Currency Exchange Rates, Hedging, and Arbitrage
Jennie MorseBA 543
Evening Section
Agenda• Intro• Exchange Rates• Forex Market• Hedging vs. Arbitrage• Currency Derivatives
– Forward Contracts– Futures Contracts– Options– Swaps
• Conclusion and Questions
Introduction
• Exchange rates becoming increasingly important due to:– Globalization– Technology
• Importance of exchange risk to – Investors– Borrowers
Exchange Rates
• Exchange Rate: the price of one currency in terms of another
Examples:– Yahoo Finance
Quoting Exchange Rates
• Direct vs. Indirect
From US Perspective: Direct:$$$$ €
Indirect:€€€€ $
American vs. European
European: - USD is base currency
American:- USD is counter currency
Quoting order: EUR, GBP, AUD, NZD, USD
Foreign Exchange Market
• Decentralized OTC market– Top 3 exchange locations:
London, US, Japan• Very liquid market
– Spot transactions (2 days)• Pegged vs. Floating rates
– 3 factors that cause flucuation:• Economic conditions• Political events• Market Psychology
Hedging & Arbitrage
• Hedging– Used to offset potential
losses and evade potential losses, but is not risk-free
– Ex: SW airlines fuel• Arbitrage
– Risk-free strategy used to capitalize on mispriced assets
– Ex: Triangular Arbitrage
Triangular Arbitrage
Currency Derivatives
• Four Instruments used for mitigating exchange rate risk:– Forward Contracts– Futures Contracts– Options– Currency Swaps
Forward Contracts• Most common way to
alleviate exchange rate risk
• Traded in OTC markets• Locks in future rate:
– Eliminate risk of adverse rate swings
– Relinquish opportunity to benefit from advantageous price changes
• Not good for LT use
Futures Contracts
• Standardized• Traded on exchanges• Only for major
national currencies• 1 year maximum; does
not protect against LT risk
Currency Options• Major currencies
traded on exchanges• Customized options
traded in OTC market• 2 types:
– Regular option where underlying is a currency and strike price is an exchange rate
– Futures Options
Currency Swaps
• Transactionally efficient vehicle to protect against LT risk
• Also used to capitalize on arbitrage opportunities where a borrower could raise funds at a lower rate than what is available domestically
Currency Swaps
• Two companies issue bonds in the other’s bond market– Swap money raised
from bond sale– Make coupon payments
to each other to cover the other’s debt
– Swap par value of bonds on maturity date
Conclusion
• Take-aways:– Definition of exchange rate – How rates are quoted– What exchange rate risk is– Key facts about Forex market:
• Decentralized OTC market; floating rates• Spot Transactions completed in 2 days
– 4 methods to protect against exchange risk• Forwards, Futures, Options, Swaps
Questions