The Forward Currency Market

and Financial Arbitrage

Managing Foreign Exchange Risk

INTERNATIONAL MONETARY AND

FINANCIAL ECONOMICS

Third Edition

Joseph P. DanielsDavid D. VanHoose

Copyright © South-Western, a division of Thomson Learning. All rights reserved.

2

Foreign Exchange Risk

• Foreign exchange risk is the risk that the value of a future receipt or obligation will change due to a change in foreign exchange rates.

• Because these international transactions span time, foreign exchange risk can arise.

3

Sources of Risk

• Transaction exposure: the risk that the domestic cost or proceeds of a transaction may change.

• Translation exposure: (also known as accounting exposure) the risk that the translation of value of foreign-currency-denominated assets is affected by exchange rate changes.

• Economic exposure: (also known as operating) the risk that exchange rate changes may affect the present value of future income streams.

4

Hedging and Speculating

• Hedging is the act of offsetting an exposure to risk.

• Covered Exposure refers to a foreign exchange risk that has been completely eliminated with a hedging instrument.

5

Long and Short Positions

• Traders are long in a foreign currency if the value of their foreign-currency-denominated assets exceeds the value of their foreign-currency-denominated liabilities.

• Traders are short in a foreign currency if the value of their foreign-currency-denominated assets is less than the value of their foreign-currency-denominated liabilities.

6

Hedging

• There are a number of instruments that can be used to hedge foreign exchange risk.

• Chapter 4 deals with the forward markets, while Chapter 5 introduces foreign exchange futures, options, and swaps.

7

Forward Market

• The forward market is the market for contracts that ensure the future delivery of a currency at a specified exchange rate.

• Typical maturity is 1,3,6, 9 and 12 months.

• The forward rate is determined by the forces of supply and demand in the forward market.

8

The Forward Market for the Pound

• Initially the forward market for the pound is in equilibrium at the forward rate or 1.620.

• An increase in the demand for the pound forward shifts the demand curve to the right.

• This results in an appreciation of the pound.

9

Forward Premium

• The forward premium or discount is the difference between the forward exchange rate and the spot rate, expressed as a percentage of the spot rate.

• The standard forward premium is the forward premium or discount annualized. the formula for the standard forward premium is:

100

12

NS

SFN

10

Example

• For example, suppose the spot rate is 1.4926 (SFr/$) and the 3-month forward rate is 1.4887.

• The forward premium on the Swiss franc is:

[(1.4887-1.4926)/1.4926]•(12/3)•100 =

-1.05%

11

Premium versus Discount

• Note that in this example, the exchange rate is expressed as SFr/$, i.e., the Swiss franc price of the dollar.

• Because the forward price of the dollar is less than the spot price of the dollar, we say that the dollar is selling at a discount.

• Likewise, we say that the Swiss franc is selling at a premium.

12

The Forward Rate as a Predictor

• Because the forward rate is determined by the supply of and demand for the future delivery of a currency, it may convey information about the future spot rate.

• Many empirical studies indicate that there is some co-movement between the forward and spot rate.

• The co-movement is less than one-to-one; thus the forward rate has limited ability in forecasting the future spot exchange rate.

13

The International Flow of Funds

• If there were no restrictions on capital flows, we would see saver move funds from one nation to another in search of the greatest exchange-rate adjusted returns.

• This flow of funds could potentially affect interest rates and exchange rates.

• Individuals who save supply loanable funds.• Those who borrow demand loanable funds.• In a competitive market, the interest rate is determined

by the supply and demand of loanable funds.

14

The Market for Loanable Funds

• In a competitive market, the supply and demand for loanable funds determines the equilibrium interest rate.

• If the interest rate were R2, the quantity of loanable funds demanded would exceed the quantity of loanable funds supplied. Hence the interest rate would rise.

• The equilibrium rate is R1. At R1, the quantity supplied equals the quantity demanded.

15

A Shift in the Supply of Loanable Funds

• Initially the market for loanable funds is in equilibrium at interest rate RA.

• The shift in the supply of loanable funds from SA to SB illustrates a decline in the supply of loanable funds in this economy.

• A new equilibrium is reached at the higher interest rate RB.

16

Covered Interest Parity

• Covered interest parity is a condition that relates interest differentials to the forward premium or discount.

• It begins with the no-arbitrage condition when exchange risk is covered with a forward exchange contract:

(1+R) = (1+R*)(F/S)• The condition can be rewritten, and with a slight

approximation, yields:R - R* = (F-S)/S.

17

Covered Interest Parity

• CIP is helpful in understanding short-term market movements.

• As an equilibrium condition, it aids in our understanding of potential adjustments in various financial markets.

• These adjustments occur if there is a flow of savings from one nation to another.

18

Covered Interest Arbitrage

• Suppose the U.S. interest rate is 4.5% while the U.K. rate on a similar instrument is 2.25% (both for an annual debt instrument with similar risk characteristics). Hence, a saver would gain an additional 2.25% on the U.S. instrument.

• suppose at the same time, the current spot rate is 1.6000 ($/£) and the one-year forward rate is 1.6200. The saver would gain 1.25% on the pound. [(1.62 – 1.60)/1.60 • 100].

• The currency gain on the pound falls short of the interest differential in favor of the U.S. financial instrument. Hence, the saver should shift fund to the United States. This outcome is illustrated by point B in the following diagram.

19

The Covered-Interest-Parity Grid

• The covered-interest parity grid illustrates all of the interest differential and forward premium or discount combinations that satisfy CIP

• These combinations lie on or near the 45 degree line.

• The narrow band around the 45 degree line illustrates transaction and opportunity costs.

20

Example

• In out previous example, the saver will shift funds from the United Kingdom to the United States.

• The reallocation of funds by savers like the one in our example could influence the spot rate of exchange, the forward rate of exchange, the U.S. interest rate and the U.K. interest rate.

21

The Spot Market for the Pound

• As individuals move funds from pound-denominated instruments to dollar-denominated instruments, there is an increase in the demand for the dollar.

• The increase in the demand for the dollar is equivalent to an increase in the supply of the pound.

• The pound depreciates.

22

The Forward Market for the Pound

• Individuals will desire to purchase the pound forward when the dollar-denominated financial instruments mature.

• There is an increase in the demand for the pound in the forward market.

• The pound appreciates in the forward market.

23

The U.K. Loanable Funds Market

• The flow of funds out of the United Kingdom is illustrated by the decrease in the supply of loanable funds.

• Because of the decrease in the supply of loanable funds, the U.K. interest rate rises to R2.

24

The U.S. Loanable Funds Market

• The flow of funds into the United states increases the supply of loanable funds.

• The increase in supply lowers the U.S. interest rate to R2.

25

The Spot Market

• Savers reallocate funds to pound-denominated financial instruments.

• This results in an increase in the demand for the pound (as the demand for the pound is a derived demand).

• The demand curve shifts to the right and the pound appreciates relative to the dollar.

26

Uncovered Interest Parity

• If foreign exchange risk is not hedged when purchasing a foreign financial instrument, the transaction is said to be uncovered.

• Uncovered interest parity (UIP), is a condition relating interest differentials to an expected change in the spot exchange rate of the domestic currency.

27

Uncovered Interest Parity

• If a saving decision is uncovered, traders base their decision on their expectation of the future spot exchange rate.

• The expected future spot exchange rate is expressed as Se

+1. UIP is represented as:

R – R* = (Se+1 – S)/S.

• In words, the right-hand-side of the UIP condition is the expected change in the spot rate over the relevant time period.

28

Deviations from UIP

• If a nation’s currency value is highly variable, individuals may be less confident about their expectations, making the purchase of a financial instrument a much riskier proposition. This risk is called currency risk.

• In addition, there may also be country risk associated with the purchase of the financial instrument. Country risk is the possibility of loss due to political uncertainty in the nation.

29

Risk Premium

• Because one instrument may be a riskier proposition than another financial instrument, borrowers may have to offer a higher rate of return on the debt instruments they issue.

• Risk premium is an increase in the return offered on a higher-risk financial instrument to compensate individuals for the additional risk they undertake.

30

Risk Premium and UIP

Using ρ to denote risk premium, the UIP condition can be rewritten as:

.* 1

S

SSRR

e

If the domestic instrument is the higher-risk instrument, then the positive interest differential should equal the expected rate of depreciation of the domestic currency plus an additional amount to compensate individuals for the additional risk they assume with the purchase of the domestic instrument.

31

Foreign Exchange Market Efficiency

• We can link the CIP condition and the UIP condition through the interest rate differential as:

(F-S)/S = R-R* = (Se+1–S)/S.

• Through simplification, this can be restated as:

F = Se+1.

• The uncovered and covered interest parity conditions imply that the expected spot rate should equal the forward exchange rate at the time of the settlement of the forward contract.

32

Market Efficiency

• Forward exchange market efficiency is a situation in which the equilibrium spot and forward rates adjust quickly to reflect all available information.

• Hence, the forward premium or discount should equal the expected rate of currency depreciation and the risk premium.

• This implies that, on average, the forward exchange rate should predict on average the expected future spot exchange rate.

• Most studies conclude that risk premium is important but are divided on whether foreign exchange markets are efficient.

33

International Financial Markets

• International capital markets are markets for cross-border exchange of financial instruments that have maturities of one year or more.

• International money markets are markets for cross-border exchange of financial instruments with maturities of less than one-year.

• Bonds are long-term promissory notes.• Equities are ownership shares that might or might not

pay the holder a dividend, whose values rise and fall with savers’ perceived value of the issuing enterprise.

34

Eurocurrencies

• Eurocurrencies are bank deposits denominated in a currency other than that of the nation in which the bank deposit is located.

• The Eurocurrency market is a market for the borrowing and lending of Eurocurrency deposits.

• The Eurocurrency market and the forward exchange market are highly integrated. Because of this, Eurocurrency interest differentials and the forward premium or discount tend to be in equilibrium.