Chapter 31

THE MARKET FOR FOREIGN EXCHANGE RATE RISK CONTROL

INSTRUMENTS

Foreign Exchange Rates

The amount of one currency that can be exchanged for a unit of another currency

Exchange Rate Quotation Conventions Direct quote Indirect quote

Foreign Exchange Risk

Foreign exchange risk refers to the risk of adverse movements in the exchange rate. Assets denominated in a foreign

currency expose investors to exchange rate risk.

Liabilities denominated in foreign currency expose borrowers to exchange rate risk.

Spot Market

The market for the settlement of foreign exchange transactions within two business days. Appreciation Depreciation American terms European terms

Spot Exchange Rates

Foreign exchange rates between major currencies are free to float, with market forces determining the relative value of a currency.

Spot exchange rates adjust to compensate for the relative inflation rate between two countries.

Cross rates

The exchange rate between two countries except the U.S.Dollar price of currency XDollar price of currency Y

Cross rate mispricing leads to triangular arbitrage it involves positions in three currencies

Foreign Exchange Dealers

Large international banks act as dealers in the foreign exchange market

Dealers are linked by telephone and cable and various information transfer services

Revenue sources: Bid-ask spread Commissions Trading profits

The Euro

European Union 15 European member countries

Treaty on European Union (1992) established monetary union

Maastricht Treaty single currency and monetary policy European Central Bank (ECB)

Economic and Monetary Union (EMU)

Entry Requirements

The annual fiscal deficit not to exceed 3% of GDP.

Cumulative public debt not to exceed 60% of GDP.

Other economic, political, and social requirements

Approval by voters of a country seeking membership

The Euro

Adopted on January 1, 1999 fixed conversion rate against member

country’s national currencies and relative to euro

free to fluctuate against all other currencies

January 1, 2002 physical replacement of member

countries’ currencies with euro

OutcomesSince Birth of Euro

The euro has been viable and fairly stable. It has developed a very large public and

cooperate capital market denominated in euros.

Since its inception at $1.17, the euro has weakened considerably, reaching a low of $0.8229 on October 27, 2000.

Potential participants include the U.K. and Sweden; Denmark voted against joining the EMU on September 28, 2000.

Instruments for Hedging Foreign Exchange Risk

Currency Forward ContractsCurrency Futures ContractsCurrency OptionsCurrency Swaps

Currency Forward Contracts

Forward Contract Maturities maturity of less than two years longer dated forward contracts have

large bid-ask spreads

Pricing Currency Forward Contracts

The forward exchange rate is determined from the spot exchange rate and the interest rates in the two countries.

Interest rate parity implies that, by hedging in the forward market, an investor will receive the same domestic return whether investing domestically or in a foreign country.

Interest Rate Parity

Relationship between the spot exchange rate, the interest rates in two countries, and the forward rate.

The arbitrage process which forces interest rate parity is called covered interest arbitrage.

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Currency Futures Contracts

Trading LocationsUnderlying CurrenciesContract SizeContract Maturity

Currency Option Contracts

Underlying Currencies spot currency currency futures

Currency Options Trading organized exchange over-the-counter

Trading LocationsContract Specifications

Currency Swaps

A package of currency forward contracts.Allows hedging of long-dated foreign

exchange risk.More traditionally efficient than futures

or forward contracts.Used to arbitrage opportunities in global

financial markets for raising funds at lower cost than in the domestic market.