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1. If the spot rate for the Won is 800 won equals...




1. If the spot rate for the Won is 800 won equals 1 US $, and the annual interest rate on fixed rate one-year deposits of won is 9% and for US$ is 3%, what is the one-year forward rate for one won in terms of dollars? Assuming the same interest rates, what is the 8-month forward rate for one dollar in terms of won? Is this an indirect or a direct rate? If the forward rate is an accurate predictor of exchange rates, in this case will the won get stronger or weaker against the dollar? What does this indicate about inflation expectations in Korea compared to the US? 2. On January 3d, 2007, Daimler-Chrysler expects to ship 10,000 cars from its Hyundai affiliated plant in Korea to the US, which it will sell through its US dealers on 240-day terms at $10,000 each. So Daimler-Chrysler will receive payment from its dealers on August 30, 2007. Assuming that Daimler-Chrysler group needs to cover its expenses in Korea and thus wants to hedge its won exposure using a forward contract with a US bank in Korea, what is the minimum amount of won they should receive on August 30th, 2007 given the eight month forward rate for one US dollar in terms of won that you calculated in problem one? What is one other way they might they hedge their won/dollar exposure?,Foreign Exchange Transaction Check List 1. Is graph, equation, transaction in US terms (direct; $ per unit of FC) or European terms (indirect; FC per dollar)? 2. If in US or $ terms, then is foreign currency appreciating or depreciating ($ price is rising or falling)? And in which direction does this appear on the chart if graphed? 3. If the transaction is stated in European terms, then the amount of foreign currency (FC) used to buy one dollar is falling (decreasing) if the currency is appreciating. It is rising if the dollar is appreciating (that is, the foreign currency, FC, is depreciating)? 4. Make sure you are using the right formulas. If US terms are used, then the spot rate is stated in $ per unit of FC, i.e. S$/FC. If European terms are used, then it is SFC/$. From the book and class, the following formulas are important where ARI is the Annual Interest Rate in US $ or Foreign Currency (FC) for a Euro deposit of n days: a) Forward in US terms = F$/FC = S$/FC (1 + ARIUS x n/360)/(1 + ARIFC x n/360) b) In European terms = FFC/$ = SFC/$ (1 + ARIFC x n/360)/(1 + ARIUS x n/360) c) Cross rate if both currencies are stated in European terms (FC1 and FC2), is CRFC1/FC2 = SFC1/$/SFC2/$ Cross rate if one is in European terms and other is in US terms, is CRFC1/FC2 = SFC1/$ x S$/FC2 Cross rate if both are in US or direct terms, is CRFC1/FC2 = S$/FC2/S$/FC1 To get the forward cross rate, first determine the spot cross rate from the formulas just given, then use the following formula, i.e. the Forward Cross Rate is FCRFC1/FC2 = CRFC1/FC2 (1 + ARIFC1 x n/360)/(1 + ARIFC2 x n/360) 5. A Forward is a contract to buy a given amount of one currency for another currency at a specific date in the future. It is mechanically determined and is dependent solely on the spot rate between the currencies, the two countries? interest rates and the period. It is usually done with a bank. As long as one can find Euro-deposits of the appropriate term, one can calculate a forward rate. Thus, for dollars versus yen, one can go as long as five years as five year Euro-deposit rates are quoted for both currencies. Since the banks have to know they will be able to exchange the funds at the forward date, some convertibility must be assured but it need not be convertibility in the exchange market. This makes forwards the most flexible and widely used way to take a position with respect to the future value of a currency. 6. The Forward?s premium or discount if the spot is stated in direct terms is given by formula: [(F$/FC - S$/FC)/S$/FC] x (360/n) x 100, and if in indirect or European terms by: [(SFC/$ - FFC/$)/FFC/$] x (360/n) x 100. Both, though, are equal to [(ARIUS - ARIFC)/(1 + ARIFC x n/360)] x 100. From this fact, one can see that to determine the forward premium or discount one only needs to know the two countries? respective interest rates and the time period for the forward in terms of days. If the time period is given in months, one may substitute n/12 for n/360. In converting from months to days, always multiply by thirty (30) since banks always calculate Euro-deposit rates on the basis of a 360 day year composed of twelve equal months of thirty days each. 7. An FX swap is the simultaneous spot purchase and forward sale of a currency. It is thus dependent on the forward rate which in turn is dependent on the difference in interest rates between the two countries. Since principal is exchanged back on an equal basis, there is no FX risk or FX gain to either party. The only cost is the difference in interest earned by the two parties. Under these circumstances, the receiver of the higher interest rate will pay the difference to the other party. The receiver is always the one who swapped into the currency with the higher interest rate. The interest earned is calculated at the forward rate. This technique is commonly used by banks to create short-term funding for loans in another currency. 8. A future is a contract traded on an exchange sold through a broker. It is not negotiated. Each contract represents a specific amount of currency to be delivered at a specific set date in the future at a specific price. The dates are usually the third Wednesday starting with January, then March, April, June, July, September, October and ending in December. The contract or exercise price is usually the spot rate on the day the contract is opened (purchased). Thus, future contracts are generally opened at the money (ATM). Contracts are closed through the purchase of an offsetting contract. The open interest on an exchange it the total value of open contracts (purchase plus sale) that have not been closed. The future contract will trade on its exchange independently of the forward. However, arbitrage will keep the values close together. If the future is more valuable, one will buy the forward and sell the future, thus increasing the value of the spot and the forward while depressing the value of the future, bringing the two values back in line. Because futures trade on an exchange which is only open at certain times, they are not as liquid as forwards which can be traded in different markets on a twenty-four hour basis. Also, as the brokers and traders need access to the underlying currency to fulfill or hedge the contracts, futures are generally limited to the major convertible currencies. 9. An option is also a contract. However, a European or American option does not mean that the currencies are stated in indirect or direct terms respectively. Rather the former means it can only be exercised on the exercise date whereas the American option can be exercised any time up to and including the exercise date. Further, while options traded on exchanges are usually tied to their respective futures contracts, i.e. the amount of the option contract and its exercise date correspond to the amount and date of the futures contract, options traded over the counter (OTC) can usually written for any time period or strike price. For the same reason, exchange traded options are usually limited to the major convertible currencies whereas OTC options can be written on other currencies as long as the banks can hedge themselves using forwards. 10.In looking at options, the following chart outlines the difference between changes in the strike price (E) and changes in the spot price (S). You need to be mindful of these differences because they move in opposite directions. From the equations on page 177, you can subtract the equation to determine the European call premium on one unit of FC, i.e. the premium paid for the right to buy one unit of FC for $ at a fixed price at a fixed date in the future, from the equation for the European put premium, i.e. the right to sell one unit of FC for $ at a fixed price at a fixed date in the future but not before. The strike price and exercise date for both the call and put are the same. This then gives: P$/FC - C$/FC = (E$/FC - F$/FC) e (exp -rdT) From this one can see that a rise in the exercise price, E$/FC, makes the put, the right to sell the FC, more valuable since the put writer must then buy the currency from the holder at a higher exercise price (E). Conversely a fall or decrease in the exercise price makes the put less valuable. Naturally, calls become relatively less valuable as the put becomes more valuable, and the call becomes relatively more valuable as the put becomes less valuable. If the forward price, F$/FC, rises due to an increased spot rate, $/FC, or due to changes in interest rates according the formula in 4a), then the call becomes relatively more valuable, i.e. its premium rises. If the forward falls, then the call becomes less valuable, i.e. its premium falls. Changes in the strike price (E) only change the option premium or cost. Only changes in the spot lead to unlimited gains (UG) or losses (UL). These relationships are summarized in the following table for puts and calls on a unit of FC. Impact on: Option Option Holder Option Writer Spot E Call on FC Put on FC Call Owner Put Owner Call Writer Put Writer Fixed $/FC Falls More Valuable Value Decreases Premium Rises Premium Falls Receives More Lower Premium Fixed $/FC Rises Less Valuable Value Increases Premium Drops Premium Increases Receives Less Higher Premium Depreciates, $/FC Falls Constant Less Valuable Value Increase Lose Premium UG + Premium UL Appreciates, $/FC Rises Constant More Valuable Value Declines Unlimited Gain Lose Premium UL + Premium The reverse is true when exchange rates for the put or call are put in indirect terms. However, make sure when using the above formula that the currencies are always stated in US terms. Also, the puts can calls in this table remain puts and calls on the FC. Only this is now read as the right to sell FC for one $ or right to buy FC for one $. That is in the case of a put, one is still selling FC (or buying $) at a predetermined price on a fixed date in the future. In the case of a call one is still buying FC (Selling $) at a fixed price at a fixed date in the future. Option Option Holder Option Writer Spot E Call on FC Put on FC Call Owner Put Owner Call Writer Put Writer Fixed FC/$ Rises More Valuable Value Decreases Premium Rises Premium Falls Receives More Lower Premium Fixed FC/$ Falls Less Valuable Value Increases Premium Drops Premium Increases Receives Less Higher Premium Depreciates, FC/$ Rises Constant Less Valuable Value Increase Lose Premium UG + Premium UL Appreciates, FC/$ Falls Constant More Valuable Value Declines Unlimited Gain Lose Premium UL + Premium 11. Spot transactions, forwards, swaps, futures, call and put options are all ways for companies and individuals to hedge, intermediate transactions, and speculate. Most multinational firms who have tried to speculate in competition with professional traders and speculators have not done well. The Showa Shell and Allied Lyons cases indicate that such loses can be very substantial. Thus, for the purposes of this course we will concentrate on hedging techniques and somewhat secondarily intermediation, the latter being done mostly by financial institutions such as large banks and brokerage firms. Intermediation usually involves the buying and selling of the same instrument, taking a spread, e.g. the bid and asked quotations on a FX spot or forward. It also can involve selling a put or call and then hedging the other side through the use of forwards and futures. Examples of such hedging needs could be related to a wide variety of international business situations involving trade (import or export transactions), foreign investment (either portfolio or strategic), dividend payments or receipts, payment for services in a foreign country, and Euro-underwritings. However, most such transactions can be broken down into either the receipt or payment of funds in a foreign currency at a point in time. (Balance sheet or operational hedging of exchange exposures usually cannot be adequately hedged using these financial instruments since such exposures are usually long term hedging problems but the financial instruments we are discussing are by their nature short-term.) An example of a short-term payment exposure would be a contract or obligation to buy DM 1 million in Euro-bonds. This could arise because one was the investment manager of an insurance company or mutual fund that had agreed to purchase these bonds in sixty days as part of a Euro-issue by a US or Canadian company. The manager has already committed to the purchase even the closing of the issue and delivery of the bonds will not be sixty days. The manager therefore wants to hedge the company?s exposure to a change in the value of the bonds. This can be done in several ways using the techniques we have discussed. First, the firm could purchase DM 1 million spot and deposit it in a German bank for sixty days. However, as German interest rates are less than Canadian or US rates this may be costly, also the fund may not be receiving receipt for the bonds until the time of purchase if it is acting as an intermediary for other investors or it is expecting an inflow of premiums in the next sixty days from which it plans to make the investment. This is analogous to an exporter who will not receive payment from the importer until the goods are delivered. Under these circumstances it may make sense to enter into a forward transaction with a local bank to buy the DM forward for delivery in sixty days. But if the investment or insurance company is a small one, the bank may require a deposit of funds as was illustrated by question #8 in Chapter 6. The company may either not have the funds or may not want to borrow. A foreign currency swap does not make sense since this is a long-term investment, and swaps are generally for a year or less. Under these circumstances, it may make sense to enter into a futures contract since the broker and the exchange will only require a small position margin, usually about 10% of the value of the contract, or DM 1 million instead of a deposit for the entire amount. However, if the DM weakens in the meanwhile, the investment company will need to put up additional margin which it may be reluctant to do. In addition, the manager has to think about the actual nature of the transaction and the risks that need to be avoided. Since the company has already decided to buy the bonds and hold them on an unhedged basis, they are clearly not concerned with exchange risk on a long-term basis. Rather, they are concerned about cover they risk prior to the investment actually being completed. Further, since they are taking that long-term exposure to the DM, they are not concerned, indeed may even be expecting, an appreciation of the DM against the $ or C$. What they are concerned with is an increase in the DM?s value prior to the investment being made since this increases the investment?s cost when the amount allocated has been decided. At the same time, since they are prepared to be unhedged long term, they have already accepted the risk of DM depreciation. Also, if the DM depreciates between now and the investment point, they can benefit by being able to either buy the same amount of DM Euro-bonds cheaper or to buy more bonds for the same $ or C$ already allocated. Under these circumstances, their exchange exposure is not really symmetrical, and it would make sense for them to buy at-the-money (ATM) call options on the DM for sixty days where they could lock in the rate at which they could purchase the DM. Then they are fully covered if the DM appreciates, but if it depreciates, they can let the options lapse and buy the DM in the market. The option has the additional benefit that once they have paid the premium that is their only cost. Since from the text this might run 1% on a sixty day option, it requires less funds than the forward or future, and there is no credit issue since they have paid the whole amount up front. So for a small company this can be an additional benefit from using options. The company could also hedge their exposure by writing ATM puts on the DM. In this case, they can potentially increase the yield on the bonds in the first year by the amount of the premium they receive, while they cannot be required to buy the DM for more than they were already prepared to pay. That is, if the current spot is $.585/DM, and they have made their investment decision on this basis, they receive the premium, and if the DM depreciates they will buy the 1 million DM for $585,000 and use that 1 million DM to buy the bonds. However, if the DM appreciates, the put lapses, but they must still buy the DM at the higher rate. The premium acts as a cushion against the higher rate, but it is not a full offset. So while in this case, the writer need not pay anything, the firm?s exposure to exceeding its investment allocation is not fully hedged. Therefore, the call option appears to be the best alternative. Another aspect to this transaction is the receipt in sixty days of DM 1 million by the US or Canadian company issuing the bonds. If the DM is for use in their German operations, then their is a natural hedge and no further action on their part is required. However, if the company is just raising funds for general corporate purposes and plans to convert the DM into US or Canadian dollars, it may wish to hedge its exposure to a fall in the value of the DM, especially if the funds are to be used for a specific investment or expenditure in the amount of $585,000. At the same time, if the underwriting were to fail at the last minute, they might not want the potential exposure to have to deliver DM required under a forward or futures contract. So in this case they would want a put option on the DM at 58.5. They will also have to give some thought to how they will pay interest and principal on the DM bonds in the future, though perhaps they are already exporting to Germany. This kind of reasoning can be applied to any transaction or series of transactions involving the payment and receipt of foreign currency to establish not only which is the lowest cost and or least risk, such as in the answers to question #8 in Chapter 6, but also which best meets the overall company?s limitations, goals and objectives. You should try to think of your own examples with respect to the case studies and other situations described in the book or with respect to operating in your countries. Most trade transactions will usually involve the use of forwards or futures because the parties involved will not continue to hold the foreign currency as in the case of an investor just described. Rather, they will actually need to exchange it to their own local currency to establish a cost basis for when they sell it, the net proceeds from which they can use to pay their workers, etc. 12. FX transactions are often combined with other types of hedges, intermediation or speculation such as those hedging commodity or security positions. Thus, a French candy manufacturer might combine a dollar/franc hedge with a hedge in sugar and cocoa futures on the New York commodity exchange of its inventory and raw material purchase contracts in sugar and cocoa. Similarly, a Scottish Pension Trust might combine a pound/yen hedge with a hedge involving Nikkei or Topix stock index futures in order to protect its investments in Japanese stocks. CURRENCY FORECASTING ANALYSIS - RELATION OF INFLATION, INTEREST RATES AND FORWARDS SCENARIO Interest Rate Inflation Real Rate Forward Predictor 1) Low real interest rates will not attract capital and low high negative Forward is bad predictor will pressure economic resources that are not as sell at a premium not a growing. This increases inflation while productivity discount increases are low and will not compensate for higher factor costs. Trade deficit rises and currency weakens from both Capital and Current Account pressures. 2-3) Attract some resources but not enough. Therefore, normal or high high normal to high Forward will indicate trade surplus drops as productivity increases do not trend as sells at a discount offset factor cost increase. So currency weakens. 4) Normal economic conditions tend to continue as long normal normal normal Equilibrium case. Should as current conditions persist. So existing trade and 3-6% be unbiased. Trend tell capital flows also continue. If that means B of P credits if good or bad indicator. increase and currency appreciates, then question is whether forwards tend to be constant, or trade at premium/discount. Operate at margin. 5) Though not as true as for scenario #9, tendency will high normal high Bad indicator as sell at a be for normal inflation so that country will attract a discount while currency capital, expand full employment, and productivity. tends to appreciate. This should lead to greater trade surplus and currency appreciation as capital and trade account work together. 6) Capital inflows weak and there may be outflows, low normal 0 or negative Bad as low interest means weakening currency. This may impact productivity premium while expect FX increases and lower trade surpluses. Trend weaker FX. to weaken. 7) Low rates not attract capital and initially it flows out. low low low Good, since tendency is But low cost means productivity and trade surplus for FX to rise after initial increase. FX rises, hurting investors. Capital then stays. FX losses hurt investors 8) Will attract capital due to high real interest. This normal low high Will not sell at a premium will improve full capacity and productivity leading though FX tends to rise. to trade surplus too. So currency will appreciate. So not good predictor. 9) High interest rates with low inflation will attract capital high low very high Bad predictor as sell at a and will create capacity. This expands full production discount while currency possibility frontier. Trade surplus should increase. will tend to appreciate Currency appreciates due to both Capital and Trade Account effects.,Hint attached


Paper#6425 | Written in 18-Jul-2015

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