Chapter Four1
CHAPTER 4
The Forward Currency Market and International Financial Arbitrage
CHAPTER OVERVIEW
Chapter 4 studies the forward currency market and its role in providing investors with opportunities to hedge against foreign currency exchange risk. The chapter begins with a discussion of the various types of risk to which companies engaging in foreign currency transactions expose themselves, and distinguishes among three types of exposure: (1) transaction exposure, which is the risk that the costs or proceeds from a transaction will change in value, (2) translation exposure, which is the risk that the value of assets and liabilities will change when translated to a single currency value, and (3) economic exposure, which is the risk that a firm’s present value stream of future income will change as a consequence of exchange rate changes. A forward exchange contract is motivated as a means by which agents can cover themselves against these risks. The section ends with a discussion of the extent to which forward exchange rates are good predictors of future spot rates, and concludes that in practice they are not very good predictors.
The next section of the chapter presents the traditional model for the supply and demand for loanable funds and shows how the market interest rate is determined in equilibrium. The text then demonstrates that when expected returns on two different instruments are the same, it is implied that the real interest rates should equalize between the two, and presents this as interest parity. If interest parity exists between the instruments of different national currencies, then no net flow of funds should occur between the two. But when the instruments are denominated in two different national currencies, then this implies that there will also be an exchange risk. If investors cover these exchange risks by using the forward exchange market, then a “covered interest parity condition” will hold between the two instruments.
Next, the concept of “uncovered interest parity” is introduced, and is described as a condition in which investors do not use the forward market to hedge against foreign exchange risk. In this case, the extent to which future exchange rate changes do not compensate for interest rate differentials on the instruments denominated in the two different national currencies reflects the presence of a risk premium. This risk premium may reflect risks other than exchange risk, such as country risk stemming from country specific political or fiscal uncertainties. The section concludes by pointing out that when both covered and uncovered interest parity hold, then this implies that the forward premium will be equal to the expected change in the spot rate, a condition which is also taken as indicative of foreign exchange market efficiency. The chapter ends with a discussion of Eurocurrency markets and the extent to which these can play a similar role as the forward exchange market in that they allow investors to avoid foreign exchange risk.
OUTLINE
I. Foreign Exchange Risk
A. Types
1. Transaction Exposure
2. Translation Exposure
3. Economic Exposure
B. Hedging
II. Forward Exchange Markets
A. Forward Contracts
1. Short Position
2. Long Position
B. Link Between Forward Rate and Prediction of Future Spot Rates
1. Standard Forward Premium
2. Standard Forward Discount
III. International Financial Arbitrage
A. Loanable Funds Market
B. Interest Parity
C. Covered Interest Parity
IV. Uncovered Interest Parity
A. Standard Theory
B. Theory with Country Risk
C. Foreign Exchange Market Efficiency
V. Eurocurrency Market
A. Origins
B. Growth
C. Relationship to Forward Market
VI.Summary
FUNDAMENTAL ISSUES
1. What is foreign exchange risk?
2. What is the forward currency market, and how are forward exchange rates determined?
3. What is covered interest parity?
4. What is uncovered interest parity?
5. What is foreign exchange market efficiency?
6. What is the Eurocurrency market, and how is it related to the forward currency market?
CHAPTER FEATURES
1. Management Notebook: “Replicating a Forward Contract”
In this management notebook, the authors illustrate how borrowing a currency, exchanging it for a second currency in the spot market, and lending the second currency replicates a forward contract.
For Critical Analysis: The different opportunity costs and risk arise from the timing of commitments and use of resources. For instance, in the case of purchasing a forward contract, no resources are tied up between the current time period and the time of settling a forward contract. On the other hand, replicating a forward contract involves the use of resources immediately. However, if a firm replicates the forward contract, the firm could benefit or suffer from a different spot exchange rate in he future than was anticipated when a forward rate was quoted.
2. Policy Notebook: “Good Grades for Brazil?”
This management notebook considers Brazil’s recent changes in its credit ratings; citing its improvement while noting that its rating is still below that of many other emerging economies. This is explained by the fact that, though Brazil has improved its macroeconomic fundamentals, these improvements are relatively recent and require continued fiscal and monetary prudence to earn better credit ratings.
For Critical Analysis: Elements that influence a country’s credit rating include: its GDP and GDP growth, its ratio of debt to GDP, as well as the growth rate of this ratio, the country’s political stability, the country’s ability to repay past debt. An important factor that influences any borrowers ability to repay a loan, whether the borrower be a country or a firm, should be an examination not only of the borrower’s present state, but at least as importantly, the borrower’s future potential. In the case of either a country or a firm, the use to which the loan will be put ought to be productive, in order to allow the country or firm sufficient growth to repay both the principal and the interest.
ANSWERS TO END OF CHAPTER QUESTIONS
1. a. From the perspective of someone holding the euro: the forward premium/discount is calculated as:
((F – S)/S)(12/1)100 = 2.239%. Further, the interest rate differential is: 5% – 7% = –2%.
c. Since the euro is losing value and the interest differential favors the U.S. dollar, one should move
his/her funds into the dollar. This is illustrated on the covered parity grid by the fact that the coordinate
lies above the 45 degree line.
2. Using the provided information and annualizing:
5% – 7% < [(1.0740 – 1.0720/1.0720)12]100
or, –0.02 < 2.239%
3. In graph (i), we see the spot market for the euro. As the demand for the U.S. dollar increases, the supply of the euro rises. Thus the dollar price of the euro falls.
In graph (ii) the forward market for the euro is illustrated. European holders of dollar denominated assets will likely want the proceeds back in euros. Therefore the demand for euro forwards will rise.
In graph (iii) we see the euro denominated loanable funds market where the supply decreases.
In graph (iv) we see the dollar denominated loanable funds market, in which supply rises.
(i)(ii)
(iii)(iv)
4. An arbitrage opportunity does exist in this example if one were to borrow the pound at a cost of 0.5052 (6.0625/12); but experience a return through the return on the euro equal to 0.3646 (4.375/12) and the gain in currency value of 0.2463 ((1.620–1.624)/1.624)100). The gains are greater than the cost.
5. The uncovered interest parity equation is: R – R* = (Se+1 – S)/S
a. Rewriting the equation for the expected future expected exchange rate yields:
Se+1 = (R – R*)S + S
b. Using the values given yields the expected future spot rate of 1.6806
6. Given this information, we can calculate the forward premium/discount with the following formula:
(F – S)/S = R – R*
Substituting: (F – 0.95)/0.95 = 0.07 – 0.05
Solving for F, we find the forward premium equal to 0.969
7. We can adjust for the shorter maturity by solving the following equation:
((F – S)/S)(12/N) = R – R*
((F – 0.95)/0.95)(12/6) = 0.07 – 0.05
Solving for F, the forward premium equals 0.9595.
MULTIPLE CHOICE EXAM QUESTIONS
1. Foreign direct investment may occur in response to
A. related to exchange rate changes altering the return too domestic currency.
B. due to the fact that domestic laws apply only to domestic transactions.
C. the chance that transaction costs will make you transaction unprofitable.
D. the possibility that your firm’s policies are made public due to international disclosure laws.
Answer: A
2. Foreign direct investment may occur in response to
A. an inability to invest through foreign financial markets.
B. a situation in which domestic capacity limits have been reached.
C. a desire to avoid exchange risk stemming from economic exposure.
D. government subsidy of domestic investment.
Answer: C
3. The act of offsetting exposure to risk is known as
A. dodging.
B. hedging.
C. speculating.
D. avoidance.
Answer: B
4. A covered exposure is one
A. that is backed by government.
B. in which all exposure too risk in neutralized.
C. that is established via foreign direct investment.
D. that is impossible in most bond markets.
Answer: B
5. The market in which contracts for a future delivery of a foreign currency are established is
A. the S&P 500.
B. the Fortune 500.
C. the foreign exchange market.
D. coordinated by central banks.
Answer: C
6. A short position in a foreign currency implies that the investor
A. will deliver the foreign currency in the future.
B. will receive the foreign currency in the future.
C. has a shortage of foreign currency.
D. has an excess supply of foreign currency.
Answer: A
7. If the forward exchange rate is greater than the spot exchange rate there is a
A. forward premium.
B. forward discount.
C. shortage of dollars.
D. surplus of dollars.
Answer: A
8. If there is a forward discount, then according to the efficient markets hypothesis one would expect
A. a depreciation of the currency.
B. an appreciation of the currency.
C. a devaluation of the currency.
D. a revaluation of the currency.
Answer: A
9. The forward premium has proved to be
A. a stable predictor of the future spot rate.
B. a near-perfect predictor of future spot rates.
C. a biased predictor of future spot rates.
D. of no help in predicting future spot rates.
Answer: C
10. The existence of unexploited profit opportunities is referred to as
A. the parity condition.
B. disequilibrium.
C. interest rate parity.
D. an arbitrage opportunity.
Answer: D
11. Interest rate equalization across countries on similar financial instruments is called
A. sterilization.
B. optimization.
C. interest rate parity.
D. an arbitrage opportunity.
Answer: C
12. Covered interest rate parity implies that the difference between the domestic and foreign interest rates
should equal
A. zero.
B. the forward premium or discount.
C. the purchasing power parity exchange rate.
D. the yield to maturity.
Answer: B
13. One limitation of using forward markets as a hedge is
A. that a sizable minimum transaction is required in order to participate in forward markets.
B. an insufficient number of speculators who are willing to absorb the riskiness of the transaction.
C. an absence of government regulation in forward markets.
D. that forward markets are exchange tradable.
Answer: A
14. The condition relating interest differentials to an expected change in the spot rate of the domestic
currency is called
A. covered interest rate parity.
B. uncovered interest rate parity.
C. absolute purchasing power parity.
D. relative purchasing power parity.
Answer: B
15. Uncovered interest rate parity may not hold exactly due to
A. a risk premium.
B. a hedge adjustment.
C. the inflation effect.
D. an adjustment for nominal rather than real interest rates.
Answer: A
16. The additional risk of a currency due to political instability is referred to as
A. anarchy.
B. the discount factor.
C. unhedgeable.
D. country risk.
Answer: D
17. If market participants could forecast perfectly, then one would expect the
A. forward premium to be equal to the future spot rate minus the current spot rate.
B. current spot rate to be equal to the future spot rate minus the current spot rate.
C. future forward premium to be equal to the future spot rate.
D. future forward premium to be equal to the current spot rate.
Answer: A
18. Suppose that a currency speculator notes that the 90-day forward rate on the French franc is $0.15/French franc. Suppose further that the speculator believes that in 90 days will be $0.20/French franc. If this is the case, the speculator should do which of the following to earn a profit?
A. Buy U.S. dollars on the forward market.
B. Sell French francs on the forward market.
C. Buy French francs on the forward market.
D. Buy U.S. dollars on the spot market
Answer: C
19. In which of the following situations would a speculator wish to sell foreign currency on the forward market?
A. If Se+1 < F
B. If Se+1 > F
C. If Se+1 = F
D. If Se+1 = 1/F
Answer: B
20. In which of the following situations would a speculator wish to purchasel foreign currency on the forward market?
A. If Se+1 < F
B. If Se +1 > F
C. If Se +1 = F
D. If Se +1 = 1/F
Answer: A
21. A market where prices adjust quickly to new and relevant information is called
A. stable.
B. opaque.
C. rational.
D. efficient.
Answer: D
22. The most likely reason why the forward rate actually does a poor job of forecasting the future spot
exchange rate is the
A. presence of irrational expectations.
B. presence of a variable risk premium.
C. unpredictability of interest rates.
D. notoriously inaccurate nature of the data on forward rates.
Answer: B
23. A bank deposit denominated in a currency other than that of the nation in which the bank deposit
is located is referred to as
A. ADR.
B. reciprocal transfer.
C. Eurocurrency.
D. foreign exchange deposit.
Answer: C
24. One theory of the of the origin of Eurocurrency markets has to do with the
A. development of a black market for illegally obtained funds.
B. former Soviet Union moving U.S. assets to Europeans banks for security reasons.
C. U.S. lending to European allies during WWII.
D. former Soviet Union selling off its reserves of U.S. dollars.
Answer: B
25. The most heavily traded currency on the Eurocurrency market is the
A. British pound.
B. German DM.
C. Japanese yen.
D. U.S. dollar.
Answer: D
26. The top five traded currencies make up what percentage of the market?
A. 95% B. 78% C. 50% D. 37%
Answer: B
27. Covered interest arbitrage in the euro markets is
A. often profitable due to the avoidance of country risk.
B. often profitable due to differing tax treatments on assets held outside of the country.
C. seldom profitable due to equilibrium conditions in the forward markets.
D. seldom profitable due to investor indifference.
Answer: C
28. The uncovered interest rate parity is a condition regarding
A. nominal interest rates and future spot exchange rates.
B. real interest rates and future spot exchange rates.
C. nominal interest rates and current spot exchange rates.
D. real interest rates and current spot exchange rates.
Answer: A