest rate abroad greater than interest rate at home BUT forward rate is less than the spot rate
Give an example of location arbitrage.
If the ask price is $1.40 at Northpac Bank and the bid price is $1.45 at Southpac Bank then you buy at Northpac and sell to Southpac.
When is there a premium on a currency?
If the forward exchange rate for a currency is higher than the spot rate, there is a premium on that currency (forward - spot = +ve).
Why do importers want to hedge?
Importers want to protect foreign exchange appreciation (home currency depreciation) where contracts are nominated in foreign currency.
When are NDFs used?
In circumstances where there is low liquidity such as; to hedge local currency risks in emerging markets where local currencies are not freely convertible, or when there are restrictions on capital flows
In a forward contract, what is the bank obligated to do?
In this situation, the bank is obligated to complete transaction (i.e., must have currency in hand to settle when contract expires).
What is locational arbitrage?
Locational arbitrage is the process of buying a currency at a location where it is priced cheap and then immediately selling it at some other location where it is priced higher.
How do you express premium as a percentage?
P = (F-S)/S x 360/days x 100/1
What is the formula for premium?
Premium (P) = Forward (F) - Spot (S)
Give an example of foreign exchange arbitrage.
Price at a NY bank is GB1 = US$2, Price at London bank is is GB1 = US$2.05. Buy @ NY bank, and SIMULTANEOUSLY selll @ London bank
Give an example of triangular arbitrage. You have $1 EUR/USD = 0.8; EUR/GBP = 1.4; USD/GBP=1.6
Sell $ for E: $1 x 0.8 = 0.8E Sell E for P: 0.8/ 1.4 = 0.57P Sell P for $: 0.57P x 1.6 = $0.912
What is triangular arbitrage?
The act of exploiting an arbitrage opportunity resulting from a pricing discrepancy among three different currencies. One of these three, is the home currency.
What is a forward rate?
The forward rate is the rate applicable to a financial transaction that will take place in the future
True or false? Covered interest rate arbitrage involves purchasing a forward contract?
True
True or false? Triangular arbitrage opportunities involve cross-rate differentials?
True
What is a non-deliverable forward contract?
a cash-settles, short-term forward contract on a thinly traded or non-convertible foreign currency. At the settlement date, profit/loss is calculated by taking the difference between the forward rate and the prevailing spot rate.
Give an example of covered interest arbitrage
- US investor buys AU$1,000,000 at US$0.70 = AU$1.00 (US$700,000) - invests at 7.0% for 1 year - investor simultaneously forward sells the future proceeds (principle + interest = $1,000,000 + $70,000) at US$0.70 = AUS1.00 - The forward contract yields a profit of US$49,000 (AU$1,070,000 x 0.70 - US$700,00).
What is interest rate parity?
- a no-arbitrage condition whereby; - the interest rate differential between two countries is equal to the differential between the forward exchange rate and the spot exchange rate
Give an example of an NDF using: AUS requires 100million Pesos to settle supplier invoice. AUS negotiate rate equal to US$200,000
- at settlement date, Peso ^ to amount of US$240,000 - AUS' bank pays US$40,000 to AUS (100,000 not delivered) - had it depreciated to US$160,000, AUS would have to PAY bank US$40,000 which would have been offset by a lower cost of imports (in US$)
What is a spot transaction?
-also known as FX spot using spot exchange rate - an agreement between two parties to buy one currency against selling another currency at an agreed price for settlement on the spot date
Explain offsetting using an example.
1. AUS has a contract to buy US$70,000, to pay US supplier in 6 months (AU$1.00 = US$0.70) costing AU$100,000. 2. The US supplier is unable to perform the work 3. AUS negotiate a 6-month forward contract to sell US$100,000 (at a rate of AU$1.00 = US$0.65) Therefore MNC will receive AU$107,692 (US$70,000/0.65) and makes a $7,692 ($107,692 - $100,000) windfall profit due to the appreciation of the US dollar.
What is uncovered interest arbitrage?
A trading strategy whereby an investor capitalizes on the interest rate differential between two countries, WITHOUT hedging. = open to future fx rate exposure.
When is there a discount on a currency?
Alternatively, if the forward rate is lower than the spot rate, there is a discount on that currency (forward - spot = -ve).
Define foreign exchange arbitrage.
The process of simultaneously buying and selling currency pairs in different foreign exchange markets to profit risk-free from exchange rate differentials in different locations.
What occurs on the spot market?
The purchase of foreign exchange, with delivery and payment between banks to take place, normally, on the second following business day (known as value date).
What is the purpose of hedging?
improves an entity's ability to weather market volatility and protect the gross margin.
Why would you hedge foreign currency payables?
on the expectation that foreign currency will appreciate or the home currency will depreciate
Why would you hedge foreign currency receivables?
on the expectation that foreign currency will depreciate or the home currency will appreciate
What is covered interest arbitrage?
process of capitalising on interest rate differentials between two countries WHILE covering risk of exchange rate movement by hedging via a forward contract
In covered interest arbitrage, what is the forward contract for?
purchasing a forward contract to convert principle plus interest to home currency at the end of the investment term
What is the purpose of engaging in the foreign forward market?
to fix the price of a foreign currency, for delivery and payment on a specified future date, to reduce exchange rate risks due to exchange rate fluctuations.
How do you hedge with foreign currency payables?
you buy foreign currency today and deposit in an interest bearing account, to settle on due date.
Give some features of NDFs.
• Used for emerging market currencies • The contract for the full amount is not delivered • Payment is based on the change in the currency • Payment for the difference is commonly in US$ • Pricing reflects interest rate differentials • Offshore contracts that are out of the jurisdiction of the nation which currency is being traded
A higher currency rate (appreciation) affects business and trade in what ways?
• ↓Exports: Country's exports become more expensive • Exports become less competitive • Downward pressure on inflation (↑imports) • ↑Imports: Imported goods become relatively cheaper (which increases unemployment in domestic industries) • Can lower the country's balance of trade by decreasing foreign currency reserve due to increased imports over exports (this is a bad thing)
