1 Chapter 16 Foreign Exchange Derivative Markets Financial Markets and Institutions, 7e, Jeff Madura Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved. 2 Chapter Outline Background on foreign exchange markets Factors affecting exchange rates Movements in exchange rates Forecasting exchange rates Forecasting exchange rate volatility Speculation in foreign exchange markets Foreign exchange derivatives International arbitrage Explaining price movements of foreign exchange derivatives 3 Background on Foreign Exchange Markets Foreign exchange markets consist of a global telecommunications network among large commercial banks that serve as financial intermediaries Banks are located in New York, Tokyo, Hong King, Singapore, Frankfurt, Zurich, and London The bid price is always lower than the ask price Institutional use of foreign exchange markets The degree of international investment by financial institutions is influenced by potential return, risk, and government regulations Institutions are increasing their use of the foreign exchange markets because of reduced information and transaction costs 4 Background on Foreign Exchange Markets (cont’d) Financial Institution Participation in Foreign Exchange Market Commercial banks Serve as financial intermediaries in the foreign exchange market by buying or selling currencies Speculate on foreign currency movements by taking long positions in some currencies and short positions in others Provide forward contracts to customers Offer currency options to customers, which can be tailored to a customer’s specific needs International mutual funds Use foreign exchange markets to exchange currencies when reconstructing their portfolios Use foreign exchange derivatives to hedge a portion of their exposure Brokerage firms and investment banking firms Engage in foreign security transactions for their customers or for their own accounts 5 Background on Foreign Exchange Markets (cont’d) Financial Institution Participation in Swap Market Insurance companies Use foreign exchange markets when exchanging currencies for their international operations Use foreign exchange markets when purchasing foreign securities for their investment portfolios or when selling foreign securities Use foreign exchange derivatives to hedge a portion of their exposure Pension funds Require foreign exchange of currencies when investing in foreign securities for their stock or bond portfolios Use foreign exchange derivatives to hedge a portion of their exposure 6 Background on Foreign Exchange Markets (cont’d) Exchange rate quotations The spot exchange rate is for immediate delivery Forward rates indicate the rate at which a currency can be exchanged in the future Cross-exchange rates Some quotations express the exchange rate between two non-dollar currencies 7 Computing A Cross-Exchange Rate The euro is worth $1.15, and the Canadian dollar is worth $0.60. What is the value of the euro in Canadian dollars? 92.1$C60.0$/15.1$C$ in euro of Value == 8 Background on Foreign Exchange Markets (cont’d) Types of exchange rate systems 1944 to 1971: the exchange rate at which one currency could be exchanged for another was maintained within 1 percent of a specified rate (the Bretton Woods era) 1971: an agreement among major countries (Smithsonian Agreement) allowed for devaluation of the dollar and a widening of the boundaries to 2.25% 1973: boundaries were eliminated and exchange rates of major countries were allowed to float Dirty float Freely floating system 9 Background on Foreign Exchange Markets (cont’d) Types of exchange rate systems (cont’d) Pegged exchange rate systems Some currencies may be pegged to another currency or a unit of account and maintained within specified boundaries ERM until 1999 Hong Kong since 1983 Argentina from 1991 until 2002 A country that pegs its currency does not have complete control over its local interest rates 10 Background on Foreign Exchange Markets (cont’d) Types of exchange rate systems (cont’d) Classification of exchange rate arrangements Many countries allow the value of their currency to float against others, but governments intervene periodically to influence its value Many governments attempt to impose exchange controls to prevent their exchange rate from fluctuating When controls are removed, the exchange rate abruptly adjust to a new market-determined level [...]... expectations of the future spot rate e.g., if the forward rate for the pound was $1.40 and the spot rate was expected to be $1.45, everyone would buy pounds forward and sell them at the future spot rate 16 Forecasting Exchange Rates (cont’d) Mixed forecasting involves using a combination of forecasting techniques No single technique has been found to be consistently superior Each of the techniques... Expected Exchange Rate Movements (cont’d) :Zena Bank should take the following steps Borrow €10 million and convert to $11,111,111 1 Invest the $11,111,111 million for ten days at 6 percent annualized (or 2 166 7 percent over ten days), which will generate $11,129,630 After ten days, convert the $11,129,630 into euros at the existing spot 3 rate, which converts to €10,573,148 Pay back the loan of €10 million . 1 Chapter 16 Foreign Exchange Derivative Markets Financial Markets and Institutions,. ©2006 by South-Western, a division of Thomson Learning. All rights reserved. 2 Chapter Outline Background on foreign exchange markets Factors affecting