Weeks 3-4 Flashcards

Question

moving from a qualitative to a quantitative pricing model

Answer 1

* Create a new portfolio with payoffs that duplicate the option’s payoffs * Begin with a 2-state model * Price the alternative portfolio and apply the law of one price

Answer 2

* Extend the two-state model * Assumptions – Future spot rates have a lognormal distribution centred at the Forward rate – Assumes that interest rates are continuous – Interest is earned on foreign currency investments * Applies to European options

Answer 3

Using short term expectations in taking positions of uncertain outcomes, with a goal of profiting from future price changes. Speculators hold uncovered positions **Benefits** * Liquidity – Price Stability – Source of instruments others can use for risk management * Market Efficiency – Price Discovery – Finding arbitrage opportunities which equalise prices across markets – Economic Signals

Answer 4

Choice of Investment depends upon Speculator’s Expectations: * Foreign currency appreciation  Desire a Long Exposure Buy foreign currency Long FX forward / futures Buy FX call option * Foreign currency depreciation  Desire a Short Exposure Sell foreign currency Sell FX forward / futures Buy a FX put option Magnified results: Leverage / Derivatives

Answer 5

In an efficient market expected movements are already incorporated into the prices of our derivative instruments * e.g. Lock in the forward rate Thus, when speculating with regards to direction using market priced instruments, you should be picking the direction relative to market expectations * e.g. The market expects the value of the Pound to depreciate. – Depending on your own forecasts, this could be a signal to either buy or sell Pounds in the forward market

Answer 6

* Spot : GBP / AUD 1.93 * 6-month Forward Rate : 1.99 (1) Australian speculator’s belief GBP is going to appreciate vs. the AUD to 2.06 Action : Buy GBP Forward (2) Australian speculator’s belief GBP is going to appreciate vs. the AUD to 1.96 Action : Sell GBP Forward

Answer 7

* Options markets allow traders to take advantage of their expectations regarding volatility. – Volatility is a factor in the value of options. * Example: – Where the hedger’s expectation is that the volatility is going to be greater than the market prediction, a hedger can lock in a forward rate to cover their exposure with respect to direction and use a ‘Straddle’ as the bet on volatility. – A speculator would simply enter the Straddle. * Long Straddle: Buying a Call and a Put Option at the same strike price.

Answer 8

**Speculating with combined put and call options** ▪ Straddle - uses both a put option and a call option at the same exercise price ▪ Good for when speculators expect strong movement in one direction or the other **Efficiency of the currency options market** ▪ Research has generally found that, when transaction costs are controlled for, the currency options market is efficient ▪ It is difficult to predict which strategy will generate abnormal profits in future periods

Answer 9

arbitrage in financial markets requires no capital and entails no risk…[it involves] the simultaneous purchase and sale of the same, or essentially similar, security in two different markets for advantageously different prices”

Answer 10

* Assigned readings: – Defined as capitalising on a discrepancy in quoted prices by making a riskless profit. * Arbitrage will cause prices to realign * Three forms of FX arbitrage: – Locational arbitrage – Triangular arbitrage – Covered interest arbitrage

Answer 11

* Defined as the process of buying a currency at the location where it is priced cheap and immediately selling it at another location where it is priced higher. * Gains from locational arbitrage are based on the amount of money used and the size of the discrepancy. * Realignment due to locational arbitrage drives prices to adjust in different locations to eliminate discrepancies.

Answer 12

*** Defined** as currency transactions in the spot market to capitalise on discrepancies in the cross-exchange rates between two currencies. *** Gains from triangular arbitrage:** – Currency transactions are conducted in the spot market to capitalise on the discrepancy in the cross- exchange rate between two countries. *** Accounting for the Bid/Ask Spread:** – Transaction costs (bid/ask spread) can reduce or even eliminate the gains from triangular arbitrage. *** Realignment** due to triangular arbitrage forces exchange rates back into equilibrium.

Answer 13

1. participants use dollars to purchase pounds - bank increases its ask price of pounds with respect to the dollar 2. participants use pounds to purchase malaysian ringgit - bank reduces its bid price of the british pound with respect to the ringgit, it reduces the number of ringitt to be exchnaged per pound received e 3. participants use malaysian ringgit to purchase us dollars - bank reduces its bid price of ringgit with respect to the dollar

Answer 14

1. The current spot rate 2. The domestic interest rate 3. The foreign interest rate If ihome > iforeign....foreign currency sells at a forward premium. If iforeign > ihome…foreign currency sells at a forward discount. Do we use bid or ask quotations? We should not use the same for both as will become evident when we see the actual cash flows.

Answer 15

Use theoretical forward rate F* * If F* = F no arbitrage If F* < > F => Possible Arbitrage F* > F => F relatively undervalued => Buy Fwd Foreign Currency (Fwd Ask) F* < F => F relatively overvalued => Sell Fwd Foreign Currency (Fwd Bid)

Answer 16

* Defined: – The process of capitalising on the interest rate differential between two countries while covering your exchange rate risk with a forward contract. * Consists of two parts: – Interest arbitrage: the process of capitalising on the difference between interest rates between two countries. – Covered: hedging the position against foreign exchange risk. * Realignment due to covered interest arbitrage causes market realignment. * Timing of realignment may require several transactions before realignment is completed.

Answer 17

Theory suggesting that the forward rate differs from the spot rate by an amount that reflects the interest differential between two currencies. When market forces cause interest rates and exchange rates to adjust such that covered interest arbitrage is no longer feasible, the result is an equilibrium state known as IRP.

Answer 18

▪ Below the IRP line: points X and Y ▪ For points to the right of the IRP line, investors in the home country should consider using covered interest arbitrage, since a return higher than the home interest rate (ih) is achievable. ▪ Points above the IRP line: point Z ▪ Domestic investors would achieve a lower return on a foreign investment than on a domestic one.

Answer 19

**Equilibrium** * As investors and firms take advantage of such opportunities, the points will tend to move toward the IRP line. * Covered interest arbitrage should continue until the interest rate parity relationship holds. **Interpretation of Interest Rate Parity** * Interest rate parity does not imply that investors from different countries will earn the same returns. **Does Interest Rate Parity Hold?** * Compare the forward rate (or discount) with interest rate quotations occurring at the same time. Due to limitations in access to data, it is difficult to obtain quotations that reflect the same point in time.

Answer 20

Political risk * A crisis in the foreign country could cause its government to restrict any exchange of the local currency for other currencies. Differential tax laws * Covered interest arbitrage might be feasible when considering before-tax returns but not necessarily when considering after-tax returns. Transaction costs * The actual point reflecting the interest rate differential and forward rate premium must be farther from the IRP line to make covered interest arbitrage worthwhile.

Answer 21

**Explaining changes in the forward rate** * The forward rate is indirectly affected by all the factors that can affect the spot rate (S) over time, including inflation differentials, interest rate differentials, etc. **Forward Premiums across Maturities** * The annualised interest rate differential between two countries can vary among debt maturities, and so will the annualized forward premiums. **Changes in Forward Premiums over Time** The relationship between interest rate differentials and the forward premium over time, when interest rate parity holds. The forward premium must adjust to existing interest rate conditions if interest rate parity holds.

Answer 22

**Arbitrage tends to allow for a more orderly foreign exchange market.** * The threat of locational arbitrage ensures that quoted exchange rates are similar across banks in different locations. * The threat of triangular arbitrage ensures that cross exchange rates are properly set. * The threat of covered interest arbitrage ensures that forward exchange rates are properly set. Any discrepancy will trigger arbitrage, which should eliminate the discrepancy. **How arbitrage reduces transaction costs** * Locational arbitrage limits the differences in a spot exchange rate quotation across locations, while covered interest arbitrage ensures that the forward rate is properly priced. Thus, an MNC’s managers should be able to avoid excessive transaction costs.

Answer 23

Warrants and options are both a form of derivative instrument. They derive their value from an underlying instrument such as a share or an index. *Key differences include:* * Warrant trades are settled on CHESS, whereas options trades are settled by the Australian Clearing House (ASX Clear) * Option terms are standardised and set by ASX, whereas the terms of warrant series are set by the issuer and vary from one warrant to another * Warrants are issued by a third party (e.g., a bank) while options are listed by ASX * Result (Key difference): Warrant holders are exposed to the credit risk of the issuer, while ASX Clear guarantees the performance of option contracts

Answer 24

- MINIs are a currency tracking product that provide investors with leveraged exposure to a number of currency pairs. MINIs are similar in nature to CFDs as they do not have an expiry date and track the underlying currency on a one for one basis. - They also contain an in-built stop loss to ensure you cannot lose more than your initial outlay. - Currency MINI longs give traders leveraged exposure to the Australian Dollar (AUD) rising against a selected currency. - Conversely Currency MINI shorts give traders leveraged exposure to the AUD falling against a selected currency

Answer 25

- Currency warrants allow exchange of foreign currency for AUD by a specific expiry date. - The value of warrants changes with the AUD/USD exchange rate. - Call warrants benefit from an increase in the exchange rate. - Put warrants benefit from a decrease in the exchange rate. - Warrants are similar to exchange-traded options but are issued by a warrant issuer, not the ASX. - Provide leveraged exposure to AUD/USD exchange rate movements. - Carry risk of issuer not fulfilling obligations. - Margins are not required; warrants can only be sold to close an existing position.

Answer 26

- Currency ETFs can provide investors with the opportunity to gain exposure to the performance of selected foreign currencies. - Currency ETFs are non-leveraged and are generally lower in cost when compared to holding a foreign currency account with a bank. - Currency ETFs are available over the Australian / United States dollar (ASX code is USD), Australian / British Pound (ASX code POU) and the Australian / Euro (EEU). They are also offered by ANZ e.g., ZCNH (for the Renminbi). NOTE: Many of these products move in and out of being offered on the ASX and others have no active trading! See the trading volumes after clicking on the product codes.