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INTERNATIONAL MONETARY
AND
FINANCIAL ECONOMICS
Third Edition
Joseph P. Daniels
David D. VanHoose
Copyright © South-Western, a division of Thomson Learning. All rights reserved.
The Forward
Currency Market
and Financial
Arbitrage
Managing Foreign Exchange Risk
Foreign Exchange Risk
• Foreign exchange risk is the risk that the value
of a future receipt or obligation will change
due to a change in foreign exchange rates.
• Because these international transactions span
time, foreign exchange risk can arise.
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Sources of Risk
• Transaction exposure: the risk that the domestic cost
or proceeds of a transaction may change.
• Translation exposure: (also known as accounting
exposure) the risk that the translation of value of
foreign-currency-denominated assets is affected by
exchange rate changes.
• Economic exposure: (also known as operating) the
risk that exchange rate changes may affect the present
value of future income streams.
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Hedging and Speculating
• Hedging is the act of offsetting an exposure to
risk.
• Covered Exposure refers to a foreign exchange
risk that has been completely eliminated with a
hedging instrument.
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Long and Short Positions
• Traders are long in a foreign currency if the
value of their foreign-currency-denominated
assets exceeds the value of their foreigncurrency-denominated liabilities.
• Traders are short in a foreign currency if the
value of their foreign-currency-denominated
assets is less than the value of their foreigncurrency-denominated liabilities.
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Hedging
• There are a number of instruments that can be
used to hedge foreign exchange risk.
• Chapter 4 deals with the forward markets,
while Chapter 5 introduces foreign exchange
futures, options, and swaps.
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Forward Market
• The forward market is the market for
contracts that ensure the future delivery of a
currency at a specified exchange rate.
• Typical maturity is 1,3,6, 9 and 12 months.
• The forward rate is determined by the forces
of supply and demand in the forward market.
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The Forward Market for the Pound
• Initially the forward
market for the pound is
in equilibrium at the
forward rate or 1.620.
• An increase in the
demand for the pound
forward shifts the
demand curve to the
right.
• This results in an
appreciation of the
pound.
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Forward Premium
• The forward premium or discount is the difference
between the forward exchange rate and the spot
rate, expressed as a percentage of the spot rate.
• The standard forward premium is the forward
premium or discount annualized. the formula for
the standard forward premium is:
FN  S   12 100
S
N
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Example
• For example, suppose the spot rate is 1.4926
(SFr/$) and the 3-month forward rate is
1.4887.
• The forward premium on the Swiss franc is:
[(1.4887-1.4926)/1.4926]•(12/3)•100 =
-1.05%
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Premium versus Discount
• Note that in this example, the exchange rate is
expressed as SFr/$, i.e., the Swiss franc price
of the dollar.
• Because the forward price of the dollar is less
than the spot price of the dollar, we say that the
dollar is selling at a discount.
• Likewise, we say that the Swiss franc is selling
at a premium.
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The Forward Rate as a Predictor
• Because the forward rate is determined by the supply
of and demand for the future delivery of a currency, it
may convey information about the future spot rate.
• Many empirical studies indicate that there is some comovement between the forward and spot rate.
• The co-movement is less than one-to-one; thus the
forward rate has limited ability in forecasting the
future spot exchange rate.
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The International Flow of Funds
• If there were no restrictions on capital flows, we would
see saver move funds from one nation to another in
search of the greatest exchange-rate adjusted returns.
• This flow of funds could potentially affect interest
rates and exchange rates.
• Individuals who save supply loanable funds.
• Those who borrow demand loanable funds.
• In a competitive market, the interest rate is determined
by the supply and demand of loanable funds.
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The Market for Loanable Funds
• In a competitive market, the
supply and demand for
loanable funds determines the
equilibrium interest rate.
• If the interest rate were R2, the
quantity of loanable funds
demanded would exceed the
quantity of loanable funds
supplied. Hence the interest
rate would rise.
• The equilibrium rate is R1. At
R1, the quantity supplied equals
the quantity demanded.
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A Shift in the Supply of Loanable Funds
• Initially the market for
loanable funds is in
equilibrium at interest
rate RA.
• The shift in the supply
of loanable funds from
SA to SB illustrates a
decline in the supply of
loanable funds in this
economy.
• A new equilibrium is
reached at the higher
interest rate RB.
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Covered Interest Parity
• Covered interest parity is a condition that relates
interest differentials to the forward premium or
discount.
• It begins with the no-arbitrage condition when
exchange risk is covered with a forward exchange
contract:
(1+R) = (1+R*)(F/S)
• The condition can be rewritten, and with a slight
approximation, yields:
R - R* = (F-S)/S.
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Covered Interest Parity
• CIP is helpful in understanding short-term
market movements.
• As an equilibrium condition, it aids in our
understanding of potential adjustments in
various financial markets.
• These adjustments occur if there is a flow of
savings from one nation to another.
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Covered Interest Arbitrage
• Suppose the U.S. interest rate is 4.5% while the U.K. rate on a
similar instrument is 2.25% (both for an annual debt
instrument with similar risk characteristics). Hence, a saver
would gain an additional 2.25% on the U.S. instrument.
• suppose at the same time, the current spot rate is 1.6000 ($/£)
and the one-year forward rate is 1.6200. The saver would gain
1.25% on the pound. [(1.62 – 1.60)/1.60 • 100].
• The currency gain on the pound falls short of the interest
differential in favor of the U.S. financial instrument. Hence,
the saver should shift fund to the United States. This outcome
is illustrated by point B in the following diagram.
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The Covered-Interest-Parity Grid
• The covered-interest parity
grid illustrates all of the
interest differential and
forward premium or
discount combinations that
satisfy CIP
• These combinations lie on
or near the 45 degree line.
• The narrow band around the
45 degree line illustrates
transaction and opportunity
costs.
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Example
• In out previous example, the saver will shift
funds from the United Kingdom to the
United States.
• The reallocation of funds by savers like the
one in our example could influence the spot
rate of exchange, the forward rate of
exchange, the U.S. interest rate and the U.K.
interest rate.
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The Spot Market for the Pound
• As individuals move
funds from pounddenominated instruments
to dollar-denominated
instruments, there is an
increase in the demand for
the dollar.
• The increase in the
demand for the dollar is
equivalent to an increase
in the supply of the pound.
• The pound depreciates.
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The Forward Market for the Pound
• Individuals will desire to
purchase the pound
forward when the dollardenominated financial
instruments mature.
• There is an increase in the
demand for the pound in
the forward market.
• The pound appreciates in
the forward market.
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The U.K. Loanable Funds Market
• The flow of funds out
of the United Kingdom
is illustrated by the
decrease in the supply
of loanable funds.
• Because of the
decrease in the supply
of loanable funds, the
U.K. interest rate rises
to R2.
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The U.S. Loanable Funds Market
• The flow of funds
into the United
states increases the
supply of loanable
funds.
• The increase in
supply lowers the
U.S. interest rate to
R2.
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The Spot Market
• Savers reallocate funds to pound-denominated
financial instruments.
• This results in an increase in the demand for
the pound (as the demand for the pound is a
derived demand).
• The demand curve shifts to the right and the
pound appreciates relative to the dollar.
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Uncovered Interest Parity
• If foreign exchange risk is not hedged when
purchasing a foreign financial instrument, the
transaction is said to be uncovered.
• Uncovered interest parity (UIP), is a condition
relating interest differentials to an expected
change in the spot exchange rate of the
domestic currency.
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Uncovered Interest Parity
• If a saving decision is uncovered, traders base
their decision on their expectation of the future
spot exchange rate.
• The expected future spot exchange rate is
e
expressed as S +1. UIP is represented as:
e
R – R* = (S +1 – S)/S.
• In words, the right-hand-side of the UIP
condition is the expected change in the spot
rate over the relevant time period.
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Deviations from UIP
• If a nation’s currency value is highly variable,
individuals may be less confident about their
expectations, making the purchase of a financial
instrument a much riskier proposition. This risk is
called currency risk.
• In addition, there may also be country risk associated
with the purchase of the financial instrument.
Country risk is the possibility of loss due to political
uncertainty in the nation.
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Risk Premium
• Because one instrument may be a riskier
proposition than another financial instrument,
borrowers may have to offer a higher rate of
return on the debt instruments they issue.
• Risk premium is an increase in the return
offered on a higher-risk financial instrument to
compensate individuals for the additional risk
they undertake.
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Risk Premium and UIP
Using ρ to denote
risk premium, the
UIP condition can be
rewritten as:
S S
R  R* 
 .
S
e
1
If the domestic instrument is the higher-risk
instrument, then the positive interest differential
should equal the expected rate of depreciation of the
domestic currency plus an additional amount to
compensate individuals for the additional risk they
assume with the purchase of the domestic
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instrument.
Foreign Exchange Market Efficiency
• We can link the CIP condition and the UIP condition
through the interest rate differential as:
(F-S)/S = R-R* = (Se+1–S)/S.
• Through simplification, this can be restated as:
F = Se+1.
• The uncovered and covered interest parity conditions
imply that the expected spot rate should equal the
forward exchange rate at the time of the settlement of
the forward contract.
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Market Efficiency
• Forward exchange market efficiency is a situation in
which the equilibrium spot and forward rates adjust
quickly to reflect all available information.
• Hence, the forward premium or discount should equal
the expected rate of currency depreciation and the
risk premium.
• This implies that, on average, the forward exchange
rate should predict on average the expected future
spot exchange rate.
• Most studies conclude that risk premium is important
but are divided on whether foreign exchange markets
are efficient.
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International Financial Markets
• International capital markets are markets for crossborder exchange of financial instruments that have
maturities of one year or more.
• International money markets are markets for crossborder exchange of financial instruments with
maturities of less than one-year.
• Bonds are long-term promissory notes.
• Equities are ownership shares that might or might not
pay the holder a dividend, whose values rise and fall
with savers’ perceived value of the issuing enterprise.
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Eurocurrencies
• Eurocurrencies are bank deposits denominated in a
currency other than that of the nation in which the
bank deposit is located.
• The Eurocurrency market is a market for the
borrowing and lending of Eurocurrency deposits.
• The Eurocurrency market and the forward exchange
market are highly integrated. Because of this,
Eurocurrency interest differentials and the forward
premium or discount tend to be in equilibrium.
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