IB 150 Lecture Notes - Lecture 15: Call Option, Efficient-Market Hypothesis, Fundamental Analysis

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IB 150 – Lecture 15
Foreign Exchange Market
Hedging with Forward Exchange Rate
When you have payables or receivables in foreign currencies, you should protect yourself.
One way to do so is to buy or sell the payables or the receivables in the forward market, e.g.,
When you have to pay 1 million euro in 60 days, buy the euro now at the forward rate of
$1.25 /euro now;
When you will receive 1 million euro in 60 days, sell the euro now at the forward rate of
$1.27/euro now.
Hedging with Currency Options
Option
A right to buy or sell foreign currencies at a fixed exchange rate within a specific period
(American option) or at a specific date (European option), e.g.,
Buy yen at Y100/$1.00 in 30, 60, or 90 days
Sell euro at $1.27/$1.00 in 30, 60, or 90 days
Call - The right to buy at a specific rate
Put - The right to sell at a specific rate
Do you exercise the option or not?
You purchased a call option to buy euro at $1.25/euro in 3 month in order to pay for your
imports from Germany.
After 3 month, the spot exchange rate is $1.27/euro. Do you exercise the option or not?
And why? Yes, because the value in your contract is less
If, after 3 month, the spot exchange rate becomes $1.23/euro, do you exercise the option
or not? Explain why. No, the value in your contract is more
What is a hedge fund?
Hedge fund
Private investment fund that buys financial assets and also sells them short
Limited to 100 investors, each with $1 million minimum, run by a manager who is also an
investor.
8,000 funds with about $2 trillion in 2008
$2.14 trillion in April 2012
Short selling, or shorting
Speculating that the value of a financial asset will decline and profiting from that decline by
selling that asset – only profitable if whatever you sold goes down in price
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The Nature of the Foreign Exchange Market
It is a global network
banks, brokers, and foreign exchange dealers connected by electronic communications
systems.
Growth of the foreign exchange market
In 1986, average total value of global foreign exchange trading was about $200 billion per
day.
In 1989, it soared to over $650 billion per day.
By 1994, it exceeded $1,000 billion per day.
By 2007, it exceeded $3 trillion a day.
Three most important trading centers
London, in 1994 $464 billion were traded each day
And London’s dominance has grown in recent years, as the size of the forex market has
expanded
In 2001 the UK had 31.8 per cent of the global share; this rose to 34.6 per cent by 2007,
36.8 per cent by 2010, and 41.1 per cent in 2013
The survey also showed that worldwide trading has shot up by more than a third since
the last report three years ago.
“Trading in foreign exchange markets averaged $5.3 trillion (£3.4 trillion) per day in April
2013 up from $4 trillion in April 2010 and $3.3 trillion in April 2007,” the BIS research
said.
New York, in 1994 $244 billion were traded each day
Tokyo, in 1994 $161 billion were traded each day
The Importance of London
Of the $3.98 trillion daily global turnover in 2009:
London accounted for around $1.36 trillion, or 34.1% of the total, making London by far the
global center for foreign exchange.
New York accounts for 16.6%,
Tokyo accounts for 6.0%.
Trading Centers 2013
Nearly 41 per cent of global forex trading goes through the intermediation of dealers in the
UK – by far the highest market share out of all trading hubs in the world.
The US is in second place on 18.9 per cent,
Japan and Singapore effectively tied in third on 5.6 per cent and 5.7 per cent respectively.
The Foreign Exchange Market
The market never sleeps
There are only 3 hours out of every 24 that the three major centers are shut down. During
this time trading continues in minor centers such as San Francisco and Sydney Australia
The market is a single market
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