chapter 31 international financial management chapter 3 the foreign exchange market michael connolly...

Chapter 3 1

International Financial Management

Chapter 3 The foreign exchange market

Michael ConnollySchool of Business Administration,

University of Miami

Michael Connolly © 2007

Chapter 3

The foreign exchange market

Nearly two trillion dollars a day of foreign exchange or forex trading daily makes the FX market one of the largest financial markets. It is made up of:

Daily global foreign exchange turnover in millions of USD (April 2004)Spots $621,073 33%

Forwards $208,333 11%FX Swaps $943,869 50%

Options $113,608 6%Total $1,886,883 100%

Source: Bank of International Settlements, Triennial Survey of Foreign Exchange and Derivatives Markets, April 2004.

Chapter 3

The foreign exchange market

The spot market in foreign exchange is for “immediate delivery” on the spot or within two business days.

Forward and future markets for future delivery at settlement prices and volumes determined today for a specific future maturity.

Chapter 3

The foreign exchange market Foreign exchange swap markets: firms

exchange or swap loans denominated in different currencies, usually for hedging purposes – acquiring a cash flow of payments in foreign currency that offsets receipts in foreign currency.

FX swaps are usually traded through a “swap dealer.”

Chapter 3

The foreign exchange market Options markets: a put is an option to sell

foreign exchange, and a call is an option to buy foreign exchange at an exercise price at or before some future specified date.

An American style option may be exercised on or before its expiration date

A European style option cannot be exercised before expiry.

Chapter 3

A floating exchange rate system

Supply and demand in the foreign exchange market determine the equilibrium exchange rate in a floating exchange rate system

The equilibrium rate is approximately the mid-point of the bid and ask rate, or (bid+ask)/2

The bid is what a bank pays for a unit of foreign exchange The ask is the price at which it sells a unit of foreign exchange

Chapter 3

Foreign exchange quotations

Forex is quoted in two ways: “European quote”: The foreign currency price of

one dollar “American quote”: The dollar price of a unit of

foreign currency

As a rule of thumb, 1/bid in one quotation equals the ask in the other, and 1/ask equals the bid.

American quotations European quotationsBID ASK BID ASK

EUR= 1.2184 1.2187 EUR= 0.8205 0.8207JPY= 0.009426 0.009434 JPY= 106 106.09GBP= 1.7669 1.7675 GBP= 0.5658 0.5660CHF= 0.563349 0.563507 CHF= 1.7746 1.7751

Source: SaxoBank, July 13, 2005.

Chapter 3

The bid-ask spread A dealer purchases at the bid rate and

sells at the offer or ask rate. The bid-ask spread (the difference

between the ask and the bid rates) represents profits to the foreign exchange dealer.

Source: Reuters, July 13, 2005.

Chapter 3

The bid-ask spread: An example At the bid and ask prices,

Rabobank trades 100 million euros. It buys 100 million euros at 1.2184 USD/€ and sells them at 1.2187

The bid-ask spread: 1.2187-

1.2184 = 0.0003, 3 basis points (or pips) in terms of foreign exchange

Rabobank’s dollar profits on the 100 million euros traded equal 0.0003x100,000,000 = $30,000

Chapter 3

A fixed exchange rate system A fixed exchange rate system

usually has a ceiling and a floor (intervention points).

The central bank purchases dollars at the floor price and sells dollars at the ceiling to maintain the exchange rate within a band.

At 1.01 pesos per dollar, the supply exceeds the demand. Consequently, the price falls to 1.00.

At 0.99, there is an excess demand for dollars, so the peso price of the dollar rises to 1.00, the equilibrium.

Chapter 3

A central bank purchase of dollars

When the supply of dollars is greater than the demand for dollars at the floor price, the central bank purchases dollars at the floor price and adds them to its foreign exchange reserves.

At a floor price of 0.99 pesos per dollar, the central bank purchases 3 million dollars at 0.99 pesos per dollar. The 3 million dollars are added to central bank reserves.

The central bank could sterilize the immediate impact on the domestic money supply by selling 0.99x$3,000,000 pesos in domestic bonds on the open market.

Chapter 3

A central bank sale of dollars When the demand for dollars

is greater than the supply of dollars at the ceiling price, the central bank draws from its reserves of dollars and sells them at the ceiling price.

The sale of reserves just equilibrates supply and demand at a price of 1.01 pesos per dollar.

Neutralization would entail a purchase of domestic bonds equal to 1.01x3,000,000 pesos. However, the loss of dollars would continue and ultimately lead to an exchange rate crisis.

Chapter 3

The monetary effects of Forex intervention

Sales of foreign exchange reserves automatically reduce the domestic money supply. Neutralization or sterilization policy: a central

bank buys a million dollars worth of Treasury Debt.

Purchases of foreign exchange reserves automatically increase the domestic money supply. Neutralization or sterilization policy: a central

bank sells a million dollars worth of Treasury Debt.

Chapter 3

The euro – irrevocably fixed exchange rates

The launching of the euro € Euro banknotes and coins have been in

circulation since January 1, 2002. The 12 member states of the euro zone were Belgium, Germany, Greece, Spain, France, Ireland, Italy, Luxembourg, the Netherlands, Austria, Portugal and Finland. On January 1, 2002 previous national currencies were withdrawn from circulation. At inception, it was worth $1.18, sank to $0.85, and then rose to a peak of $1.35, before stabilizing somewhat at $1.25.

Chapter 3

The euro – irrevocably fixed exchange rates

The launching of the euro € Consequences:

Costs of conversion are disappearing. The bid-ask spread has gone to zero for

banknotes and coins, and wire transfers are less expensive.

Forex risk management is no longer necessary in the euro zone.

Exchange rate volatility is zero, so options are worthless.

European interest rates have converged since currency risk in the euro zone is eliminated.

Capital markets are enjoying lower interest rates virtually everywhere in Europe.

Chapter 3

The SWIFT international clearing system

The Society for Worldwide Interbank Financial Telecommunications (SWIFT) has over a thousand members for whom it provides secure electronic transfer of monies and communication of messages internationally.

Each member bank has an electronic identification. When the bank ID is confirmed, transactions and communications can take place swiftly and securely since the computer system is a dedicated one.

Chapter 3

Clearing House Interbank Payments System

SWIFT is connected to CHIPS (Clearing House Interbank Payments System) in the U.S., which handles tens of thousands of transactions and transfers billions of dollars internationally per day.

Member banks make electronic payments in CHIP dollars during the day and at the end of the day the system nets the sums to be paid, then transfers only the net amounts.

Verification, confirmation, and authentification of transactions is also carried out by the CHIPS system .

Chapter 3

Purchasing power parity If a commodity can be purchased in one

place and sold in another without any transport costs, tariffs, nor transactions costs, its price should be the same in both markets. This is known as the law of one price. E.g.: The price of the product in yen is

multiplied by the spot dollar price of the yen to yield the same price in the United States.

jus SPP j

us

P

PS or

Chapter 3

Absolute purchasing power parity

Absolute PPP states that exchange rates correspond to consumer price indices of similar commodities in each country. That is:

The spot exchange rate can be inferred from commodity prices in different markets.

That is the reasoning underlying The Economist’s Big Mac hamburger standard.

j

us

P

PS

Chapter 3

The Big Mac Index

Chapter 3

Arbitraging Big Macs Arbitraging a Big Mac – buying “low” in China

and selling “high” in the U.S. - has high transactions costs. The arbitrage profits are:

The costs of arbitrage include: The purchase of yuan at the ask rate, . The purchase of a Big Mac in China at . The payment insurance and freight charges to ship

the Big Mac to the US, . The payment of U.S. customs duties on prepared

foods, . Finally, we sell the Big Mac in the U.S., paying the

sales tax there, .

askS

usct

us

ust

CP

uscuscaskusus tPStP 11

Chapter 3

The Law of One Price For the law of one price to exactly hold,

taxes, transports costs, import duties, and the bid-ask spread must all be zero.

In this case arbitrage in either direction imposes the strict law of one price, or:

Clearly, the condition does not hold for non-traded goods nor goods subject to to high transport costs and tariffs.

cus SPP

Chapter 3

Relative purchasing power parity Relative PPP requires only

that changes in the change exchange rate reflect the inflation rate differential between countries.

The expected appreciation of the foreign currency equals the expected inflation rate at home minus the expected inflation abroad.

jt

jt

jt

ust

ust

ust

t

tt

P

PPE

P

PPE

S

SSE

111

Chapter 3 24

If different movements in price levels cause movements in the exchange rate, it is natural to ask what causes different inflation rates internationally.

The old view that “inflation is too much money chasing too few goods” is not far from the truth. When money grows faster than income, prices tend to rise.

Consequently, countries that inflate their money supply relative to the supply of goods experience higher inflation and greater depreciation of their currencies.

The monetary approach to the exchange rate

Chapter 3 25

This is known as the monetary approach to the exchange rate.

The quantity theory of money states:

where M is the money supply (currency plus checking deposits), V is the income velocity of circulation of money, P is the price level - the implicit GDP deflator - and y is real GDP.

PyMV


Chapter 3 26

The price level is thus determined by:

An equivalent but insightful way of defining income velocity as the inverse of the demand for money as a fraction of income,

y

MVP

Vk

1


Chapter 3 27

That is, we may express the price level as the ratio of money supply to money demand:

where M is the money supply and ky is the demand for money.

The higher the money supply relative to money demand, the higher the price level.

ky

MP


Chapter 3 28

In terms of percentage changes over time, indicated by a dot over the variable, the rate of inflation is determined by growth in the money supply relative to growth in money demand:

Inflation is caused by “too much money chasing too few goods”, compounded any acceleration in the income velocity of money,

kyMVyMP


Chapter 3 29

In a steady state equilibrium, the demand for money as a fraction of income remains constant, we have the simple case of inflation caused by money chasing goods:

yMP


Chapter 3 30

Seigniorage finance of fiscal deficits is often known as “the printing press.”

In a sense, money is the root of all inflationary evil. It helps to understand why inflation bursts out here and there periodically.

Seigniorage finance of fiscal deficits

Chapter 3 31

To avoid inflation, any third grader as Governor of the Central Bank could follow a simple Milton Friedman rule to maintain a low, constant rate of growth in the money supply to avoid inflation.


Chapter 3 32

The problem is that the issue of money, seigniorage, is often the finance of last resort of the fiscal deficit.

For example, if the fiscal deficit is 10% of GDP, and 3% can be financed by borrowing at home, and 2% can be finance by borrowing abroad, the residual 5% finance must come from the “printing press” or seigniorage.


Chapter 3 33

New money must be issued when bond finance is insufficient:

Where is the sale of domestic bonds and is the sale of foreign bonds.

In this context, is interpreted as new seigniorage.

dt

dD

dt

dBTG

dt

dM

dt

dB

dt

dD

dt

dM


Chapter 3 34

Another way of expressing inflationary finance is as the inflationary tax. multiplying and dividing the left hand side of 3.6d by M yields:

where

is the percentage inflationary tax rate and M is the inflationary tax base.

dt

dM

M

1


dt

dD

dt

dBTG

dt

dM

MM

1

Chapter 3 35

There is a limit to the amount of inflationary tax since high inflation renders money a poor store of value. Consequently, money demand collapses i.e. velocity accelerates. The collapse in money demand exacerbates inflation. Inflationary episodes - Peru in the late 1980s - are often the result of collapsing real GDP, a fiscal deficit equal to 20% of GDP, financed solely my new money issue, and accelerating velocity. Inflation made the inti worthless, so the currency had to be changed by a currency reform adopting the new sole.

Limits to inflationary finance

Chapter 3 36

Countries that rely more heavily on inflationary finance witness currency depreciation. This suggests that purchasing power parity is founded on the growth of money supply relative to the growth of money demand.

Limits to inflationary finance

Chapter 3 37

China’s inflation is a puzzle. The percentage increase in China’s Consumer Price Index in 2005 was only 1.8%, despite high money growth 17.6%. This is due to some prices being controlled, particularly fuel and gasoline.

However, the implicit price deflator, a broader measure, rose 3.4% more accurately reflecting inflation.

A strong factor keeping inflation down, in addition to 9.9% real growth in GDP, is the rise in demand for money relative to income in China, 4.3% , a sign of financial deepening in Ronald McKinnon’s terminology.

The monetary approach to China

Chapter 3 38

There is greater financial intermediation due to an income elasticity of demand for money equal nearly to 2. Here is a summary for 2005.

• Increase in Implicit GDP Deflator 3.4%,

• Increase in Money supply (Money + Quasi-Money) 17.6%,

• Increase in Real GDP 9.9%,

• Increase in demand for money as a fraction of Nominal GDP 4.3%.


Chapter 3 39

These results are based on an application of the monetary approach to China:

Had money demand not increased relative to income by 4.3%, the inflation rate would have been 7.7%. In terms of the actual outcome:

3.4 = 17.6 - 9.9 - 4.3


kyMVyMP

Chapter 3 40

The great advantage of the quantity theory of money is that it provides a basis for estimating the difference in expected inflation rates, thus providing the foundation for the theory of purchasing power parity.

** yk

M

ky

M

S


Chapter 3 41

That is, the level of the exchange rate is determined by the relative money supplies and money demands.

Movements in the exchange rate are due to movements in relative price levels: Thus, relative purchasing power parity as a monetary phenomenon can be expressed as:

*** kyMkyMS


Chapter 3 42

More rapid monetary growth at home causes the home currency to depreciate, as does less rapid real economic growth. By the same token, a fall in domestic money demand compared to foreign money demand also depreciates the home currency. This is known as the monetary approach to the exchange rate.


Chapter 3 43

Deviations in exchange rates from purchasing power parity can, however, result from real shocks and changes in the terms of trade.

For that reason, it is useful to have a measure of the real exchange rate to capture changes in the exchange rate relative to the PPP rate. The concept of the real exchange rate is a simple one, measuring the costs of one country’s goods in terms of another’s.

The real exchange rate

Chapter 3 44

A bilateral real exchange rate is defined as:

Where P is the price level at home and SP* is the foreign price level expressed in terms of home currency.

When domestic prices rise relative to foreign prices, a real appreciation is said to take place. This means home goods can buy more foreign goods because a positive deviation from purchasing power parity has taken place.


*SP

PRER

Chapter 3 45

Real dollar depreciation A dramatic example of the real depreciation of the dollar in terms of the euro has been the increase in the dollar price of the euro from $0.90 to $1.55 from 2005 to 2008, while there has been little difference in the inflation rates. The euro has thus experienced a real appreciation, while the dollar has suffered a real depreciation.

Naturally, there are many currencies, so the best RER measurement is one that takes into account the weight of each currency in terms of trade. The IMF provides such a calculation.


Chapter 3

The real effective exchange rate The IMF’s real effective exchange rate

(RER) measures the price of a home country's goods in terms of foreign goods.

where : the product of the i terms, : the consumer price index (CPI) of the home

country, : the home currency price of currency i, : the CPI in country i, : the currency weights of the different countries.

P

iS

iP

iW

ni W

nn

WWWW

ii

n

i PS

P

PS

P

PS

P

PS

P

PS

PRER

...100100321

3322111

Chapter 3

The real effective exchange rate When the home country’s price rises

relative to other countries, a real appreciation takes place. It costs fewer home goods to buy foreign goods.

When foreign inflation is higher than domestic inflation, a real depreciation occurs. It costs more home goods to buy foreign goods.

Chapter 3

Futures contracts Futures are standardized contracts per

currency traded on the floor of an organized exchange, usually Chicago or Philadelphia. Futures have fixed maturity dates, usually less

than one year. Each future contract corresponds to a fixed

amount of foreign exchange, for example 100,000 €.

Prices are determined by the Chicago method of “open outcry”.

Initial margin is required as collateral. The position is “marked to market” daily.

Chapter 3

Futures contracts Margin maintenance is required - the broker may

make a “margin call” to restore margin collateral.

If not restored, the broker may liquidate the position.

A single commission is paid for the round trip purchase and sale, as well as the bid-ask spread.

There is no counterparty risk as the exchange guarantees the contracts.

Trading hours are regular exchange hours, but recently electronic trading takes place on a 24 hour basis.

While liquid, the futures market is small in size – delivery rarely takes place.

Chapter 3

Forward contracts Forwards, on the other hand, are

any size and maturity desired, with maturities occasionally longer than a year.

For this reason, the forward market is known as the over the counter market (OTC). Trading occurs between firms and banks

in the interbank market, with prices determined by bid ask quotes - the spread providing profits for the banks.

Chapter 3

Forward contracts Standing bank “relations” are necessary,

but not margin collateral. Banks are connected 24 hours a days via

the SWIFT system and negotiate forward prices directly.

In volume, the forwards market dwarfs the futures markets.

It is mainly used by firms to hedge operational exposure.

Chapter 3

Forward contracts for hedging International businesses hedge their

risks through the forward market. Forwards give them the flexibility in terms of size of contract and maturity dates.

Forwards do not require the firm to tie up working balances in margin deposits.

In forward markets, money markets, and swap markets, there is counterparty risk, broadly defined as downgrading, either partial or complete, of the terms of financial contract.

Chapter 3

Commodity and Forex futures Similarities:

Futures and forward contracts are agreements to exchange an underlying asset, such as gold, at an agreed price at some future date.

Futures and forward contracts may be used either to manage risk or for speculative purposes.

Chapter 3

Commodity and Forex futures Differences

A forward contract is negotiated directly between counterparties and is therefore tailor-made, whereas futures contracts are standardized agreements that are traded on an exchange.

Although forward contracts offer greater flexibility, there is a degree of counterparty risk, whereas futures contracts are guaranteed by the exchange on which they are traded.

Chapter 3

Commodity and Forex futures Differences

Because futures contracts can be sold to third parties at any point prior to maturity, they are more liquid than forward contracts.

Futures prices are determined by the carrying costs at any time. These costs include the interest cost of borrowing gold plus insurance and storage charges.

The cost of a futures contract is determined by the "initial margin", the cash deposit that is paid to the broker.

Chapter 3

Positions in forward contracts A speculative position in a forward

contract is the uncovered forward purchase or sale of an asset or commodity for delivery at some specified date in the future at a price, F, determined today.

A short sale may be financed by borrowing the asset from a broker to be returned later.

Chapter 3

A short position in gold A short position:

A short position is the sale of gold for delivery at maturity at a price F. The short seller covers the position by buying at S in the spot market at maturity.

The profits/losses per unit of gold are F-S per metric ton, the contract unit in gold.

If the spot price of gold is greater than F the trader loses S-F per ton in covering the forward contract. If F>S, the trader gains.

The payoff for a forward sale of gold at the price F is shown by the negatively sloped line.

Chapter 3

A short position in gold: numerical example

Suppose you sell 500 ounces of gold short for delivery in the futures market at $422 in three months. In a short sale, an investor borrows shares or gold from a brokerage firm and sells them, hoping to profit by buying them back at lower prices.

If they rise, the investor faces a loss. Uncovered short sales are those shares or gold that have been borrowed and sold, but not yet covered by repurchase.

Chapter 3

Gains from a short sale of gold If the spot price falls to $400, three

months later when you cover your short position, you gain $22 per ounce or $11,000.

Chapter 3

Losses from a short sale of gold If the price of gold rises in the spot

market to $444, you lose $22 an ounce, or $11,000.

Chapter 3

A long position in gold A long position

A long position in gold is a purchase of gold for forward delivery.

If the spot price upon maturity is higher than the forward price, the trader gains S-F per ton.

If the spot price is less, the trader loses F-S.

The payoff is indicated by the positively sloped line.

Chapter 3

Gains from a long position in gold Suppose you buy 500 ounces of gold at

$422 for delivery in three months, and the spot price rises to $442. You gain $20 per ounce, or $10,000 by paying $20 per ounce below the spot price.

Chapter 3

Losses from a long position in gold Suppose you buy 500 ounces of gold at

$422 for delivery in three months, but the spot price falls to $402. You lose $20 per ounce, or $10,000 by paying $20 per ounce above the spot price.

Chapter 3

A hedged position in gold A hedged position

A hedged position is the combination of a long and a short position of the same amount and maturity of a security or asset.

What is gained on the long position is lost on the short position, and vice versa.

Graphically, the hedged position is the sum of the long and short positions, yielding the horizontal axis in the figure on the right - a zero payoff.

Chapter 3

The cost of carry Take the following steps:

Borrow S at interest rate r today.

Purchase one unit of a security for S today.

Sell forward at F for delivery of one unit of the security in one year.

At maturity, cash in the dividend, k, and deliver the security at the agreed upon price, F, then

Pay off the loan.

Chapter 3

The cost of carry The no profit arbitrage condition requires:

where

is the cost of carry.

In terms of percentages, the gain on the forward sale is just offset by the cost of carry:

The difference between the cost of borrowing and the rate of return is the cost of carry as a percent.

SkrSF

Skr

krS

SF

Chapter 3

Covered interest arbitrage It is possible to risklessly arbitrage short

terms funds taking advantage of interest rate differentials in Treasuries relative to FX discounts or premia in the forward market.

In general, if UK Treasuries pay 2% more than US Treasuries, and the forward pound is at less than a 2% discount, say 1%, an arbitrage gain can be realized, in this case, 1% .

Two percent is gained on the interest differential and one percent lost on the forward sale of the pound.

Chapter 3

Covered interest arbitrage To focus on strict interest rate parity –

the no arbitrage profit condition - we ignore the foreign exchange and Treasury bid-ask spreads. To take advantage of small profit opportunities by arbitraging short term liquid capital, take the following two steps:

Step I. Compare dollars to dollars1. Route one: With one million dollars, buy

90 day US Treasury bills. At maturity, they will yield principal plus interest of million dollars. Each dollar invested yields dollars – quarterly rate - in 90 days.

usR1

usR

Chapter 3

Covered interest arbitrage2. Route two:

a. Buy million pounds sterling in the spot market at S. b. Invest pounds sterling in 90 day U.K. T-bills, yielding million pounds in three months.c. Sell pounds sterling in the forward market at F, yielding

million dollars at settlement in three months.

S1

ukRS 11

S1

ukRS 11

ukRS

F

1

Chapter 3

Covered interest arbitrage Step II. Select the higher dollar

return If

place short term capital in UK Treasuries due to the higher yield. That is, sell 90 day U.S. Treasuries from your portfolio, buy pounds spot, buy U.K. 90 day Treasuries, sell the pound proceeds forward for delivery in 90 days.

You have completed a round trip and gained the covered arbitrage differential.

ukus RS

FR

11

Chapter 3

Covered interest arbitrage Step II. Select the higher dollar

return If

place short term capital in U.S. Treasuries due to the higher yield. That is, sell 90 day U.K. Treasuries from your portfolio, buy dollars spot, buy U.S. 90 day Treasuries, sell the dollar proceeds forward for delivery in 90 days.

You have completed a round trip and gained the covered arbitrage differential.

ukus RS

FR

11

Chapter 3

Covered interest arbitrage

However, if

covered interest rate parity holds: there are no unexploited arbitrage profit opportunities, so do nothing!

ukus RS

FR

11

Chapter 3

Covered interest arbitrage

Covered interest parity can also be expressed in terms of the percentage interest rate differential versus the percentage premium or discount on the forward pound.

which says that the interest rate differential in favor of U.S Treasuries is just (approximately) offset by the premium on the pound sterling.

ukukus RS

SFRR

1

Chapter 3

Covered interest arbitrage Covered interest parity can be depicted

graphically:

which says that on the interest rate parity line, the 1% interest rate differential in favor of U.S Treasuries is offset by the 1% premium on the pound sterling.

Chapter 3

Uncovered interest arbitrage Uncovered interest arbitrage takes place when the

exchange rate risk is not covered in the forward market. The investor sells the proceeds at the subsequent spot rate in 90 days.

Since , it is generally true that expected arbitrage gains are zero when interest rate parity holds.

which says that the 1% interest rate differential in favor of U.S Treasuries is offset by the 1% premium on the pound sterling.

9090 FSE

Chapter 3

Uncovered interest arbitrage An uncovered interest arbitrageur gains when

the sale of foreign exchange is at a higher than expected price, for example at $1.27 rather than $1.25.

Chapter 3

Uncovered interest arbitrage An uncovered interest arbitrageur loses when

the sale of foreign exchange is at a lower than expected price, for example at $1.20 rather than at $1.25.

Chapter 3

A foreign exchange swap In a direct counterparty swap, a German firm

borrows euros and a U.S. firm borrows dollars. They swap the loans, the German firm servicing the dollar loan, the U.S. firm servicing the euro loan. Each firm hedges its ongoing receipts in the foreign currency at a lower borrowing rate than it could obtain by direct borrowing.

Chapter 3

A call option – an option to buy forex

The Black-Scholes formula for the premium for a FX call option:

where and

C = the value of the European style FX call option T = the time to option’s maturity, in years S = the spot price of the underlying foreign currency X = the option’s exercise price r = the continuously compounded US risk-free interest rate = the continuously compounded foreign risk-free interest rate = volatility (the standard deviation of the returns on the

exchange rate)

1 2T rTC Se N d Xe N d

2

1

ln / / 2S X r Td

T

2 1d d T

Chapter 3

A call option – an option to buy forex

A call option has greater instrinsic value – if immediately exercised - the further it is in the money.

Chapter 3

A put option – an option to sell forex

The Black-Scholes formula for the premium for a FX put option:

where and

P = the value of the European style FX put option T = the time to option’s maturity, in years S = the spot price of the underlying foreign currency X = the option’s exercise price r = the continuously compounded US risk-free interest rate = the continuously compounded foreign risk-free interest rate = volatility (the standard deviation of the returns on the exchange

rate)

2

1

ln / / 2S X r Td

T

2 1rT TP Xe N d Se N d

2 1d d T

Chapter 3

A put option – an option to sell forex

A put option has greater instrinsic value – if immediately exercised - the further it is in the money.

Chapter 3

Conclusion

The foreign exchange market provides for currency conversion and hedging against unanticipated changes in the exchange rate.

The resources devoted to the foreign exchange market are the bid-ask spread and commissions.

The movement toward common currency areas, such as the euro, facilitate trade in commodities and assets by reducing the transactions costs associated with different currencies.

chapter 31 international financial management chapter 3 the foreign exchange market michael connolly...

Documents