WEEK 4 - The Parities Flashcards
What is Foreign Exchange Risk?
The risk that the value of a future receipt or obligation will change due
to a change in foreign exchange rates.
What are the three types of Foreign Exchange Risk?
- Transaction Exposure
- Translation Exposure
- Economic Exposure
What is Transaction Exposure?
The risk that the cost of a transaction, or the proceeds from a transaction, in terms of the domestic currency, may change due to
changes in exchange rates.
What is Translation Exposure?
Foreign exchange risk that results from the conversion of the value of a firm’s foreign-currency denominated assets and liabilities into a
common currency value.
What is Economic Exposure?
The risk that changes in exchange values might alter a firm’s present value of the future income streams.
What is Hedging?
Used to reduce/eliminate risk exposure
What is Covered Exposure?
A foreign exchange risk that has been completely eliminated with a
hedging instrument.
What is the early 2010’s example of Hedging?
- > Early 2010’s US kept depreciating against yen, profits of Toyota and Honda reduced
- > This generated large increases in dollar price of vehicles exported from JP to US and export revenues drop
- > So, Japanese automakers began ramping up production of automobiles in US
- > Both production costs and revenues would be denominated in $
- > Provided natural hedge for JP automakers
- > To address source of foreign exchange risks, automakers turned to financial instruments
What is a Forward Exchange Mkt? (ONE OF THE INSTRUMENTS)
A market for contracts that ensure the future delivery of a foreign currency at a specified exchange rate.
-> Most forward trades in amount of $1mil+ and occur between large commercial banks
What is a long position in the Forward Exchange Mkt?
An obligation to purchase a financial instrument at a given price and at a
specific time
What is a short position in the forward exchange mkt?
An obligation to sell a financial instrument at a given price and at a
specific time.
How can forward contracts be used to hedge?
Guarantees a rate of exchange at a future date
How else can firms experience transaction exposure and how can they solve it?
- > Transaction exposures resulting from foreign-curency-denominated payments they’ll receive in the future
- > In this situation firms have long positions, because they will receive amounts denominated in foreign currencies in future
- > To solve, firms could purchase forward contracts enabling them to sell foreign currencies at guaranteed exchange rates
What drives forward exchange rates?
-> Mkt forces of supply and demand
SEE GRAPH IN NOTES
How is the forward rate a predictor of the future spot rate?
- > Forward exchange rate reflects supply and demand for a currency of future delivery
- > Therefore, possible that forward rate provide info on the future spot exchange rate
When can it be said a currency is trading at a forward premium?
If the forward exchange rate is greater than spot exchange rate, a
currency is said to trade at a forward premium.
When can it be said a currency is trading at a forward discount?
if the forward exchange rate of a currency is less than the spot exchange rate, the currency is said to trade at a forward discount
What is the equation for the forward premium or discount?
Stated in standardised manner and expressed in annual terms
FP = Fn - S/S x 12/N x 100
Where:
Fn = Forward Rate
S = Spot Rate
N = Number of month of the forward contract
What is the definition of the forward premium or discount?
The difference between the
forward exchange rate and the spot exchange rate, expressed as a percentage of the spot exchange rate.
In what conditions would an equilibrium hold in a premium or discount?
If traders share same expectation, then difference between forward premium and expected appreciation elminated, equilibrium would hold:
(Fn - S)/S = (Fne -S)/S
What is Interest parity?
IDK
What is the reasoning/logic behind interest parity?
f expected exchange rate adjusted return on similar investment is different and no capital restrictions, saver can freely move funds from each country
-> This can potentially affect interests in both
nations, as well as the exchange rate between their currencies.
->In a competitive market, the supply of and demand for funds available
for lending, or loanable funds, determine interest rates
-> In equilibrium the rates are equal
What is the Covered Interest Parity condition given as?
r-r* = f - s
Where: f = forward rate r = domestic interest r* = foreign interest s = spot rate
-> Essentially showing interest rate differential = differential from spot and forward rate
What is the Covered Interest Parity? (CIRP)
The interest rate differential between two countries is equal to the differential between the forward exchange rate and the spot exchange rate
How does arbitrage opportunities cause CIRP to hold?
SEE EXPLANATION IN NOTES
How do you derive forward rates?
SEE EXAMPLES IN NOTES
Why does CIRP hold very well?
CIRP is an arbitrage opportunity so holds very well.
-> Arbitrageurs make sure condition holds -> They will use arbitrage til CIRP comes into effect
Why might CIRP not hold?
- Transaction Costs
- Tax Treatment of individuals
- Political Risk
- Non comparable asset
What is an uncovered interest rate parity?
Condition where changes in spot exchange rate not hedged with a future contract
-> As a result we see a risk associated with it
How is uncovered interest denoted?
r-r* = se + 1 - s
R-R* = Interest rate differential
Se + 1 =Expected spot rate in the future
S = Spot Rate
How is uncovered interest denoted when including a risk premium?
r- r* = se +1 - s+p
What is a risk premium?
An increase in the return offered on a higher-risk financial instrument
to compensate individuals for the additional risk they undertake
What is Country Risk?
The possibility of losses on holdings of financial instruments issued in
another nation because of political uncertainty within that nation.
What did Kenneth Froot and Jeffrey Frankel uncover about the interest rate parities?
Uncovered interest parity does not hold to the extent
that covered interest parity does.
-> Deviations from uncovered interest parity were
due to currency traders chronic forecast errors and a risk premium.
What is the Carry Trade strategy?
An investor borrows an amount of the currency of a
country with low interest rates and converts the funds into the currency of
a nation in which interest rates are higher and lends that sum at the
higher interest rate.
-> In another version investors focus on forward premium
What is the relation between uncovered and covered parity?
-> Via interest rate differentials
Denoted as:
r-r* - f + s = r-r* - Se + 1 +S
Forward Rate equal to expected change in spot rate:
f = Se + 1
-> If the forward exchange rate differs from the expected future spot exchange rate, then financial market traders perceive an arbitrage
opportunity.
What is an efficient market?
One in which market prices adjust quickly to new
and relevant information
-> equilibrium spot and forward exchange rates
adjust to reflect all available information.
Increased international capital inflows?
The capital market liberalization in 1990s have increased international
capital inflows, both to industrial and emerging countries.
How does international investment often work?
SEE GRAPH IN NOTES
What is the law of one price?
In the absence of transaction costs and official trade barriers, identical goods will have the same price in different markets when the prices are expressed in the same currency.
What is the domestic price in the US?
Pus = S$/£Puk
What is PPP?
Explains the relationship between the prices of goods and services and exchange rates.
-> How much money needed to purchase same goods and services in two countries
What is Absolute PPP
the exchange rate between two currencies is equal to the ratio of their price indexes.
How is the absolute PPP expressed as?
S$/£ = P us/P uk
S£/$ = 2.00 implies that price lvl in US twice higher than price lvl in UK
How do you measure P uk or P us (using them as an example)
- > More likely: CPI
- > Most likely: PPI
What are the downsides of using the Big Mac Index (you know what this is)?
Many currencies with large over or under valuation from implied PPP exchange rates
Why do we see deviations from Absolute PPP?
->Differentiated products (not comparable between countries)
->Transaction costs (information and transportation costs are different across countries)
->Trade barriers (ex. tariff, quota, etc.)
->Some goods are not tradable across borders (so low arbitrage activities)
such as services.
->Local regulations and taxes.
Consumer preferences differ in different countries
Why does the PPP equilibrium rarely exist? (PT 1)
The actual exchange rate (S$/£) differs from the ‘should be’ spot rate
SEE GRAPH IN NOTES
Why does the PPP equilibrium rarely exist?
-> Over and undervalued currencies
- > If we see P uk rise faster than P us
- > Then we would expect S$/£ to fall (Dollar appreciate)
- > If S $/£ does not fall by amount suggested by absolute PP, then say dollar undervalued and pound overvalued
- > These terms indicate they not at equlibrium
Examining absolute PPP condition at one point in time
S £/$ = k x Pus/Puk
K is a constant representing tariffs,quotas,govt restrictions etc.
What is relative PPP?
% change in exchange rate equal to difference in inflation rates (π) between domestic and foreign countries
What is relative PPP denoted as?
Change S $/£ = πUS - πUK
Where:
π = Pt - Pt-1
Why is relative PPP better to use than absolute PPP?
can ignore the actual levels of spot exchange rate and prices in two countries and consider the changes
Thus, if absolute PPP holds so does relative PPP
But if absolute PPP doesnt hold relative PPP can still hold
