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Chapter 31
THE MARKET FOR
FOREIGN EXCHANGE
RATE RISK CONTROL
INSTRUMENTS
Foreign Exchange Rates
The amount of one currency that can be
exchanged for a unit of another currency
Exchange Rate Quotation Conventions
Direct quote
Indirect quote
Foreign Exchange Risk
Foreign exchange risk refers to the risk of
adverse movements in the exchange rate.
Assets denominated in a foreign currency
expose investors to exchange rate risk.
Liabilities denominated in foreign currency
expose borrowers to exchange rate risk.
Spot Market
The market for the settlement of foreign
exchange transactions within two business
days.
Appreciation
Depreciation
American terms
European terms
Spot Exchange Rates
Foreign exchange rates between major
currencies are free to float, with market
forces determining the relative value of a
currency.
Spot exchange rates adjust to
compensate for the relative inflation rate
between two countries.
Cross rates
The exchange rate between two countries
except the U.S.
Dollar price of currency X
Dollar price of currency Y
Cross rate mispricing leads to triangular
arbitrage
it involves positions in three currencies
Foreign Exchange Dealers
Large international banks act as dealers in
the foreign exchange market
Dealers are linked by telephone and cable
and various information transfer services
Revenue sources:
Bid-ask spread
Commissions
Trading profits
The Euro
European Union
15 European member countries
Treaty on European Union (1992)
established monetary union
Maastricht Treaty
single currency and monetary policy
European Central Bank (ECB)
Economic and Monetary Union (EMU)
Entry Requirements
The annual fiscal deficit not to exceed 3%
of GDP.
Cumulative public debt not to exceed
60% of GDP.
Other economic, political, and social
requirements
Approval by voters of a country seeking
membership
The Euro
Adopted on January 1, 1999
fixed conversion rate against member
country’s national currencies and relative to
euro
free to fluctuate against all other currencies
January 1, 2002
physical replacement of member countries’
currencies with euro
Outcomes
Since Birth of Euro
The euro has been viable and fairly stable.
It has developed a very large public and
cooperate capital market denominated in euros.
Since its inception at $1.17, the euro has
weakened considerably, reaching a low of
$0.8229 on October 27, 2000.
Potential participants include the U.K. and
Sweden; Denmark voted against joining the
EMU on September 28, 2000.
Instruments for Hedging
Foreign Exchange Risk
Currency
Currency
Currency
Currency
Forward Contracts
Futures Contracts
Options
Swaps
Currency Forward
Contracts
Forward Contract Maturities
maturity of less than two years
longer dated forward contracts have large
bid-ask spreads
Pricing Currency Forward
Contracts
The forward exchange rate is determined
from the spot exchange rate and the
interest rates in the two countries.
Interest rate parity implies that, by
hedging in the forward market, an
investor will receive the same domestic
return whether investing domestically or
in a foreign country.
Interest Rate Parity
Relationship between the spot exchange
rate, the interest rates in two countries,
and the forward rate.
 1  iA  

F  S 
 1  iB  
The arbitrage process which forces
interest rate parity is called covered
interest arbitrage.
Currency Futures
Contracts
Trading Locations
Underlying Currencies
Contract Size
Contract Maturity
Currency Option Contracts
Underlying Currencies
spot currency
currency futures
Currency Options Trading
organized exchange
over-the-counter
Trading Locations
Contract Specifications
Currency Swaps
A package of currency forward contracts.
Allows hedging of long-dated foreign
exchange risk.
More traditionally efficient than futures or
forward contracts.
Used to arbitrage opportunities in global
financial markets for raising funds at lower
cost than in the domestic market.