© 2004 South-Western Publishing 1

Chapter 10

Foreign Exchange Futures

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Outline

Introduction Foreign exchange risk Forward rates Foreign currency futures Dealing with the exposure

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Introduction

The capital markets across the globe have become one giant playing field– The U.S. share of market capitalization is

steadily declining as foreign markets develop

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Foreign Exchange Risk

Introduction FX risk and interest rates The concept of exposure FX risk from a business perspective FX risk from an investment perspective

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Introduction

Overseas investments and international business involve foreign exchange risk

A survey of corporate treasurers indicates that the primary corporate use of derivative assets is hedging foreign exchange exposure

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Introduction (cont’d)

Foreign exchange risk is the risk of loss due to changes in the relative value of world currencies– Modest changes in exchange rates can result in

significant dollar differences

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FX Risk and Interest Rates

Introduction The real rate of interest The inflation premium The risk premium

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Introduction

Events in one industrial country affect the rest of the world– Interest rates are often a good barometer of

events like high unemployment, changes in economic policy, etc.

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The Real Rate of Interest

The nominal interest rate (the stated rate) can be expressed as the sum of:– The real rate– An inflation premium and– A risk premium

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The Real Rate of Interest (cont’d)

The real rate reflects the rate of return investors demand for giving up the current use of funds– Indicates people’s willingness to postpone

spending their money– Is not directly observable– Hovers in the 3% to 4% range

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The Inflation Premium

The inflation premium reflects how the general price level is changing– Measures how rapidly the money standard is

losing its purchasing power– In the past 75 years, U.S. inflation has averaged

about 3.2% annually

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The Risk Premium

The risk premium is the component of interest rates that is most difficult to measure– Risk-averse investors expect to be compensated

for risks they take– The price of a risky security must reflect a risk

premium to entice someone to buy it– The magnitude of the risk premium depends on

how much risk the security carries– The higher the risk premium, the lower the price

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The Concept of Exposure

Introduction Accounting exposure Economic exposure

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Introduction

Exposure is the extent to which you face foreign exchange risk

There are two general types of exposure:– Accounting exposure– Economic exposure

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Accounting Exposure

Accounting exposure is the exchange rate exposure that results when consolidated financial statements are prepared in a single currency

Two types of accounting exposure:– Transaction exposure– Translation exposure

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Accounting Exposure (cont’d)

Transaction exposure results from transactions involving the purchase or sale of goods or services with the price stated in foreign currency– Exists until the payable or receivable is

liquidated– E.g., a U.S. importer must pay a European

supplier in Swiss francs

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Accounting Exposure (cont’d)

Translation exposure results from translating foreign assets and liabilities into U.S. dollars on the consolidated balance sheet

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Economic Exposure

Economic exposure measures the risk that the value of a security or a firm will decline due to an unexpected change in relative foreign exchange rates– Would reduce the value of the security or firm– The most important type of exposure for

security investors

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FX Risk From A Business Perspective

A Business Example of Economic Exposure

An American importer agrees to purchase 400 Swiss overcoats at a price of CHF1,200 each, for a total of CHF480,000. The coats will take 3 months to produce, and the importer is to pay for them upon delivery.

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FX Risk From A Business Perspective (cont’d)

A Business Example of Economic Exposure (cont’d)

Assume the following exchange rates exist today:

$ per CHF = $0.8073 (direct quotation) CHF per $ = CHF1.2387 (indirect quotation)

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FX Risk From A Business Perspective (cont’d)

A Business Example of Economic Exposure (cont’d)

If the importer paid for the coats today, each coat would cost the importer:

CHF1,200 x $0.8073/CHF = $968.76

The importer is concerned that the U.S. dollar might weaken between now and coat delivery time.

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FX Risk From A Business Perspective (cont’d)

A Business Example of Economic Exposure (cont’d)

If the dollar strengthens and the value of the Swiss franc falls to $0.7500, the cost of each coat will be:

CHF1,200 x $0.7500/CHF = $900.00

If the dollar weakens to an exchange rate of $0.9000, the cost of each coat will be:

CHF1,200 x $0.9000/CHF = $1,080.00

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FX Risk From An Investment Perspective

An Investment Example of Economic Exposure

You just placed an order with your broker to purchase 10,000 shares of Kangaroo Lager, trading on the Sydney Stock Exchange. You can currently purchase the shares for AUD1.45 apiece.

The current exchange rate is $0.5755/AUD. Thus, the shares cost you:

10,000 x AUD1.45 x $0.5755/AUD = $8,344.75

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FX Risk From An Investment Perspective (cont’d)

An Investment Example of Economic Exposure (cont’d)

You hold the Kangaroo shares for six months, at which time the shares sell for AUD1.95. This is a return of

(1.95 – 1.45)/1.45 = 34.5%

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FX Risk From An Investment Perspective (cont’d)

An Investment Example of Economic Exposure (cont’d)

In six months, the exchange rate is $0.5500. If you were to sell the shares, you would receive:

10,000 x AUD1.95 x $0.5500/AUD = $10,725.00

This is a return on investment of

($10,725.00 - $8,344.75)/$8,344.75 = 28.52%

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Forward Rates

Introduction Purchasing power parity Interest rate parity

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Introduction

The spot exchange rate is the current exchange rate for two currencies

The forward exchange rate is a contractual rate between a commercial bank and a client for the future delivery of a specified quantity of foreign currency

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Introduction (cont’d)

Forward exchange rates are normally quoted on the basis of one, two, three, six, and twelve months

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Introduction (cont’d)

The forward rate is an unbiased estimate of the future spot rate for foreign exchange– E.g., if forward rates show that the dollar is

expected to strengthen against the Swiss franc, it would make sense to delay paying Swiss francs as long as possible

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Introduction (cont’d)

The difference between the forward and spot rates can be quoted as an annual premium or discount:

100forward months #

12:QuotationIndirect

100forward months #

12:QuotationDirect

forward

forwardspot

spot

spotforward

P

PP

P

PP

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Purchasing Power Parity

Purchasing power parity is an arbitrage-based idea that in a world of perfect markets, the same good should sell for the same price in different countries– Assumes there are no trade barriers, no taxes,

etc.

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Purchasing Power Parity (cont’d)

Unexpected inflation causes the value of the home currency to fall

Differentials in international inflation rates can be a source of foreign exchange risk

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Interest Rate Parity

Interest rate parity states that differences in national interest rates will be reflected in the currency forward market– Two securities of similar risk and maturity will

show a difference in their interest rates equal to the forward premium or discount, but with the opposite sign

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Interest Rate Parity (cont’d)

According to interest rate parity:

rate risklessforeign the

rate risklesscountry -home the

$per currency foreign in expressed rate,spot

$per currency foreign in expressed rate, forward

where

1

1

foreign

domestic

domestic

foreign

R

R

S

F

R

R

S

F

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Interest Rate Parity (cont’d)

Computing Implied Foreign Interest Rates

It is now January 2, 2004. The six-months forward rate for the British pound is £0.5658/$; the spot rate is £0.5576/$. Also, the six-month T-bill rate is 1.01%.

What is the implied British 6-month interest rate based on the

interest rate parity relationship?

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– £.5576 $1– X% 1.01%– £.5576 *(1+x/2) 1*(1+.0101/2)– If the forward is quoted per $1 as in the example

£.5576 *(1+x/2) = .5658

1*(1+.0101/2)

(we should divide by the dollar amount)

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– £.5576 $1– X% 1.01%– £.5576 *(1+x/2) 1*(1+.0101/2)

If the forward is quoted per £ it will be $1.7674

1*(1+.0101/2) = 1.7674

£.5576 *(1+x/2)

(we should divide by the £ amount)

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Interest Rate Parity (cont’d)

Computing Implied Foreign Interest Rates (cont’d)

The implied British 6-month interest rate is 3.96%:

The actual UK rate in early 2004 was 3.90%.

%96.320198.2

0101.1

1

5576.0

5658.0

UK

UK

R

R

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Foreign Currency Futures

Introduction Pricing of foreign exchange futures

contracts

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Introduction

Foreign currency futures contracts were the first financial futures traded on exchanges in the U.S.– Began trading at the Chicago Mercantile

Exchange in 1972

Foreign currency futures were quickly recognized as very effective ways to deal with foreign exchange risk

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Pricing of Foreign Exchange Futures Contracts

Futures prices are a function of– The spot price– The cost of carrying the particular asset or

financial instrument

For foreign currency futures, the cost of holding one currency rather than another is an opportunity cost measured by differences in interest rates

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Pricing of Foreign Exchange Futures Contracts (cont’d)

A basic pricing model:

ratecurrency Local

rate Eurodollar

price futures

where

365

delivery todays1ratespot

lc

ed

f

lcedf

R

R

P

RRP

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Pricing of Foreign Exchange Futures Contracts (cont’d)

Pricing A Foreign Currency Futures Contract Example

In the Land of Leptonia interest rates are 10.00%, and the current dollar price of a Lepton is $0.4817. The current Eurodollar deposit rate is 7.50%.

For how much should a 90-day futures contract on Lepton’s sell?

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Pricing of Foreign Exchange Futures Contracts (cont’d)

Pricing A Foreign Currency Futures Contract Example (cont’d)

Using the equation:

The futures price for Leptons should be less than their cost in the spot market. This is because Leptonia’s interest rates are 2.5% higher than the U.S. rate.

4787.0

365

90100.0075.014817.0

fP

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Dealing With the Exposure

Introduction Ignore the exposure Reduce or eliminate the exposure Hedge the exposure

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Introduction

The portfolio manager needs to decide whether to:– Ignore the exposure,– Eliminate the exposure, or– Hedge the exposure

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Ignore the Exposure

Investors may be aware of economic exposure but accept it as a fact of life

Ignoring the exposure may be appropriate if the dollar amount of the exposure is relatively small

Ignoring the exposure may be appropriate if the dollar is expected to depreciate

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Reduce or Eliminate the Exposure

Amounts to selling the foreign security or reducing the size of the position

May be appropriate if the dollar is expected to appreciate dramatically

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Hedge the Exposure

Involves taking a position in the market that offsets another position– Hedging foreign exchange risk is also called

covering the risk– Hedging can be done in the forward market or

the futures market