FIN329 Exam 2

Value at maturity (SHORT) equation

(Short position)= −Notional principal × (Spot − Futures)

percentage change in the value of a currency =

(beginning rate - ending rate) /ending rate x100

problems with NDF

"fixing of spot rate on the fixing date," the spot rate at the end of the contract used to calculate the settlement, a problem because should a country suspend currency exchanges (such as venezuela) then the NDF cannot be delivered

wsj2.3.16

Government relies on massive imports of bills from foreign printing companies to keep economy going, Venezuela government boosts the supply of the country's increasingly worthless currency which all stems from a desperation to have Bolivar Notes in order to pay for exports but their efforts are only backfiring as they are inflating the currency further and making many of the lower-denominated bills increasingly worthless (a 2-bolivar note is cheaper than a napkin)

wsj2.16.13

Heinz swiss account freeze, speculations about insider trading from a swiss trading account who would gain millions if Heinz stock prices rose from the sale to Hathaway. They are investigating if this another 3G idea as well, the deal that bought Burger King

"beggar-thy-neighbor"

Historically, a primary motive for a government to pursue currency value change was to keep the country's currency cheap so that foreign buyers would find its exports cheap

three key concepts clarify the differences between swap agreements:

1. If the agreement is for one party to swap its fixed interest rate payment for the floating interest rate payments of another, it is termed an interest rate swap (plain-vanilla swap) 2. If the agreement is to swap currencies of debt service, for example Swiss franc interest payments in exchange for U.S. dollar interest payments, it is termed a currency swap or cross-currency swap. 3. A single swap may combine elements of both interest rate swaps and currency swaps. For example, a swap agreement may swap fixed-rate dollar payments for floating-rate euro payments.

six basic option sensitivities

1. The impact of changing forward rates 2. The impact of changing spot rates 3. The impact of time to maturity 4. The impact of changing volatility 5. The impact of changing interest differentials 6. The impact of alternative option strike prices

Exchange rate movements, similar to equity price movements, can be subdivided into three periods:

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, characterized by up and down long-term trends

plain vanilla swap strategies:

1. debt structure 2. debt cost

intervention methods

1. direct intervention 2. indirect intervention 3. capital controls

rules of thumb for effective intervention

1. dont lean into the wind 2. coordinate timing and activity 3. use good news 4. don't be cheap- overwhelm them

outcomes on interest rate forwards with a LONG position: 1. if interest rates fall, prices rise 2. if interest rate rises, prices fall

1. gain/profit 2. loss

outcomes on interest rate forwards with a SHORT position: 1. if interest rates fall, prices rise 2. if interest rate rises, prices fall

1. loss 2. gain/profit

determinants of the foreign exchange currency rates (3 theories):

1. parity conditions 2. asset approach 3. balance of payments

management alternatives to managing risk

1. refinancing 2. forward-rate agreements 3. interest rate futures 4. interest rate swaps

three prices that characterize options:

1. spot rate 2. exercise price 3. premium

problems with PPP forecasting

1. the assumption that the only thing that matters is relative price changes (while there are many reasons for change other than just price) 2. deciding which indexes of prices to use across countries

in plain vanilla swap of floating rates for fixed rates, there are two principles why only the floating portion is swapped for the fixed rate, excluding the interest risk premium credit spread:

1. the swap market does not wish to deal with the credit risk of any individual borrower, only the core fixed and floating-rate foundations 2. the fixed-rate credit spread is indeed a fixed-rate component, and does not change over the life of the loan. The swap market is intended only for the true floating-rate component

the United Kingdom and United States together make up nearly ______% of daily currency trading

60

profit of an option

Profit = Premium − (Spot Rate − Strike Price)

hedging

Purchasing a contract (including forward foreign exchange) or tangible good that will rise in value and offset a drop in value of another contract or tangible good, undertaken to reduce risk by protecting an owner from loss

international monetary market (IMM)

A branch of the Chicago Mercantile Exchange that specializes in trading currency and financial futures contracts

what happens in the CH5 minicase

Santiago, and many other business owners like him, struggled to finance his business due to the lockdown on swapping the Venezuelan bolivar for US dollars--stemmed from Political Chaos, Capital Controls, and an emergence of the grey and black market (the only way for many to get any foreign currency). They had to hire a broker, often paying them a large stipend as well to make transactions. It was often very risky but he needed to loan money some way so had to do it through the grey market

credit spread

The added interest cost assessed a borrower to compensate the lender or investor for the assessed credit risk of the borrower. The spread is typically based upon the credit rating of the borrower

commodity currency

The currency of a country that is dependent on the export of a certain commodity

forward discount/premium

The difference between spot and forward rates, expressed as an annual percentage (positive--premium, negative--discount)

speculative grade

A credit quality that is below BBB, below investment grade. The designation implies a possibility of borrower default in the event of unfavorable economic or business conditions (charged a high premium)

investment grade

A credit rating, typically assigned by Moody's, Standard & Poors, or Fitch, symbolizing the assured ability of a borrower to repay in a timely manner regardless of business or market conditions. (Denoted as BBB- (or equivalent by credit rating agency) or higher) (charged a relatively small premium)

margin/collateral

A deposit made as security for a financial transaction otherwise financed on credit

financial derivative

A financial instrument, such as a futures contract or option, whose value is derived from an underlying asset like a stock or currency

over-the-counter (OTC) market

A market for share of stock, options (including foreign currency options), or other financial contracts conducted via electronic connections between dealers. The over-the-counter market has no physical location or address, and is thus differentiated from organized exchanges that have a physical location where trading takes place

forward transaction

An agreed-upon foreign exchange transaction to be settled at a specified future date, often one, two, or three months after the transaction date

triangular arbitrage

An arbitrage activity of exchanging currency A for currency B for currency C back to currency A to exploit slight disequilibrium in exchange rates.

speculation

An attempt to make a profit by trading on expectations about future prices

interest rate futures

Exchange-traded agreements calling for future delivery of a standard amount of any good, e.g., foreign exchange, at a fixed time, place, and price (popular because of liquidity, easy to use, and standardized exposures) (most used--eurodollar and US Treasury bond futures of CBOT)

intrinsic value

The financial gain if an option is exercised immediately

risk-free-rate of interest

The return on an asset assumed to possess no possibility of failure to pay. Typically a debt security issued by a government like a U.S. Treasury bill, note, or bond

you exercise your option when the spot price is _____________ (above/below) the option price

above

why you would choose a SHORT position

because you are afraid the currency might fall in value before maturity

A(n) _______ is the price (i.e., exchange rate) in one currency at which a dealer will BUY another currency.

bid

The single largest interest rate risk of the nonfinancial firm is

debt service

One of the defining characteristics of futures is the requirement that the purchaser

deposit a sum as an initial margin or collateral

the "big three" (____________, _____________, and _____________) continue to dominate global currency trades, totaling roughly 92% of all trading surveyed.

dollar, euro, and yen

T/F every individual organizational borrower is charged the same rates and has the same access to capital

false, individual organizational borrowers not only pay different rates to borrow but also have access to different amounts of capital or debt

T/F---intervention never fails

false, it may-and often does- fail

T/F---the cost of debt for corporate borrowers remains the same over time, even at maturity

false, the cost of debt changes over the course of maturity

T/F---the 3 theories of what determines foreign exchange rates are competing against one another

false, they are complementary of one another

A European option can be exercised anytime, not just on its expiration date, not before

false- it can only be exercised on its expiration date

T/F---The maximum profit that the writer of the call option can make is much more than the premium

false--its limited to the amount of the premium

as short term floating rates rise in the market place, so do ____________ rates

fixed

"what worries bankers is_______________, but what worries elected officials is __________________"

inflation, unemployment

reference rate

is the rate of interest used in a standardized quotation, loan agreement, or financial derivative valuation (LIBOR, the London Interbank Offered Rate, is by far the most widely used and quoted)

The break-even price for the put option

is the strike price less the premium

foreign exchange

means the money of a foreign country; that is, foreign currency bank balances, banknotes, checks, and drafts

"Swissie"

nickname for Swiss francs

"Aussie"

nickname for the Australian dollar

"loonie"

nickname for the Canadian dollar, named after the water fowl on Canada's one dollar coin.

"Kiwi"

nickname for the New Zealand dollar

"Sing dollar"

nickname for the Singapore dollar

"Cable"

nickname for the exchange rate between U.S. dollars and U.K. pounds sterling, the name dating from the time when transactions in dollars and pounds were carried out over the Transatlantic telegraph cable

When the spot rate rises above the strike price, the intrinsic value becomes ________________ because the option is always worth at least this value if exercised

positive

non deliverable forward swap transaction (NDF)

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 -contracted offshore, uses standards set by ISDA -primarily for emerging countries or those sanctioned by major exchange controls -beyond the control of the "home" country

The IMF defines manipulation as

protracted large-scale intervention in one direction in the exchange market

foreign exchange market

provides the physical and institutional structure through which the money of one country is exchanged for that of another country—the rate of exchange between currencies is determined and foreign exchange transactions are physically completed

american terms

the U.S. dollar price of one EURO and the U.S. dollar price of one POUND sterling (major two currencies that use this, along with Australian dollar and new zealand dollar)

sovereign credit risk

the ability of these sovereign borrowers to repay foreign currency denominated debt—U.S. dollar debt in this case—in a timely manner

direct intervention

the active buying and selling of the domestic currency against foreign currencies

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 in and out of specific currencies, most widely used is interest rates

technical analysis

the belief that the study of past price behavior provides insights into future price movements, assumption that exchange rates, or for that matter all market-driven prices, follow trends. And those trends may be analyzed and projected to provide insights into short-term and medium-term price movements in the future, derived from inadequacies in the other foreign exchange forecasting models in the short and medium-run

forward-forward swap transaction

the buying and selling simultaneously of the same amount of money in the forward market, where there is a difference in interest rates is equal to the interest rate differential (due to interest rate parity) so therefore its a technique fore borrowing another currency on a fully collateralized basis

The premium or option price

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

value date

the date of settlement

bid-ask spread

the difference between a bid and an ask quotation (a dealer often makes their profit from this)

purchasing power parity (PPP) approach

the long-run equilibrium exchange rate is determined by the ratio of domestic prices relative to foreign prices, most widely used and accepted

Options differ from all other types of financial instruments in

the patterns of risk they produce

credit/roll-over risk

the possibility that a borrower's creditworthiness at the time of renewing a credit—its credit rating—is reclassified by the lender, can result in changing fees, changing interest rates, altered credit line commitments, or even denial

direct quote is

the price of a foreign currency in domestic currency units (ex--in new york, USD1.2174 =EUR1.00)

indirect quote is

the price of the domestic currency in foreign currency units

spot transaction

the purchase of foreign exchange with delivery and payment between banks taking place normally on the second following business day

capital controls

the restriction of access to foreign currency by government. This involves limiting the ability to exchange domestic currency for foreign currency (When access and exchange is permitted, trading takes place only with official designees of the government or central bank, and only at dictated exchange rates)

repricing risk

the risk of changes in interest rates charged (earned) at the time a financial contract's rate is reset

cost of debt for an individual borrower has two components:

the risk-free-rate of interest plus a credit-risk premium

marked-to-market

the value of the contract is revalued using the closing price for the day. The amount to be paid is called the variation margin.

foreign exchange markets are defined by the __________________ set for delivery

timing (the future date)

The usual motivation for a currency swap is

to replace cash flows scheduled in an undesired currency with flows in a desired currency

pros to the BOP approach with foreign exchange rates

trade surpluses and deficits, current account growth in service activity, and, recently, the growth and significance of international capital flows continue to fuel this theoretical fire

T/F---An American option gives the buyer the right to exercise the option at any time between the date of writing and the expiration or maturity date

true

T/F---At spot rates less than the strike price, the option will expire worthless and the writer of the call option will keep the premium earned

true

T/F---Swaps allow them to alter the fixed/floating composition quickly and easily without the origination and registration fees of the direct debt markets.

true

T/F---The main advantage of OTC options is that they are tailored to the specific needs of the firm

true

T/F---the swap market itself does not carry the credit risk associated with individual borrowers. Individual borrowers with obligations priced at LIBOR plus a spread will keep the spread

true

T/F---what the holder of the option gains, the writer loses, and vice versa

true

The asset market approach assumes that whether foreigners are willing to hold claims in monetary form depends on an extensive set of investment considerations or drivers:

--Relative real interest rates are a major consideration for investors in foreign bonds and short-term money market instruments. --Prospects for economic growth and profitability are an important determinant of cross-border equity investment in both securities and foreign direct investment. --Capital market liquidity is particularly important to foreign institutional investors. Cross-border investors are not only interested in the ease of buying assets, but also in the ease of selling those assets quickly for fair market value if desired. --A country's economic and social infrastructure are important indicators of its ability to survive unexpected external shocks and to prosper in a rapidly changing world economic environment. --Political safety is exceptionally important to both foreign portfolio and direct investors. The outlook for political safety is usually reflected in political risk premiums for a country's securities and for purposes of evaluating foreign direct investment in that country. --The credibility of corporate governance practices is important to cross-border portfolio investors. Poor corporate governance practices can reduce foreign investors' influence and cause subsequent loss of the firm's focus on shareholder wealth objectives. --Contagion is defined as the spread of a crisis in one country to its neighboring countries and other countries with similar characteristics—at least in the eyes of cross-border investors. Contagion can cause an "innocent" country to experience capital flight with a resulting depreciation of its currency. --Speculation can either cause a foreign exchange crisis or make an existing crisis worse. We will observe this effect through the three illustrative cases—the Asian crisis, Russian crisis, and Argentine crisis

forward transaction requirements

-delivery at a future value date of a specified amount of one currency for a specified amount of another currency -exchange rate established at agreement -payment and delivery not needed until maturity -payment occurs two business days after the even-month anniversary of the trade

types of swap transactions

-spot against forward -forward-forward -non-deliverable forwards

problems with LIBOR

-the origin of the rates submitted by banks. rates are based on "estimated borrowing rates" to avoid reporting only actual transactions, as many banks may not conduct actual transactions in all maturities and currencies each day. As a result, the origin of the rate submitted by each bank becomes, to some degree, discretionary. -banks have a number of interests that may be impacted by borrowing costs reported by the bank that day

most significant LIBOR Maturities due to widespread use: (3)

1 month, 3 month, 6 month

Every option has three different price elements:

1) the exercise price or strike price, 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 3) the underlying or actual spot exchange rate in the market.

cross rate

An exchange rate between two currencies derived by dividing each currency's exchange rate with a third currency. Colloquially, it is often used to refer to a specific currency pair such as the euro/yen cross rate, as the yen/dollar and dollar/euro are the more common currency quotations.

forward-rate agreements (FRA)

An interbank-traded contract to buy or sell interest rate payments on a notional principal

out-of-the-money (OTM)

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

at-the-money (ATM)

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

In: CUR1/CUR2 ---> CUR1 is the __________ _______________, and CUR2 is the _________ ____________________

CUR1--base/unit currency (always a single unit) CUR2--price/quote currency (in terms of how much for one of the base currency)

in-the-money (ITM)

Circumstance in which an option is profitable, excluding the cost of the premium, if exercised immediately

On the value date, most dollar transactions in the world are settled through the computerized ______________________________________ in New York, which calculates net balances owed by any one bank to another and which facilitates payment of those balances by 6:00 p.m. that same day in Federal Reserve Bank of New York funds

Clearing House Interbank Payments System (CHIPS)

swap transaction

In general it is the simultaneous purchase and sale of foreign exchange or securities, with the purchase executed at once and the sale back to the same party carried out at an agreed-upon price to be completed at a specified future date. Swaps include interest rate swaps, currency swaps, and credit swaps

value of a call option

Total Value (premium) = Intrinsic Value × Time Value

wsj2.10.17

Trump trade "punishment", speculating on Trump's trade discussions with other countries and how this agreements affect USA's agricultural economy. Most of his support came from the heavy agricultural states, and his decision to pull out of the Transpacific Partnership has already hurt exports because other countries can beat USA with cheaper commodities. Further, the threat to renegotiate NAFTA or impose many tariffs on China could be detrimental to the businesses in the USA. top countries USA exports to--Canada, China, Mexico

most widely used currencies with LIBOR:

US dollar and euro

value at maturity (LONG) equation

Value at maturity (Long position) = Notional principal × (Spot − Futures)

wsj2.17.16

Venezuela Tries to Prop Up Crumbling Economy, Mr. Maduro created a plan to raise the pice of oil for 95 octane gasoline in an effort to increase inflow of capital and increase export of oil. This however left the cheaper and more pollutant 91-octane oil exposed as an alternative many will choose which will have detrimental consequences (many environmental and other economic as the demand for the better oil decreases and prices rise further) The major changes need to be structural since much of the economy's struggles come from a lack of currency availability due to capital controls.

Wsj12.17.15 (within wsj11.20.16)

Venezuela, Black-Market Currency News Site Square Off in U.S. Court Lawsuit alleges DolarToday.com is destabilizing Venezuelan economy, the general counsel for DolarToday believes "This is part of the revolutionary government's ongoing mission to retain its dwindling grip on power and harass, intimidate, and silence anyone who publishes information that sheds light on the troubled state of Venezuela's economy", the defendants (DolarToday) say the threats of Mr. Maduro to imprison the presidents of the site "are so illusory, speculative, and lacking in 'facial plausibility,' that the complaint should not have crossed the proverbial threshold of the courthouse door." Mr. Wolkov said Venezuela "has not been able to silence DolarToday because the company is a U.S.-based media outlet with rights to freedom of speech and freedom of press," adding that the site will continue to publish information.

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

foreign exchange quotation (or quote)

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

wsj12.17.15

agrentina and the peso--Argentina's peso lost more than a quarter of its value against the U.S. dollar Thursday, a day after the new government of President Mauricio Macri said it would lift currency controls to attract investors and kick-start the economy. --wanting the lowered rate to give investors confidence, regrow the agribusinesses to export goods and receive capital inflow -the fall of the peso is a move than could expand Argentina's economy well or it could crush it by putting exceeding pressure on the consumers, the investors, and the companies who have debts in foreign currencies while only receiving pesos

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

call

an option to buy foreign currency

put

an option to sell foreign currency

wsj5.19.16

argentina and congress, Mr. Macri president is expected to veto a law that would protect private and public employees from getting laid off by doubling the cost to lay them off. Substantial political corruption and pressure against Mr. Macri vince he is not peronist, and his party is the minority in both houses (rather odd to have the minority in a position of power for Argentina) -Later Thursday, the president moved to regain the political initiative, announcing increases in the minimum wage that will raise it 33% by January -a combination of roughly 40% annual inflation, declining purchasing power and an anemic economy is hurting sales and leading companies to consider layoffs. Last month, retail sells fell 6.6% on the year, according to CAME, a confederation of medium-size companies.

asset market approach (relative price of bonds)

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

balance of payments approach with foreign exchange rates

argues that the equilibrium exchange rate is found when the net inflow (outflow) of foreign exchange arising from current account activities matches the net outflow (inflow) of foreign exchange arising from financial account activities.

criticism to the BOP approach with foreign exchange rates

arise from the theory's emphasis on flows of currency and capital rather than on stocks of money or financial assets, relative stocks play no role

A(n) ______ is the price (i.e., exchange rate) at which a dealer will SELL the other currency

ask

wsj11.20.16

bolivar black market, Public Enemy No. 1 of Venezuela's revolutionary government is Gustavo Díaz, a Home Depot Inc. employee in central Alabama. Mr. Diaz is president of one of Venezuela's most popular and insurgent websites, DolarToday.com, which provides a benchmark exchange rate used by his compatriots to buy and sell black-market dollars and is fighting for economic freedom and for Venezuelans' access to information in a country that makes financial and other data secret. As a colonel that fought in a coup against the predecessor Venezuela President, realized that It's ironic that with DolarToday in Alabama, he does more damage to the government than he did as a military man in Venezuela

we are currently in a global race to the _________ (bottom, top) as far as values of currencies

bottom

long position

buying currency/contract

wsj3.8.17

china deficit, china has been experiencing a trade surplus (exports exceeding imports) for several years and just reported a trade deficit. the surge in imports was a combination of higher commodity prices and stronger domestic demand, economists said. China is in the midst of an infrastructure-building spree and prices of oil, copper, steel and other raw materials have shot up in recent months (although china plans to return to a trade surplus soon, they are wary of imposed tariffs specifically by the US that could hurt their plans)

individual borrowers possess their own individual ____________ ____________, the market's assessment of their ability to repay debt in a timely manner

credit quality

wsj7.18.17

foreign buyers pump up US house prices, due to major price increases in the real-estate markets of China, Canada, Britain, Mexicans, and Indians, major people from these countries are purchasing and investing in homes in the US because the prices are relatively much cheaper. While this is a huge source of capital inflow, all this increased demand is now surpassing supply of housing in prime areas since states like Florida, Texas, and California make up 46% of foreign buying activities. In order for this not to become a crisis, more supply of houses must be constructed top foreign buyers--China, Canada, Britain, Mexico, India

all-in-costs (AIC)

found by calculating the internal rate of return (IRR) of the total cash flow stream, including proceeds up-front and repayment over time

The single most important element of technical analysis is that

future exchange rates are based on the current exchange rate

sovereign debt

historically considered debt of the highest quality, higher than that of non-government borrowers within that same country. This quality preference stems from the ability of a government to tax its people and, if need be, print more money

monetary approach to foreign currency exchange rates

in its simplest form states that the 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 instruments, such as bonds, are not considered)

criticism of the monetary approach for foreign exchange rates

real economic activity is relegated to a role in which it only influences exchange rates through changes in the demand for money along with 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; and (3) the level of economic activity and the money supply appear to be interdependent, not independent.

of the three parts of PPP, _________________ PPP is thought to be the most consistently relevant to possibly explaining what drives exchange rate values

relative

Unwinding a currency swap

requires the discounting of the remaining cash flows under the swap agreement at current interest rates, then converting the target currency back to the home currency of the firm

The buyer of a put option wants to be able to

sell the underlying currency at the exercise price when the market price of that currency drops

short position

selling currency/contract

swap transaction requirements

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

forecasting foreign currency exchange rates

spot rate of base currency x (change in price of base currency/ change in price of quoted currency)

European terms

whenever a currency's value is quoted, it is quoted in terms of number of units of currency to equal one U.S. dollar.

spot against forward swap transaction

where the dealer buys a currency in the spot market, at spot rate, and simultaneously sells the same amount back to the same bank in the forward market (one counterparty, so no unexpected foreign exchange risk) (most common type of swap transaction)

why you would choose a LONG position

you believe the currency would rise in value before maturity

Intrinsic value will be ________ when the option is out-of-the-money—that is, when the strike price is above the market price—as no gain can be derived from exercising the option

zero