FNCE 219 Notes - Professor Urban J. Jermann PDF

Preview

Summary

Professor Urban J. Jermann...

Description

FNCE 219 Notes Forward Exchange Rate Chapter)

Currency Options Chapter)

HERE

Class Notes- 10/8) Napa Wine example:

Asian options are cheaper as upside is more limited. Napa Wine is indirect exposure to FX risk that is non linear.

Arbitrage opportunity:

Need a forward to be in middle of the strike prices of the put and the call options, otherwise there is arbitrage. Introduction Slides Notes) 

Interest rate, foreign exchange risk and credit risk is top three reason for using derivative

COVID 19 disruption in liquidity: margin call requirements, corporate need for short term funding, large decline in equity markets.

Class 2 Notes)   

FX market in 2019, size/turnover, 6590 billion dollars. Only do every three years changed. Stocks traded on exchange is about 0.24 trillion, maybe increase it 2-3x to account for total trading per day. Foreign exchange swaps is the main driver of growth, banks using swaps more. Spot transactions also driving growth- high frequency traders.



2015- some banks suffered losses and closed forex trading to retail investors due to Swiss central bank giving up its peg to the Euro, led to large movements in currency- Swiss franc jumped 30%



China has capital controls and reduces volume. HKD is integrated markets, similar market place so you can add these up. Dollar is heavily transacted due to stable currency, reserve currency for many central banks, used not just for US transactions and for international transactions (American firms deal with European firms, use dollars, OR commodities) Use dollar as intermediate currency, vehicle currency, to organize transactions efficiently UK/London has highest share of FX turnover London has some advantage due to similar time zones as US compared to Asia



  

     



  

Reporting dealers= major banks Non reporting banks- smaller banks, may offer some FX products but are not active in wholesale market, so go through the big banks Institutional investors- mutual funds or pension funds Market makers are players that constantly buy and sell, new entrants are high frequency trading firms that are almost like market makers XTX Markets is a high frequency trader that falls into this category Broker is a intermediary between dealer banks, only available to dealer banks (private market for big traders), EBS or Reuters. Used to be done by voice, but now it is all electronic and instant. Hedge funds and high frequency traders use a primer broker (one of the large dealer banks- offer trading services). Most useful is HFT is allowed to trade directly on EBS/Reuters. Can trade in most liquid markets. Multi dealer platform allows you to see different prices between banks, put pressure on the spreads. Retail aggregator- for retail investors, new companies upstarts in trading, allow investors to trade with leverage. Continuing trends: Concentration of FX trading in financial hubs and increased electronic trading



Quotes on Bloomberg is not exact price you would get, indication that dealers are trading at right now.

 

Exchange rates go down during times of crisis July- EU announced borrow money to help countries most affected by COVID, so the Euro exchange rate jumped. They thought European Union would fall apart at next crisis. Pound flash crash in 2016





 



 



Eurocurrency market is developed as way of avoiding regulations: US used to have interest rate ceiling, at some point, actual interest rate would go higher and people would go offshore Now there are far fewer regulatory differences. LIBOR is now more general, not just interbanks, banks borrowing from other parties

Trimmed average gets rid of idiosyncratic effects with each bank- unsecured borrowing rate, want LIBOR to be representative of overall market. Makes it harder for banks to manipulate LIBOR. Trading manipulation: moving around LIBOR rates by deliberately submitting incorrect rates, derivative traders wanted to take advantage of very small movements in LIBOR. Reputation manipulation: some banks have to borrow at very high rates due to financial difficulty, but they don’t want to submit a high rate that signals it is in trouble. Therefore, it submits an artificially low rate. Fed Fund Rate isn’t really needed much, low volume, banks use it to borrow reserves but they have plenty of reserves, so Fed Fund rate is not a good replacement for LIBOR.

 

 



T Bill rate is extremely safe rate, has additional factors driving it. If T bill rates go down a lot during crisis, banks don’t want interest rate to go down. Fed wants to have an option of switching target, if its target rate is used by everyone then makes life difficult.

SOFR will not give banks a hedge during crisis. In serious crisis, credit risk goes up a lot so LIBOR will spike, banks would have been more fragile if they were using SOFR More risky for banks to give loans on SOFR, may not give loans for longer maturities.

Interest rates across currencies don’t have to be the same, but once you hedge away currency risk, two are the same.



You get the same return in a domestic return as a foreign investment once FX risk is covered away, interest rates should be equalized. If you don’t want to bear currency risk, you will lose the higher interest rate in the foreign currency High interest rate means forward discount, low interest rate currency means forward premium. Transaction costs (bid ask spread) and credit risk means that interest rate parity won’t hold perfectly in the real world. Credit risk= other side could be gone in a year’s time. Could just collateralized transactions to avoid credit risk. Could invest in repo transaction (collateralized/Gov securities) instead of depositing at bank (could go bankrupt). Credit risk in forwardcounterparty could be gone in a year, but that can also be collateralized. Should get pretty close to 1 for IRP as big players get low transaction costs.



Costs of hedging via forwards: spread fees of forward and opportunity cost.

    



The bid ask spread additional for a forward isn’t actually that great on top of spot spreads:



In the spot market, CNY is undervalued because in NDF market, investors are paying more for CNY (less CNY required per US dollar), and vice versa. We don’t have the same amount of maturity choices when trading futures compared to trading forwards:



  



Brazil has a large futures market, goes back and forth with the Euro in terms of most futures contracts traded Floor trading moved to electronic trading saw large volume trading increases since 2002 CME went public in 2003 and has been continuously growing

Reason why interest rate is inversely correlated with future pricing: spot moves down way more than the interest rate movement upwards, hence the net effect on future prices is downwards

Buy something= positive, sell something= negative.

Put minus call= domestic T bill subtract by foreign T bill (discounted at respective rates). One you have a call price, don’t need to have a model to calculate the put option because you just add the call to the forward sale price.

If foreign interest rate is significant (large), then the simple interest differential would not be a good approximation for the percentage forward premium etc. Look at the interest rates in each countries to tell whether a country’s currency should be trading at a premium or discount going forward.

Need to discount using a risk adjusted rate/cost of capital, as opposed to risk free rate, OR just convert future cash flow into home currency using the forward rate that accounts for any risks as opposed to using future expected spot rate. Alternatively, can also just discount back at risk free rate and convert cash flows into HC using spot rate.

The number of outstanding contracts for a given type of futures= open interest A proxy for the closing price which is used to ensure that a futures price is not Manipulated= settlement price....