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74 Cards in this Set
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Forward Rate |
Price at which foreign exchange is quoted for delivery at a specified future date |
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Foreign Currency Demand |
Derived from the demand for foreign country's goods, services, and financial assets |
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How Do Exchange Rates Change (3 ways) |
1. Increased demand as more foreign goods are demanded more foreign currency is demanded 2. the price of the foreign currency in local currency increases 3. Home currency Depreciation |
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Home Currency Depreciation |
Foreign currency more valuable than the home currency |
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What are the 3 factors affecting exchange rates? |
1.Inflation Rates 2. Interest rates 3. GNP growth rates |
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Currency Appreciation Formula |
(e1 - e0)/ e0 e0 = old currency value e1 = new currency value |
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What is the law of one price? |
Identical goods sell for the same price worldwide Also known as "no arbitrage condition", "no free lunch", "Arbitrage free market" |
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What are the 5 parity conditions? |
1. Purchasing Power Parity (PPP) 2. Fisher Effect (FE) 3. International Fisher Effect (IFE) 4. Interest Rate Parity (IRP) 5. Unbiased Forward Rate (UFR) |
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Define Purchasing Power Parity (PPP) |
states that a unit of home currency should have the same purchasing power around the world. (absolute version of PPP) |
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Purchasing Power Parity Equation |
e(t) (1 + i(h))^t ____=___________ e(0) (1 + i(f)) ^t Where e(t) = future spot rate e(0) = spot rate i (h) = home inflation i (f) = foreign inflation t = the time period |
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PPP relationship to inflation |
The currency with the higher inflation rate is expected to depreciate relative to the currency with the lower rate of inflation |
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real exchange rate (PPP) |
e'(t) is the quoted or nominal rate e(t)* (P(f)/P(h)) |
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Equation for e'(t) |
e'(t) e(t) ((1 + i(f)) ^t ____ =_______________ (1+ i(h) )^t |
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Fisher Effect (FE) definition |
states that nominal interest rates (r) are a function of the real interest rate (a) and a premium (i) for inflation expectations |
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The fisher effect definition formula |
r = a +i |
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What does the Fisher Effect say about countries inflation rates and interest rates |
According to the fisher effect: countries with higher inflation rates have higher interest rates |
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The International Fisher Effect Defined |
The spot rate adjusts to the interest rate differential between to countries |
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IFE = PP + FE equation |
_ e(t) (1 + r(h))^t ------=---------------------- e(o) (1 + r(f) ) ^t |
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What did fisher postulate |
1. The nominal interest rate differential should reflect the inflation rate differential 2. Expected rates of return are equal in the absence of government intervention |
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What is the Simplified IFE equation (approximation) if r(f) is really small |
e(1) - e(o) r(h) - r(f) = ----------- e(o) |
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Implications of IFE (2 things) |
1. currency with lower interest rate is expecte to appreciate relative to the one with higher rate 2. Financial market arbitrage insures interest rate differential is an unbiased predictor of change in future spot rate |
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Interest Rate Parity Theory |
the forward rate (F) differs from the spot rate (S) at equalibrium by an amount equal to the interest differential r(h) - r(f) between two countries |
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Interest rate parity theory reationship between premium and discount |
The forward premium or discount equals the interest rate differential |
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Interest Rate Parity Theory equation |
(F-S)/S = r(h) - r(f) Where r(h) = the home rate r(f) = the foreign rate |
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IRPT Covered interest Arbitrage |
conditons required: interest rate differential des not equal the forward premium or discount funds will move to a country with a more attractive rate |
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Interest rate Parity Theory Interest rates and discounts |
Higher interest rates on a currency are offset by forward discounts Lower interest rates are offset by forward premiums |
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Define the Unbiased Forward Rate |
if the forward rate (f(t)) is unbiased, then it should reflect the expected future spot rate (e(t)) f(t) = e(t) |
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Define the Currency Market |
a place where money denominated in one currency is bought and sold with money denmiated in another currency |
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International Trade and Capital transaction |
Facilitated with the ability to transfer purchasing power between countries |
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Currency Market Location |
Otc-type, no specific location Most trades by phone |
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Breakdown of participants at foreign exchange markets |
Wholesale level 95% Major Banks retail level (business consumers) |
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Foreign Exchange Markets 2 types of currency markets |
Spot Market -immediate transaction, recorded by 2nd business day Forward Market - transactions take place at a specified future date |
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Participants in spot and forward markets 7 |
Commercial banks brokers customers of commercial and central banks arbitrageurs traders hedgers speculators |
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What are the different types of quotes |
1. spot price 2. 30 day 3. 90 day 4. 180 day |
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Direct quote structure |
gives home currency price in numerator |
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ASK |
= the price bank will sell currency |
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Bid |
= price at which the bank is willing to buy |
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Percentage spread formula (PS) |
Ask - Bid PS = -------------------- x 100 Ask |
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Cross Rates |
exchange rate between 2 non - US$ currencies |
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Currency Arbitrage definition |
1. Possible if the cross rates differ from one financial center to another 2. Buy cheap in one int'l market, sell at a higher price in another 3. The critical role of Available information |
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Settlement date/ value date |
date that monies are due 2nd working day after date of original transaction |
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What risk is there in exchage markets |
Banks are middle men 1. Incurring risk of adverse exchange rate moves 2. increased uncertainty about future exchange rate requires A. Demand for higher risk premium B Bankers widen die ask spread |
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What are the steps to a spot transaction |
1. Currency transaction: verbal agreement, U.S. importer specifies 2. Bank sends importer contract note including 3. Settlement |
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Forward contract definition |
an agrrement between a bank and a customer to deliver a specified amount of currency against another currency - at a specified future date - at a fixed exchange rate |
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What is the purpose of forward contract |
hedging |
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what is hedging |
the act of reducing exchange rate risk |
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How so you quote a forward rate |
1. Outright Rate 2. swap rate |
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Definition Outright Rate |
quoted to commercial customers |
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Swap Rate |
quoted in the inter-bank market as a discount or premium |
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What is the equation for forward premium/discount |
= F-S * 12 * 100 ----------------------- s n |
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Forward rate equation what is F, S, N |
F = the forward rate of exchange S = the pot rate of exchange N = the number of months in the forward contract |
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Future contract definition |
contracts written requiring a standard quantity of an available currency as a fixed exchange rate at a set delivery date |
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What are the two futures contracts safeguards |
Maximim price movement rules Maintenance margins |
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What is the maximum price movement rules |
contracts set daily to a price limit that restricts maximum daily upward and downward movement |
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Maintenance Margins |
when the account balance falls below the maintenance margin, a margin call may be necessary to maintain the minimum balance |
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6 futures markets exchanges |
1. IMM International Monetary Market 2.) Liffe london international financial futures exchange 3.) CBOT chicago Board of Trade 4.) SIMEX Singapore international Monetary Exchange 5) DTB Deutsche Termin Bourse 6) HKFE Hong Kong Futures Exchange |
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2 Advantages to futures contracts |
1) Easy liquidation 2) well organized and stable market |
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Disadvatages of futures |
1. limited to 7 currencies 2. limited dates of delivery 3. rigid contract sizes |
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Currency option definition |
a contract writer (seller) gives the right not the obligation to the holder (the buyer) to buy or sell a standard amount of an available currency at a fixed exchange rate for a fixed time period |
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Currency Option 2 types |
Call Put |
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what is a call |
give the owner the right to buy the currency |
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Put |
give the owner the right to sell the currency |
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What is "in the money" |
Call: Spot > strike Put: Spot < strike |
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Out of the money |
Call: Spot < strike Put: Spot > strike |
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At the money |
Spot = the strike |
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2 reasons why you should use currency options |
1. for a firm hedging foreigh exchange risk when a future event is very uncertain 2. for speculators who profit from favorable exchange rate changes |
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Define Interest rate swaps |
an agreement between 2 parties to exchange US$ interest payments for a specific maturity on an agreed notional amount |
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define Notional principal |
reference amount used only to calculate interest expense but never repaid |
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Maturity duration |
Maturity is less than 1 to over 15 years |
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What are the 2 types of swaps |
Coupon Swap Basis sawp |
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coupon swap |
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basis Swap |
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Libor |
most important reference rate in a swap |
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Swap Usage |
to reduce risk potential and costs |
