Ch. 6: Fundamental questions in international finance: What are the determinants of exchange rates?; Are changes in exchange rates predictable?

The economic theories which link exchange rates, price levels, and interest rates together are called international parity conditions

The Law of one pricestates that all else being equal (no transaction costs or restrictions) a product’s price should be the same in all markets

When prices are in different currencies: P$ – price of the product in US dollars; S -  spot exchange rate (S, yen per dollar); P¥ - price of the product in Japanese yen; (P$ x S = PY)

Conversely, if the prices were stated in local currencies, and markets were efficient, the exchange rate could be deduced from the relative local product prices (S=Py/P$)

f the Law of One Price were true for all goods, the purchasing power parity (PPP) exchange rate could be found from any set of prices;

By comparing the prices of identical products denominated in different currencies, one could determine the “real” or PPP exchange rate that should exist if markets are efficient. This is the absolute theory of purchasing power parity

Absolute PPP states that the spot exchange rate is determined by the relative prices of similar basket of goods

Big Mac Index: Cost Country 1/Exchange rate = terms of country 1 OR Cost Country 1/ Cost Country 2 = terms of country 2

Undervalued/Overvalued: Country 2 terms – Exchange rate/exchange rate

Relative PPP: Not helpful in determining current spot rate; determines exchange rate of a period of time

PPP tends to not be accurate in predicting future exchange rates; holds up well over the very long term but Is poor for short term estimates

The degree to which the prices of imported & exported goods change as a result of exchange rate changes is termed exchange rate pass-through

Fisher Effect: States the nominal interest rate in each country is equal to the required rate of return plus compensation for expected inflation; Formula: I = (1+real rate interest)(1+pi) – 1 =real rate interest(r) + pi+ rpi OR I = r + pi

The international Fisher effect, or Fisher-open, states that the spot exchange rate should change in an amount equal to but in the opposite direction of the difference in interest rates between countries the expected change in the spot exchange rate between the dollar and yen (indirect quote, FC/D) should be (in approximate form)

A forward rate is an exchange rate quoted for settlement at some future date

A forward exchange agreement between currencies states the rate of exchange at which a foreign currency will be bought forward or sold forward at a specific date in the future

The forward premium or discount is the percentage difference between the spot and forward rates stated in annual percentage terms; formula = F^FC= Spot-Forward/Forward x 360/days x 100

The theory of Interest Rate Parity (IRP), states that the difference in the national interest rates for securities of similar risk and maturity should be equal to, but opposite in sign to, the forward rate discount or premium for the foreign currency, except for transaction costs

Because the spot and forward markets are not always in a state of equilibrium as described by IRP, the opportunity for “risk-less” or arbitrage profit exists

The arbitrageur who recognizes this imbalance can invest in the currency that offers the higher return on a covered basis (covered interest arbitrage)

Rule of Thumb: If the difference in interest rates is greater than the forward premium (or expected change in the spot rate), invest in the higher yielding currency.

If the difference in interest rates is less than the forward premium (or expected change in the spot rate), invest in the lower yielding currency. 

A deviation from CIA is uncovered interest arbitrage (UIA), wherein investors borrow in currencies exhibiting relatively low interest rates and convert the proceeds into currencies which offer higher interest rates

Ch. 7:Financial Derivatives

Hedging If someone bears an economic risk and uses the derivatives to reduce that risk, the person is a hedger

Speculation; A person or firm who accepts the risk the hedger does not want to take is a speculator; Speculators believe the potential return outweighs the risk

A foreign currency futures contract is an alternative to a forward contract

It calls for future delivery of a standard amount of currency at a fixed time and price

These contracts are traded on exchanges with the largest being the International Monetary Market located in the Chicago Mercantile Exchange

Futures contracts traded on an organized securities exchange: Require an upfront cash payment called margin; eliminate credit risk, guarantee performance

The risk reduction capabilities of futures are similar to those of forwards

The margin requirements and marking-to-market require an upfront cash outflow and liquidity to meet any margin calls that may occur; Futures contracts are standardized, so the firm

may not be able to hedge the exact quantity it desires; Short position: selling a futures contract based on view that currency will fall in value

Long position: purchase a futures contract based on view that currency will rise in value

A foreign currency option is a contract giving the purchaser of the option the right, but not the obligation, to buy or sell a given amount of currency at a fixed price per unit on or before a given date

Call: buyer has the right to purchase currency

Put: buyer has the right to sell currency

The buyer is termed the holder, while the seller of the option is referred to as the writer or grantor.

Strike or exercise price: fixed price at which currency may be bought (or sold)

Expiration date: the last day that the option can be exercised

Option premium: price paid to the option writer for the right

An American option gives the buyer the right to exercise the option at any time on or before the expiration date.

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

In the Money:

Call: spot price > exercise price

  Put: exercise price > spot price

Out of the Money

  Exercising the option would result in a negative payoff

  Call: spot price < exercise price

  Put: exercise price < spot price

Swaps are contractual agreements to exchange or swap a series of cash flows

Interest rate swap – swap a fixed interest payment for a floating interest rate payment

Currency swap – swap currencies of debt service obligation

Interest Swaps:

Swap agreement to pay fixed and receive floating to protect from rising debt-service payments

Swap agreement to pay floating and receive fixed to take advantage of lower debt-service payments

The cash flows of an interest rate swap are interest rates applied to a set amount of capital, no principal is swapped only the coupon payments

Currency Swaps

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

The desired currency is probably the currency in which the firm’s future operating revenues (inflows) will be generated

Firms often raise capital in currencies in which they do not possess significant revenues