Chapter 16
Foreign Exchange Derivative Markets
Outline
Foreign Exchange Markets
Institutional Use of Foreign Exchange Markets
Exchange Rate Quotations
Types of Exchange Rate Systems
Eurozone Arrangement
Abandoning the Euro
Virtual Currencies
Factors Affecting Exchange Rates
Differential Inflation Rates
Differential Interest Rates
Central Bank Intervention
Forecasting Exchange Rates
Technical Forecasting
Fundamental Forecasting
Market-Based Forecasting
Mixed Forecasting
Foreign Exchange Derivatives
Forward Contracts
Currency Futures Contracts
Currency Swaps
Currency Options Contracts
Use of Foreign Exchange Derivatives for Speculating
International Arbitrage
Locational Arbitrage
Triangular Arbitrage
Covered Interest Arbitrage
Chapter 16: Foreign Exchange Derivative Markets ❖ 2
Key Concepts
1. Identify factors that influence exchange rates.
2. Explain how various foreign exchange derivatives can be used to hedge against exchange rate
movements.
3. Explain how arbitrage can assure that currency values are not mispriced.
POINT/COUNTER-POINT:
Do Financial Institutions Need to Consider Foreign Exchange Market
Conditions When Making Domestic Security Market Decisions?
WHO IS CORRECT? Use the Internet to learn more about this issue and then formulate your own
opinion.
Questions
1. Exchange Rate Systems. Explain the exchange rate system that existed during the 1950s and 1960s.
How did the Smithsonian Agreement in 1971 revise it? How does today’s exchange rate system
differ?
2. Dirty Float. Explain the difference between a freely floating system and a dirty float. Which type is
more representative of the United States system?
3. Impact of Quotas. Assume that European countries impose a quota on goods imported from the
United States, and that the United States does not plan to retaliate. How could this affect the value of
the euro? Explain.
Chapter 16: Foreign Exchange Derivative Markets ❖ 3
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ANSWER: A quota on goods imported from the United States by Europe will reduce the supply of
euros for sale (to be exchanged for dollars) and places upward pressure on the euro.
4. Impact of Capital Flows. Assume that stocks in the United Kingdom become very attractive to U.S.
investors. How could this affect the value of the British pound? Explain.
5. Impact of Inflation. Assume that Mexico suddenly experiences high and unexpected inflation. How
could this affect the value of the Mexican peso according to purchasing power parity (PPP) theory?
6. Impact of Economic Conditions. Assume that Switzerland has a very strong economy, placing
upward pressure on both inflation and interest rates. Explain how these conditions could place
pressure on the value of the Swiss franc, and determine whether the franc’s value will rise or fall.
7. Central Bank Intervention. The Bank of Japan desires to decrease the value of the Japanese yen
against the U.S. dollar. How could it use direct intervention to do this?
8. Conditions for Speculation. Explain the conditions under which a speculator would like to take a
speculative position in which it will invest in a foreign currency today, even when it has no use for
that currency in the future.
9. Risk from Speculating. Seattle Bank just took speculative positions by borrowing Canadian dollars
and converting the funds to invest in Australian dollars. Explain a possible future scenario that could
adversely affect the bank’s performance.
Chapter 16: Foreign Exchange Derivative Markets ❖ 6
Managing in Financial Markets
You are the manager of a stock portfolio for a financial institution, and about 20 percent of the stock
portfolio that you manage is in British stocks. You expect the British stock market to perform well over
the next year, and you plan to sell the stocks one year from now (and will convert the British pounds
received to dollars at that time). However, you are concerned that the British pound may depreciate
against the dollar over the next year.
a. Explain how you could use a forward contract to hedge the exchange rate risk associated with
your position in British stocks.
b. If interest rate parity holds, does this limit the effectiveness of a forward rate contract as a hedge?
c. Explain how you could use an options contract to hedge the exchange rate risk associated with
your position in stocks.
spot rate.
d. Assume that while you are concerned about the potential decline in the pound’s value, you also
believe that the pound could appreciate against the dollar over the next year. You would like to
benefit from the potential appreciation of the pound but wish to hedge against the possible
depreciation of the pound. Should you use a forward contract or options contracts to hedge your
position? Explain.
Problems
1. Currency Futures. Use the following information to determine the probability distribution of per
unit gains from selling Mexican peso futures.
Spot rate of peso is $.10.
Price of peso futures per unit is $.102 per unit.
Your expectation of peso spot rate at maturity of futures contract is:
Chapter 16: Foreign Exchange Derivative Markets ❖ 7
Possible Outcome for
Future Spot Rate Probability
.09 10%
.095 70%
.11 20%
ANSWER:
Possible Outcome Gain per Unit from
for Future Spot Selling Futures
Rate Contracts Probability
2. Currency Call Options. Use the following information to determine the probability distribution of
net gains per unit from purchasing a call option on British pounds:
Spot rate of the British pound = $1.45
Premium on the British pound option = $.04 per unit
Exercise price of British pound option = $1.46
Your expectation of British pound spot rate prior to the expiration of option is:
Possible Outcome for
Future Spot Rate Probability
$1.48 30%
1.49 40%
1.52 30%
ANSWER:
Gain per Unit from
Possible Outcome Purchasing a Call Option
for Future Spot (After Accounting for
3. Locational Arbitrage. Assume the following exchange rate quotes on British pounds:
Bid Ask
Orleans Bank $1.46 $1.47
Kansas Bank 1.48 1.49
Explain how locational arbitrage would occur. Also explain why this arbitrage will realign the
exchange rates.
Chapter 16: Foreign Exchange Derivative Markets ❖ 9
b. What is the risk of hedging with currency futures?
c. How could Carson use currency options to hedge its position?
d. Explain the advantage and disadvantage to Carson of using currency options instead of currency
futures.
Solution to Integrative Problem for Part 5
Choosing Among Derivative Securities
1. The scenario suggests that the United States will rebound from the recession, which should place
upward pressure on interest rates (primarily because of an increase in the demand for loanable funds,
as spending increases). If interest rates rise, the savings institution should hedge. Assuming that
2. Economic conditions will likely improve, so that stock prices will rise. While this is a subjective
3. Since interest rates will likely increase, there is reason to consider hedging the bond portfolio. The
proper hedge would be to sell bond index futures. The pension fund would not wish to buy bond
index futures because it would be even more exposed to interest rate risk.
© 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
4. A short position (selling bond index futures) in a U.S. bond index will not necessarily be an effective
hedge against the interest rate risk of non-U.S. bonds. Interest rates in the United Kingdom will not
always move in tandem with U.S. interest rates. Therefore, prices of these bonds could decline even
more than those of U.S. bonds, as the respective interest rates in the U.K. could possibly increase by a