Module 4.4

Question 1

Foreign Exchange Markets

Answer 1

§Foreign exchange markets are a global telecommunications network among the large commercial banks that serve as financial intermediaries.

§The price at which banks will buy a currency (bid price) is lower than the price at which they will sell it (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. (Exhibit 16.1)

Question 2

Institutional Use of Foreign Exchange Markets

Answer 2

Question 3

Exchange Rate Quotations

Answer 3

The direct exchange rate specifies the value of a currency in U.S. dollars.

The indirect exchange rate specifies the number of units of a currency equal to a U.S. dollar

§Forward Rate — The rate at which a currency can be exchanged in the future.

§Cross-Exchange Rates — The exchange rate between two nondollar currencies.

Question 4

Types of Exchange Rate Systems

Answer 4

§Bretton Woods era (1944-1971): The exchange rate was maintained by governments within 1% of a specified rate.

§Smithsonian Agreement (1971): Allowed for devaluation of the dollar and called for a widening of boundaries from 1 to 2.25%.

§Floating exchange rates (1973)

§Dirty float: exchange rates are market determined but subject to some government intervention.

§Freely floating system: foreign exchange market is totally free from government intervention.

Question 5

§Pegged Exchange Rate System

Answer 5

§Some currencies may be pegged to another currency or a unit of account.

§A country that pegs its currency does not have complete control over its interest rates.

Question 6

Eurozone Arrangement

Answer 6

§In 1999, the euro replaced 11 national currencies in Europe.

§The countries that participate in the euro make up a region called the eurozone.

§Since all of these countries use the same currency, transactions between them do not require any exchange of currencies.

Question 7

§Eurozone Monetary Policy

Answer 7

§The European Central Bank (ECB) is responsible for setting monetary policy for all countries in the eurozone.

§The bank’s objective is to maintain price stability (control inflation) in these countries, as it believes that price stability is necessary to achieve economic growth.

§Eurozone Crisis

§During 2010-12, Greece suffered from a week economy and a large increase in its government budget deficit.

§Portugal, Spain, Italy, and Ireland suffered as well.

§Institutional investors moved their investments out of the Eurozone

Question 8

Abandoning the Euro

Answer 8

§Some critics have argued that a country’s government should abandon the euro rather than accept funding from the European Central Bank, because the austerity conditions are too harsh.

§Impact of Abandoning the Euro on Eurozone Conditions

§Multinational corporations and large institutional investors outside the eurozone might not invest more funds in the eurozone for fear of failure because of other countries following suit on dropping out.

Question 9

Virtual Currencies

Answer 9

■Virtual currencies are created and operate independently of national governments, so until recently they have been outside the jurisdiction of central banks and the financial regulations issued by governments.

§Bitcoins

§Can be purchased at online exchanges or received as payment for goods or services. One major advantage is the speed of transactions, especially international transactions. A potential disadvantage of bitcoins is the volatility of their value.

Regulating Bitcoin Exchanges — Some states now require bitcoin dealers to obtain a license to operate in the state

Question 10

Factors Affecting Exchange Rates

Answer 10

§In equilibrium, there is no excess or deficiency of a currency.

§Demand for European leads to demand for the euro. If demand for the euro exceeds supply, the euro will appreciate.

§A currency’s supply and demand are influenced by:

§Differential inflation rates

§Differential interest rates

§Government (central bank) intervention

Question 11

Differential Inflation Rates

Answer 11

§Purchasing power parity (PPP) suggests that the exchange rate will, on average, change by a percentage that reflects the inflation differential between the two countries of concern.

§In reality, exchange rates do not always change as suggested by the PPP theory. Other factors that influence exchange rates can distort the PPP relationship.

Question 12

Differential Interest Rates

Answer 12

§Interest rate movements affect exchange rates by influencing the capital flows between countries.

Question 13

Central Bank Intervention

Answer 13

Central banks can adjust a currency’s value to influence economic conditions.

§Direct Intervention — Occurs when a country’s central bank sells some of its currency reserves for a different currency.

§Indirect Intervention — The Fed can affect the dollar’s value indirectly by influencing the factors that determine its value.

Question 14

§Indirect Intervention during the Peso Crisis

Answer 14

§In 1994, Mexico experienced a large balance of trade deficit and on December 20, 1994, Mexico’s central bank devalued the peso by about 13% and increased interest rates to discourage investors from withdrawing their investments.

§Indirect Intervention during the Asian Crisis

In 1997, many Asian countries experienced weak economies and their banks suffered from substantial defaults. Some countries (e.g., Thailand and Malaysia) increased their interest rates as a form of indirect intervention to encourage investors to leave their funds in Asia.

Question 15

§Indirect Intervention during the Russian Crisis

Answer 15

§May 1998, over a 4 month period, the Russian currency (the ruble) had consistently declined and stock market prices had declined by more than 50%. The Russian central bank attempted to minimize such outflows by tripling interest rates

§Indirect Intervention during the Greek Crisis

§In 2010, Greece experienced weak economic conditions and a large increase in its government budget deficit. The ECB responded with a stimulative monetary policy that was intended to keep interest rates low.

Question 16

Forecasting techniques can be classified as:

Answer 16

■Technical forecasting

■Fundamental forecasting

■Market-based forecasting

■Mixed forecasting

Question 17

Technical Forecasting

Answer 17

§Involves the use of historical exchange rate data to predict future values.

§A computer program can be developed to detect particular historical trends.

§There are also several time-series models that examine moving averages and thus allow a forecaster to identify patterns, such as currency tending to decline in value after a rise in moving average over 3 consecutive periods.

Question 18

Fundamental Forecasting

Answer 18

§Based on fundamental relationships between economic variables and exchange rates.

§Given current values of these variables along with their historical impact on a currency’s value, corporations can develop exchange rate projections.

Question 19

Market-Based Forecasting

Answer 19

The process of developing forecasts from market indicators is usually based on either the spot rate or the forward rate.

§Use of the Spot Rate — Corporations can use the spot rate to forecast because it represents the market’s expectation of the spot rate in the near future.

§Use of the Forward Rate — Speculators would take positions if there were a large discrepancy between the forward rate and expectations of the future spot rate.

Mixed Forecasting: Some MNCs use a combination of forecasting techniques.

Question 20

Foreign Exchange Derivatives

Answer 20

Forward contracts — Typically negotiated with a commercial bank and allow the purchase or sale of a specified amount of a particular foreign currency at a specified exchange rate (the forward rate) on a specified future date.

§The forward market is a telecommunications network where large commercial banks match participants who wish to buy and sell.

§Many of the commercial banks that offer foreign exchange on a spot basis also offer forward transactions for widely traded currencies.

Question 21

Estimating the Forward Premium

Answer 21

Where:

p = Forward Rate Premium

FR = Forward Rate

S = Spot Rate

n = number of days forward rate

Question 22

Currency Futures Contracts

Answer 22

§Standardized contracts that specify an amount of a particular currency to be exchanged on a specified date and at a specified exchange rate.

§A firm can purchase a futures contract to hedge payables in a foreign currency by locking in the price at which it could purchase that specific currency at a particular point in time.

Currency Swaps

§Agreements that allow one currency to be periodically swapped for another at specified exchange rates.

Question 23

Currency Options Contracts

Answer 23

§Primary advantage over forward and futures contracts is that the parties have the right but not the obligation to purchase or sell a particular currency at a specified price within a given period.

§A currency call option provides the right to purchase a particular currency at the exercise price within a specified period.

A put option provides the right to sell a particular currency at the exercise price within a specified period

Question 24

Use of Foreign Exchange Derivatives for Hedging

Answer 24

§If the firm requires a tailor-made hedge that cannot be matched by existing futures contracts, a forward contract may be preferred. Otherwise, forward and futures contracts should generate similar results.

§The firm must choose between an obligation type of contract (forward or future) and options contract.

Question 25

Use of Foreign Exchange Derivatives for Speculating

Answer 25

§If a currency is expected to appreciate, a speculator could:

§Purchase the currency forward, and when it is received, then sell it in the spot market.

§Purchase futures contracts on the currency, and when the currency is received, sell it in the spot market.

§Purchase call options on the currency, and if the spot rate exceeds the exercise price, then exercise the option and sell the currency in the spot market.

Question 26

If a currency is expected to depreciate, a speculator could

Answer 26

§Sell the currency forward, and purchase it in the spot market just before fulfilling the forward obligation.

§Sell futures contracts on the currency, and then buy it in the spot market just before fulfilling the futures obligation.

§Purchase put options on the currency, and if the spot rate is less than the exercise price, then purchase the currency in the spot market and exercise the option.

Question 27

§Speculating with Currency Futures

Answer 27

§If the future spot rate is expected to be higher than the futures price, a firm could buy currency futures.

§The risk of this speculative strategy is that the currency may decline rather than increase in value.

§Speculating with Currency Options

§The risk is that the currency does not appreciate or depreciate as expected, and the loss will be the premium paid for the option. (Exhibit 16.2)

Question 28

Estimating Speculative Gains from Options Using a Probability Distribution

Answer 28

Question 29

International Arbitrage

Answer 29

Locational Arbitrage

§The act of capitalizing on a discrepancy between the spot exchange rate at two different locations by purchasing the currency where it is priced low and selling it where it is priced high.
(Exhibit 16.3)

Triangular Arbitrage

§Involves buying or selling the currency that is subject to a mispriced cross-exchange rate.

Question 30

Bank Quotes Used for Locational Arbitrage Example

Answer 30

Question 31

Covered Interest Arbitrage

Answer 31

The coexistence of international money markets and forward markets forces a special relationship, between a forward rate premium and the interest rate differential of two countries, that is known as interest rate parity.