FINS3616 Lecture Notes - Lecture 3: Forward Rate, Exchange Rate, Autoregressive Conditional Heteroskedasticity
Week 2 – Forward Markets & Exchange Rate Systems
Transactions exchange risk: Possibility of taking a loss in foreign exchange transactions
• Who incurs this risk – corporations, institutional investors, individuals
• How to avoid – hedging (protect against losses & get rid of uncertainty)
Iforatio availale at tie t – conditional (conditional probability distributions)
Within 1 S.D. range is probability of 68.26% and within 2 S.D. range is 95.45%
Calculating the likelihood of a given outcome:
• Find difference between given point and conditional mean
• Divide this y oditioal volatility = “t * siga
• This gives number of standard deviations
Forward rate – specified in a forward contract
• Eliminates risk / uncertainty
• Usually a large sum of money
• With bank
What is the appropriate way to view cost of a hedge?
• Ex ante (before) – risk important for hedging
• Ex post (after) – risk used to judge performance (e.g. mutual fund)
Outright forward contracts – only 12% of all transactions
Swaps – simultaneous purchase and sale of a certain amount of foreign currency for two
different dates in the future
• More than 44% of transactions
Forward contract maturities and value dates
• Highly customizable (most active dates are 30, 60, 90 and 180 days)
• Exchange takes place on the forward value date
Forward bid/ask spreads
• Larger than in spot market (main reason is LOWER LIQUIDITY – also more risk)
• Spreads higher for greater maturities
• .10% for major currencies
• 90 day: 15% greater than spot contracts
Foreign exchange cash flow swap types:
• Purchase of foreign currency spot against sale of foreign currency forward
• Sale of foreign currency spot against the purchase of foreign currency forward
• Less common:
Purchase of foreign currency short-term forward against sale of foreign-currency
long-term forward
Sale of foreign currency short-term forward against purchase of foreign currency
long-term forward
Swap Quotes and Rules
find more resources at oneclass.com
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2
• Swap points – basis points added or subtracted to yield actual 30-day bid / ask
forward prices
If first number is smaller than second, add points
If first number is bigger than second, subtract points
Forward premium – occurs when price of currency contract is higher than spot rate
Forward discount – occurs when price of currency contract is lower than spot rate
Annualised percent – [(Forward – Spot) / Spot] * [(360 / N days)]
Changes in Exchange Rate Volatility
• Volatility clustering (if high, tends to remain high and vice versa)
• GARCH model
V(t) = a + b v(t-1) + c e(t)2
• Volatility today affected by: (a) past volatility and news terms = 0, (b) sensitivity of
current conditional variance to past volatility and (c) sensitivity to current news
Exchange Rate Systems
Systems around the world:
• Floating – determined by market forces of supply and demand, generally increasing
in number (i.e. US, Japan, EU, Australia, Sweden)
• Managed floating – countries whose Central Banks intervene enough that the IMF
at lassify the as freely floatig i.e. Argetia, Brazil, Coluia, Idoesia,
South Africa)
• Fixed/ pegged currencies – fixing a currency to another or a basket of currencies,
generally decreasing in number (i.e. IMFs “DR and Chinese yuan)
Often implemented using a currency board
• No separate legal tender – adopt aother outrys urrey i.e. Euador, El
Salvador and Panama have adopted the USD)
• Target zone – forex is kept within band
• Crawling pegs – changes kept lower than preset limits that are adjusted regularly
(i.e. with inflation)
• Special arrangements – central bank controls the forex rate system for several
countries (Euro & CFA franc zone – guaranteed by French treasury)
Currency risks:
• Floating rate systems
Generally symmetric (same upside risk as downside risk)
Observable through historical exchange rate volatility – no hidden risk
• Target zones
Less historical volatility than floating
Underlying risk can be big due to devaluations/revaluations
• Pegged
Latent volatility (not observable through historical exchange rate movements)
• Currency board/Monetary unions
Have frequently collapsed
find more resources at oneclass.com
find more resources at oneclass.com
Document Summary
Week 2 forward markets & exchange rate systems. Transactions exchange risk: possibility of taking a loss in foreign exchange transactions: who incurs this risk corporations, institutional investors, individuals, how to avoid hedging (protect against losses & get rid of uncertainty) I(cid:374)for(cid:373)atio(cid:374) availa(cid:271)le at ti(cid:373)e (cid:858)t(cid:859) conditional (conditional probability distributions) Within 1 s. d. range is probability of 68. 26% and within 2 s. d. range is 95. 45% Calculating the likelihood of a given outcome: find difference between given point and conditional mean, divide this (cid:271)y (cid:272)o(cid:374)ditio(cid:374)al volatility = (cid:894)t(cid:895) * (cid:858)sig(cid:373)a(cid:859, this gives number of standard deviations. Forward rate specified in a forward contract: eliminates risk / uncertainty, usually a large sum of money, with bank. What is the appropriate way to view cost of a hedge: ex ante (before) risk important for hedging, ex post (after) risk used to judge performance (e. g. mutual fund) Outright forward contracts only 12% of all transactions.
