Internationl Finance FINOPMGT 413
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Week 3 The Foreign Exchange Markets Spot quotes bidask Spreads triangular arbitrage Forward rates FINOPMGT 41 3 Spot and Forward Markets Foreign exchange trading occurs in two separate but connected markets Spot and the Forward market Spot market Buying and selling of fX with settlement in 2 business days from today Forward market Settlement occurs at some future date That is you may enter into a forward contract to buy 10 million Yen 90 days from today FINOPMGT 41 3 FX Rate Quotes We can View FX rates as quotes in director indirect terms Direct a direct fX quote is in units of domestic currency per unit of foreign currency DCF C For exam le a Auote of the USDBritish Pound is direct for the US ifit is quoted as 19631USBP Indirect an indirect fX quote is in units of foreign currency per unit of domestic currency FCDC Example 10686 YenUSS is an indirect quote for the US but direct quote for the Yen We will interpret every quote as being direct DCFC Therefore we will always think of whichever country is in the denominator as being the foreign country Please always remember this convention FINOPMGT 41 3 AppreciationDepreciation A currency is said to appreciate depreciate against a foreign currency if you can buy more less foreign currency per unit of domestic currency Examples The WSJ reported the following on Wednesday Yesterday afternoon in New York the euro was at 14635 om 14827 late Monday The Euro buys less dollars on ruesaay as opposed to Monday therefore the Euro depreciated and the appreciated If the Yen rate changed from 10686 Yen33 to 10674 Y has the Yen appreciated or depreciated Answer Depreciated When the currency is quoted in direct terms then an increase decrease in the quote is an appreciation depreciation of the foreign currency When its quoted in indirect terms then an increase in the rate is an appreciation of the domestic currency FINOPMGT 41 3 Cross Rates The cross rate is the exchange rate for converting one foreign currency to another For example the rate for YenBP would be a called a cross rate If we know the exchange rate for USYen and USBP we can easily calculate the cross rate Example Friday Sept 14 2007 USBP20068 YenUS 11530 USEuro13878 What is the YenBP cross rate Answer 23138 YenBF What is the EuroBP cross rate Answer 14460 EuroBP Qt Given the rates of the previous week diu L115 1 en appreciate or depreciate against the BP FINOPMGT 41 3 Arbitraging Cross Rates 12 Suppose a bank quotes you the following rates USBP 18193 YenUS 11027 and 199 YenBP The implied YenBP cross rate from the BP Yen quotes is 20061 YenBP If the implied Cross rate uoes IlUL equal the quoted cross rate there there exists an arbitrage opportunity in this case the arbitrage opportunity has a speci c name triangular arbitrage How would you actually implement such an arbitrage Buy low sell high In other words you buy the currency Where it is cheaper and sell Where it is more expensive FINOPMGT 41 3 Arbitraginu Cross Rates 12 The Yen is cheaper at 20061 YBP and more expensive at 199 YenBP So you buy Yen 20061 sell BP and sell Yen 199 buy BP How do you implement the arbitrage trade You simultaneously make the following trades Buy Yen for US 11027 Sell Yen for BP 199 Sell BP for US 18193 US 1 gt 11027 Yen 11027Yen Yen 11027 gt 11027199 05541 BP199 YenBP BP 05541gt 10081 US 18193BP You make gains of 8100 for every 1 million in capital FINOPMGT 41 3 Summarizing Steps in Triangular Arbitrage Assume that the three currencies are the USS and two other foreign currencies and that you want to make your arbitrage in US 31gt 1 Identify the weaker nonUS currency between implied cross rate and quoted cross rate Yen is weaker at imA lied cross rate of 20061 YenBP as comA ared with actual quote of 199 YenBP 2 Buy the weak currency low Buy Yen 11027 YUS 1 gt 11027 Yen 3 Sell the currency you bought in 2 high at the crossrate to buy the other currency cheap Sell Yen 199 YenBP 11027 Yen gt05541BP 4 Sell the currency high to buy the US cheap Sell BP 18193 USBP 05541 BP gt 10081 FINOPMGT 41 3 BidAsk Spreads As the dealer who trades foreign currency with J ou has to make money there is a bidask spread associated with the quote ie the price for buying the foreign currency is different from the price fOl selling ulC currency Bid the price at which the dealer is willing to buy the foreign currency Ask or Offer the price at which the dealer is willing to sell the foreign currency FINOPMGT 41 3 Examples of BidAsk Spreads BPUS 1822018229 BP The quote of 18220 is the bid or the price at which the dealer will buy the BP foreign currency and 18229 is the ask price Qt On a 1000000 roundtrip transaction with the BF What is the cost that you incur because of the bidask spread on BP Ans 494 FINOPMGT 41 3 BidAsk Rates and indirect Quotes Suppose the rate is quoted in indirect terms What is the bid ask Example YenUSD 10766 10772 We have to be careful of how the currency is quoted to gure out the bid and ask using the principle that the dealer will buy foreign currency low and sell FC high Thus the dealer will buy bid Yen at 10772 and sell offer at 107 66 and the dealer will buy USD at 107 66 and sell at 10772 If the currency is quoted in direct indirect then the lower higher number is the bid A word of warning Its easy to get confused unless you always use one convention FINOPMGT 413 BidAsk and Cross Rates 12 Suppose a US bank quotes 1701936 BP and 0985067 Euro What would be the cross rate for EuroBP in Frankfurt In Frankfurt the dealer will buy BP at the lower rate and sell BP at a higher rate in terms of the Euro So the cross rate will re ect this Bid the dealer buys BP at 17 019 lower price bid and sells Euro at 09867 hivher 1 rice ask l7019O9867l7250 EuroBP FINOPMGT 41 3 BidAsk and Cross Rates 22 Similarly to get the offer rate the dealer will sell BP at the higher rate in terms of Euro So Dealer sells BP for USD at offer or ask rate of US17036BP and buys Euro at bid rate of 09850 So the offer rate for EuroBP is l7036O9850l7295 bum1511 Therefore the cross rate is 1725017295 EuroBF FINOPMGT 41 3 Triangular Arbitrage with BidAsk Spreads 12 1 1701936 BP 2 0985067Eur0 3 1720017300 EuroBP The implied cross rate is 1724895 EuroBP Does this constitute a triangular arbitrage FINOPMGT 41 3 Triangular Arbitrage with BidAsk Spreads 22 For there to be a triangular arbitrage J ou have to be able to buy low and sell high Dealer 1 implied cross rate 1724895 Dealer 2 1720017300 Can you buy the BP low and sell it high No Because one dealer sells you BP 17290 while the second buys 17200 You cannot reverse the transaction also because the second dealer will sell you at 173 00 and the rst dealer buys at 17248 In each cas J Vu lose money Qt Can you give examples of a quote that would allow for arbitrage Provide two examples one where the BP is priced too low and one where it is priced too high FINOPMGT 41 3 Forward Rate Basics 12 What is ad orwara rate agreement The forward exchange contract is an agreement to exchange currencies in the future at a xed exchange rate How does one determine the forward exchange rate Answer by the basic pricing principle that the forward exchange rate should be such that it does not allow for arbitrage FINOPMGT 41 3 B381po According to he WSJ on 262008 the spot for the Japanese Yen was at 10686 the 3 month forward was at 10624 the 6month forward at 10576 Thus the Yen traded at a premium was stronger in the futures market Does the futures prices indicate that the market expects the Yen to appreciate over the next year FINOPMGT 41 3 What determines the Forward Rate Expectations 10 n0t determine tne Iorward excnange rate It does not matter that people think or feel that the currency is going to depreciate or appreciate What determines the forward exchange rate The forward exchange rate only depends on the relative interest rates FINOPMGT 41 3 The Forward Exchange Rate The forward exchange rate only depends on the relative interest rates Here are the Eurocurrency interest rates as of 262008 from the CME June Eurodollar 243 June Euroyen 067 We shall see that the Yen forward is at a premium to the s ot Yen is stron er because the interest rates in Yen are lower that the interest rates in US FINOPMGT 41 3 An example to motivate the pricing of the forward future Suppose as an importer of Japanese goods you need to make a payment in Yen exactly one year from today However you don t want to take any exchange rate risk how can you eliminate exchange risk W ave V options 1 Enter into a forward contract today this will guarantee you an exchange rate of F where F is the forward exchange rate 2 Buy Yen today at the spot rate S and hold the Yen until you need it in the future FINOPMGT 41 3 Determining the forward rate Which option will you prefer Answer you should be indifferent between the two because if they are priced such that you prefer one over the other ou can make an arbitra e rofit Consider the rst option when you enter into a forward contract today at F Y If you start off with 1 today then this will guarantee you 11 rUS F YenU SD This assumes that you invest your 1 in an US bank and earn the US interest rate FINOPMGT 41 3 Alternatively you can use your 1 to buy S yen today and invest these S yen in a Japanese bank earning an interest rate of rJP This will guarantee you an amount of S1 rJP after a year It must be that in either case you have the same amount of money so that F 1 rUS S1rJP YenUS F S1rJP1 rUS YenUS FINOPMGT 41 3 The Forward Rate when Exchange Rat are Vluoted in Direct Terms It is important to note the units is it DCFC or FCDC Suppose the rate is quoted in direct terms Yen Then the 1year forward price would be F Sl rUSl rJP Yen In general for n days when we use the Eurocurrency 1ntere5t rates F S1 rUS n360 1 rJP n360 We will use the notation that represents the interest rate in the foreign currency so that we can also write F S1 rn360 1 r n360 FINOPMGT 41 3 CME Eurocurency Quotes Note The CME quotes the interest rate contracts as lOOr Where r is the interest rate If the December Eurodollar rate is 243 the futures contract will be quoted at 100 243 9757 Thus to get the interest rate from the futures contract price subtract the futures price from 100 If the futures price is 95285 then uic interest laLC 1s 100952854715 FINOPMGT 41 3 Pricing the Currency Future The spot on 262008 is 10657 YenUS The June Euroyen contract is at 9933 and the June Eurodollar contract is at 9757 From the price of the futures contract the interest rates are US interest rate 100 97570243 Yen interest rate 100 99330 067 What would be the price of the June 08 Yen futures contract The contract expires on the second business day before the third Wed of the month Thus the expiration date is June 16 Therefore there are 131 calendar days left to expiration The June Futures price is computed as F 10657100067 X1313601 00243 X131360 10589 Yen FINOPMGT 41 3 An approximation for the forward premium Suppose n360 1year Then with some algebraic manipulation we can write the forward premium as where F S are quoted in direct terms F SS r rl r For low levels of interest rates we can approximate this as FSS r r That is the oneyear forward premium is approximately equal to the difference in interest rates If the forward is Auotes for n da s we can annualize it 360nFSS r r Thus if the Japanese interest rates are 2 lower than US interest rates then the 1year Yen forward will be approximately at a premium of 2 over the spot FINOPMGT 413 Forward PremiumDiscount If F gtS then we say that the foreivn currencd is tradinv at a premium F lt S then we say that the foreign currency is trading at a discount Note that F gtS F lt5 also implies that rgtr rltr FINOPMGT 41 3 Forward Contracts and Arbitrage in the MOIIUy Markets If the forward contract is not correctly 1 riced then J ou may be able to make arbitrage pro ts from this this is called covered interest arbitrage FINOPMGT 41 3 Covered Interest Arbitrage You have the following data 90 day interest rates 1 BP r 420430 lendingborrowing rates 2 Dollar r 17 01 85 lendingborrowing rates Exchange Rates Spot S 1520015300 BP 90 day forward F 1515015200 BP Is there an arbitrage FINOPMGT 41 3 The Mechanics of the Arbitrage 1 Borrow 1US at 185 for three months so you need to repay 1 0018590360 1004625 after three months 2 Buy BP at offer price to get ll53 06536 BP 3 Lend BP for three months at lending rate of 420 so at end of three months you have 065361 0042903600660458 BP 4 Sell BP 0660458 in the forward market at bid of 1515BP to get 1000593 Net gain 100059310045 lt 0 So there is no arbitrage Now construct an exam lgptghdelmonstrate an arbitrage Summarizing the conditions for absence of arbitrage To ensure that there is no arbitrage in either direction it must be that 1 FbidSask1 rl n3601rb n360 lt 1 2 SbidFask1rl n3601 rb n360 lt 1 Note tha 1 represents the lending interest rate and b represents the borrowing interest rate FINOPMGT 41 3 L reat1ng a synthet1c Interest rate By borrowinglending in a currency and then hedging your exposure with a forward contract can effectively allow you to get different effective interest rates The synthetic net cost of lending or borrowing can be quickly calculated precisely in the following manner We can rewrite the relation between F S r and r as follows 1 FSSl r 1 r 0r 1 swap points Sl r l r So r synthetic l FSSlrl Note that you again have to be careful of bidask borrowinglending rates FINOPMGT 41 3 Forward Quotation in terms of Swap Spreads Often the forward market luotation is 1 rovided in terms of a swap spread FS A swap is an exchange in this case it is an exchange of the spot for the forward or Vice versa Example Spot Yen 0007540Yen 6 Month Swap Rate 000020 premium Forward 0007 5400000200007 740 The foreign currency Yen is quoted at a premium FINOPMGT 41 3 Swap Rate with BidASK bpreads Suppose the spot for the BP is quoted at 15235 15340BP with the one month swap spread at 0004100039 and the three month swap spread at 0011400119 How do we get the bidask spread for the forward We use the rule that the bidask spreads should increase in the forward market So we subtract the swap spread if the bid is higher than the offer and add if the bid is lower than the offer Thus one month forward 1519415301 and the three month forwar i 44915459 FINOPMGT 41 3 Using Futures How many contracts 14 Suppose you need to make a payment of 100000000 Yen in a few days Today you decide to hedge against exchange rate risk by buying futures contract on the CME Qt how many contracts will you buy You look up the product specifications on the CME and nd that each futures contact is equal to 122500000 Yn So you need to buy 100 1258 contracts FINOPMGT 41 3 Using Futures Marking to market 24 The futures contact is market to market on a daily basis Thus if have to book any gains or loss at settlement on a daily basis Suppose the futures price ncreases by 36 from the previous day Recall that the Yen contract is quoted in 1 1000000 so that the change in the price is equal to 0000036 How much do you gain per contract For each 1 0000001 change in the contract the value of the contract changes by 12500000X00000011250 Thus for a change of 3 6 the value of the contract chan es b 450 In this case as the value of the futures increases the Yen appreciates you make 450 per contract FINOPMGT 413 Using Futures The hedge 34 The Yen futures on Monday Tue and Wed settles at 8110 8146 8155 You own 8 contracts On Tuesday you make 450 X 8 3600 On Wed you make 1125u A o 900 Suppose the futures matures also on Wed so you take delivery of the 12500000 X 8 100000000 Yen at the rate of 0008155Yen You pay 815500 for the Yen What is the net rate you get Your total net cash ow is 125000003600 900811000 As expected the net rate you get for your 100 million Yen is 0008110Y because you hedged on Monday at that price FINOPMGT 413 Using Futures Other Issues 44 It is yer likel that ou ma not be able to match either the maturity or the amount with a futures contract You have to be careful you don t end up increasing risk instead of reducing risk Because futures are marked to market you have to be careful that you have the liquidity to make your margin calls in case the market moves against you Thus if you don t have the cash to may your payments you may be forced to close out your position prematurely To see the effect of liquidity assume that to hedge your Yen liabilities you have to hold a long 100 million Yen futures position for 1 year Suppose now the Yen depreciates by 50 Examine how your cash ow change s FINOPMGT 41 3 Week 2 Currency Systems and Crises Definition 0 An exchange rate is the amount of currency that one needs in order to buy one unit of another currency or the amount of currency that one receive when selling one unit of another currency Exchange Rates Today 1 Exchange rates are volatile If the exchange rate oats the value of the rate fluctuates daily When the exchange rate is xed or pegged it does not fluctuate daily but can change dramatically if the peg is broken 2 Booms and Busts Exchange rate systems are subject to currency crises The Asian currency crisis of October 1997 Argentina 2002 Exchange Rates Today 0 3 Despite much effort exchange rates have proven to be very difficult to predict or control Historically almost all nations have sought to exert control over their exchange rates but often with limited success 4 Exchange rate fluctuations can have substantial impact on the real economy The Asian crisis had a substantial impact on the domestic economies of the countries that were affected In the case of Indonesia it also had an impact on the political environment resulting in the resignation of Indonesia s President Suharto Questions Every nation has a choice to choose a specific type of exchange rate system What has been our historical experience with exchange rate systems Why is the choice of an exchange rate system important What are the advantages and disadvantages of each system Exchange Rate Systems Over The Times 1 Gold Standard Value of currency is fixed in terms of gold The gold standard was popular before the WW1 Now only of historical interest 2 Fixed Pegged against a single currency or a basket of currencies Thai baht before 1097 currency crisis Chinese renminbi 3 Free Floating US Japanese Yen Euro BP 4 Hybrid Systems egManaged Floating floating with interventions for example with target zones or crawling adjustments Brazil before January 1999 5 Currency BoardFixed exchange rate with foreign reserves sufficient to support 100 of currency Argentina until 12002 HK Estonia and Lithuania Our focus will be mainly on the Fixed Floating and Currency Boards A Quick Look at History 0 1 US and Europe exchange rate and monetary systems 1879 to today 0 2 Recent Currency Crises The Gold Standard 18791913 111 1 The official gold price was fixed mint parityquot with free convertibility between domestic money and gold US adopted standard in 1879 and defined the US as 2322 fine grains of gold or US 2067ounce of gold 2 All national currency is backed by gold and growth in money supply is linked to gold reserves 3 As each separate currency was convertible into gold at a fixed price the exchange rate between the two currencies was automatically fixed 4 There is no fluctuation in the exchange rate unless either country changes the local price of gold Between WW1 and WW2 and the Great Depression 211 0 Countries experimented with floating rates in the 1920 s and 30 and this was widely thought to be a failure Here s a view from Ragnar Nurske 1944 of the League of Nations If there is anything that the interwar experience has clearly demonstrated it is that currency exchanges cannot be left free to fluctuate from day t00 ay under the influence of demand and supply I39f currencies are left to fluctuate 39specuatI39on Is ley to play havoc With the exchange rate Bretton Woods Agreement 1945 312 1 Fix an official par value of the currency in terms of gold 0ra currency tied to gold 2 In the short run the exchange rate should be pegged within 1 of par value but in the long run leave open the option to adjust the par value unilaterally 3 Permit free convertibility for current account transactions but use capTa controls to limit currency speculation FixedRate Dollar Standard 195070 411 0 1 US maintained a gold standard at US 35ounce 2 All other countries fixed an official par value in terms of the US and tried to keep their currency within 1 of par value Breakdown of Bretton Woods 511 By the late 1960 s US liabilities abroad exceeded their gold reserves US had run an expansionary monetary policy during the height of the Vietnam wars and its current account and trade balance had deteriorated It wasn t possible for the US to back its commitment to its currency with gold On August 15 1971 Nixon officially took the US off the gold standard Floating Exchange Rates 611 By March 1973 all major currencies were allowed to float against each other Rules of the Game 1 Nations tried to smoothen short term variability without committing to an official par value 2 Permit free convertibility for current account transactions while trying to eliminate restrictions on flow of capital Floating Rates in the 70 s and 80 s 711 Within a few years the major nations had eliminated restrictions on flow of capital and over time the flow of capital became more important as a major determinant of shortterm currency movements than trade imbalances Although in principle the exchange rate was to be determined by the market policymakers soon came to the conclusion that the price reflected by the exchange rate was either not warranted or should be manipulated to better suit domestic economic policies Aside This notion is quite contrary to our usual thinking of other prices as for example stock prices Interventions in the Currency Market 811 For the first decade the US was passive towards the US exchange rate But between 198085 the US had appreciated by almost 50 in real terms Plaza Accord of 1985 To counter the US appreciation the G5 countries met at the Plaza hotel in NY and agree to intervene in a coordinated fashion to depreciate the US This agreement came to be known as the Plaza Accord The accord worked and the US depreciated sharply through 1986 and 1987 This was the first major coordinated intervention Interventions in the Currency Market 911 By 1987 it was clear that the Plaza accord had worked well and the currencies now needed to be stabilized around their current levels Louvre Accord Feb 22 1987 At a meeting in Louvre the G5 countries decided to set target zonesquot or exchange rate ranges and the central banks agreed to defend their currency by active intervention in the currency markets European Monetary Union 1011 0 European Monetary System ECU ERM and the Euro In December 1978 the European countries voted to establish a European Monetary System with the ECU and ERM as some of its building blocks 1 ECU The European Currency Unit ECU was defined as a fixed amount of the national currencies of the member countries European Monetary Union 1111 2 ERM The Exchange Rate Mechanism was the plan to limit exchange rate fluctuations Each country that participated within the ERM agreed to limit the fluctuations to within 225 or 6 for UK Italy Spain and Portugal of the rate defined in terms of the ECU This narrow range proved hard to defend and it was widened to 15 after the ERM currency crisis of 199293 3 Euro Common currency for the countries of the European Union introduced 1 1 1999 The ECU became the Euro Something to think about Will UK join the Euro someday in the future Will Switzerland Currency Crises Example 1 Asian Currency Crisis Thailand Indonesia Malaysia Korea and others Example 2 Brazil in 199899 Example 3 Argentina 20012002 Example 1 Asian Currency Crisis October 1997 c To date the biggest postwar crisis in terms of its geographic reach and magnitude All countries in the region experienced severe economic downturns Pegged before 1097 and float afterwards 60 55 50 45 40 35 30 25 20 Thai Baht vs US THAI BAHT TO US EXCHANGE RATE FROM 1 1 96 TO 9 10 99 WEEKLY 1996 1997 1998 1999 HIGH 5610 1 12 98 LOW 2413 6 16 gun e39b g1 REAM Indonesian Rupiah vs US Pegged before 1097 float afterwards IN DONESIAN RU PIAH TO OOO39S US EXCHANGE RATE 16 FROM 1 1 96 TO 9 1 0 99 WEEKLY 2 1996 1997 1998 1999 HIGH 1527500 7 13 98 LOW 22800033Egg egk gg 7ggggp Example 2 Brazil s Currency Crisis in 199899 Brazil August 1998January 1999 In defending its currency Brazil lost more than 45 billion and had to raise interest rates to over 40 However it could not stop the fall of the real and ultimately decided to float the currency Brazil Real vs US Managed Float before 1999 crisis BRAZLMNREALTOUSEXCHANGERATE FROM 1 1 96 TO 1 1 99 WEEKLY 1996 1997 1998 1999 HIGH 120800 12 28 98 LOW 0970008Jg gqjstqngggqg Brazil Real vs US Free Float after the 1999 monetary crisis BRAZILIAN REAL TO US EXCHANGE RATE FROM 1 1 99 TO 9 10 99 DAILY JAN FEB MAR APR MAY JUN JUL AUG SEP HIGH 216000 3 2 99 LOW 120180 gab ggt 1se gm Example 3 Argentina 2002 0 See attached WSJ articles about events on the crises Argentine Peso vs US Currency Board before 2002 ARGENTINE PESO TO US EXCHANGE RATE 101 FROM 1 1 96 TO 9 1 0 99 WEEKLY 1 996 1 997 1 998 1 999 HIGH 1000 1 8 96 LOW 0999 1 1 9 OICCT B gS l REAM 122002 222002 322002 422002 522002 622002 722002 822002 922002 Or NFOP omAmwamAm gt u Q c m U ARSUSD Argentine Peso vs US 2002 Choice of Exchange Rate Systems 0 Every country has to make a choice of an exchange rate system The possible choices are fixed or pegged float currency board or some mixture like managed float Why is the choice of exchange rate system important 0 1 Because the exchange rate affects the price of traded goods and therefore domestic inflation and production growth rates The high industrial growth in China can be directly linked to their choice of a fixed and grossly undervalued exchange rate Why is the choice of exchange rate system important 0 2 Because the exchange rate is tied in with the monetary system it directly impacts flexibility of domestic policy decisions Currency board The Central Bank has no discretionary power to change money supply and thus for example stimulate or slow down the economy Fixed The Central Bank has some flexibility with monetary policy but this flexibility is secondary to the task of maintaining the peg Floating The Central Bank can focus completely on domestic policy ignoring the exchange rate fluctuations Evaluating the Fixed Exchange Rate 0 1 Can create stability in the short run 0 2 Reduces flexibility of both domestic fiscal and monetary policy as domestic policy has to be geared towards keeping the peg A country with a history of economic mismanagement can create a short window of credibility to set into place new policies 0 3 Our historical experience has been that without restrictions on capital flow a fixed exchange rate system is difficult to sustain Both Malaysia and China have restrictions on capital flow Evaluating the Floating Exchange Rate System 0 1 Domestic policy can be conducted independently of the exchange rate This may be good or bad depending on quality of domestic institutions In US GreenspanBernanke worry a lot of inflation and growth but rarely about the exchange rate Loss of confidence can create a selffulfilling crisis with a severely depreciating currency leading to hyperinflation and panic Exchange rate volatility has to be managed by corporations and investors Requires a sophisticated derivatives market for hedging risk Evaluating the Currency Board 0 1 Limited discretionary domestic policy Central Bank cannot change money supply or change exchange rate 0 2 It links the domestic economy to the country that the currency is tied to This is good in the short run but may have adverse consequences in the long run as domestic producers have to compete on an equal footing with the foreign country s firms Why did Argentina break its currency board in 2002 Some Questions to Think About 0 1 The consensus before WWII was that floating exchange rates were dangerous But today we are more comfortable with floating rates than fixed Why do you think the shift has occurred 0 2 China is the most important country that pegs its currency now its more of a managed float rather than a peg Do you think it can successfully manage the strengthening of its currency the RMB renminbi or yuan Why Currency Crises First three common reasons you will hear discussed in the press 1 Speculators The Malaysia PM Mahathir blamed George Soros for the Asian crisis 2 Investor panic I panic and therefore you panic and eventually we all panic 3 Contagion Because markets are inter linked a crisis in one market leads to a crisis in another Why Currency Crises The above reasons apply to all markets including equity In addition there are reasons that are specific to the currency markets 0 4 Domestic policy is not in sync with exchange rate policy Example Suppose a country has a fixed rate but its domestic inflation consistently exceeds the foreign country s inflation This will lead the currency to be overvalued in real termsquot eventually leading to lower growth rates unemployment loss of confidence and eventual panic Why Currency Crises 5 Politics matter Governments decide to abandon a regime after doing a costbenefit analysis so their politics or who governs matters Devaluing or keeping a currency weak helps growth rate lower unemployment rate Keeping a currency strong can help control inflation bring credibility to the government and be a source ofnannalpnde Week 5 Options Basic Concepts Definitions 12 Although many different types of options some quite exotic have been introduced into the market we shall only deal with the simplest plainvanilla options like calls and puts Call A call gives you the option to buy an underlying asset at a fixed price called the strike or exercise price before or on a certain date called the maturity or the expiration date of the option Put A put gives you the right to sell the underlying asset Definitions 22 A European option is one that can be exercised only on the maturity date An American option is one that can be exercised any time before the exercise date The American option price is equal to or greater than the European option price Why As before we will denote S as the spot exchange rate and F as the fonNard Example Example A call on the BP at a strike of 1 60 expiring say on 12152005 This call gives you the option to buy 1 BP for 160 on 12152005 You will exercise the call if the BP is stronger than the strike BP gt 16 on that date Let us denote ST as the exchange rate on 121505 X as the strike and T as the exercise date Then you will exercise the option if ST gtX For example if the exchange rate at maturity is 170BP you will exercise the call and your payoff will be ST X170160010 Payoff of the Call and Put When Exercised Denote CT and PT we can write the payoff of the call and put on the exercise date as follows Payoff on call at T CT 0 if STltX and CT ST X if STgtX Thus CT MaxSTXO Payoff on put at T PT 0 if XltST and PT X ST if XgtST Thus PT MaxX STO Payoff Diagrams The payoff diagram represents the payoff of the option on the expiration date T as a function of the price of the underlying security To trade options it is essential to understand payoff diagrams Examples How would you draw the payoff of the following options or portfolio s of options 1 LongShort call of strike X 2 LongShort Put with strike X 3 Long C and Long P both with same strike X 4 Long C and short P both with same strike X Long Call with Strike160 Payoff STXO2 X 16 ST18 Short Call with Strike160 Payoff STX 04 39X16 sT20 Long Put with Strike160 o Payoff XST 02 sT14 X16 Short Put with Strike160 Payoff XST 06 sT10 X16 Other Examples The basic payoff s of a longshort call and a longshort put can be combined into much more complicated payoff structures Examples Please draw the payoffs 1 Straddle A straddle is an option position of long 1 C long 1 P where the call and put have the same strikes This position allows the trader to take a view on volatility 2 Bull Spread Long 1 call of strike 160 short 1 call of strike 180 This allows the trader to take a bullish position but with a capped upside The capped upside makes the position cheaper to implement Some Terminology Intrinsic value value of the option if it is immediately exercised For a call the intrinsic value is StX For a put the intrinsic value is X St An atthemoney option is one with intrinsic value equal to zero An inthemoney option is one whose intrinsic value is positive An outthemoney option is one whose intrinsic value is negative Issues What is the relation between the call put forwards and the spot We can derive this by assuming that the prices of the options the spot and the forward should not allow for arbitrage Put Call Parity 15 Let us figure out today s t0 price of a portfolio of1 long call and 1 short put C P with the same strike X and maturity T What is the payoff of this portfolio of CP Payoff of CP f ST gt X then the call is exercised and the put is not so the combined payoff is STX 81quot f STltX then the put is exercised and the call isn t so the combined payoff is XST 81quot Put Call Parity 25 Thus for any spot rate at tT the payoff on the portfolio of C P is STX Suppose the underlying asset is 1 British Pound BP This means that buying a call and selling a put is the same as receiving one BP at maturity of value ST for a price of X Can we replicate this payoff using the underlying securities That is can we replicate this payoff by trading the foreign exchange and borrowinglending at the domestic and foreign interest rates PutCall Parity 35 Here is one strategy buy the present value of lBP at t0 and hold it until tT and borrow the present value ofX dollars If the option has a maturity of T days then the value of this portfolio is PVS PVX S1 rT360 X1rT360 What would be the total payoff on this portfolio of PVS PVX The payoff on this portfolio is exactly STX ie the same as that on CP Note that when you take the present value of the foreign currency you need to discount at the foreign interest rate PutCall Parity 45 Thus to prevent arbitrage it must be that the following is true for currency options CP S1 rT360 X1rT360 We have figured out a relationship between C P and S This is called the PutCall Parity Put Call Parity 55 We can also write the relation for currency options in terms of the forward price FS1rT3601rT360 Substituting for S in the put call parity we get CP F1rT360 X1rT360 F X1rT360 Thus we can either express the put call parity in terms of the spot rate or the forward rate Summary of PutCall Parity These are the important points to note from PutCall Parity 1 There is a precise relation between the prices of the call and the put of the same strike given by CPS1rn360 X1rn360 If the observed option prices do not follow this relation then there exists an arbitrage t easier in practice to construct an arbitrage using the futures C PFX1rn360 Thus given the price of the call one can deduce the price of the put or vice versa 3 If SX then the prices of the atthemoney call and put will be equal to each other only if rr The call will be more expensive than the put if rgtr and PgtC if rgtr
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