Mid-Term 2 Study Guide - Moore PDF

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FINA 4810: Mid-Term 2 Study Guide The Forward Market -OTC, Not on exchanges like the NYSE -Contracting today for future purchase/sale of an asset; No money changes hand today. -Currency forward contract: an agreement between a bank and a customer (or another bank) to deliver a specified amount of currency against another currency at a specified future date and at a fixed exchange rate  for (1) speculating and (2) hedging -Hedging: the use of financial or operational strategies to offset or minimize the risk of adverse price changes; giving the potential upside and downside for certainty -Speculating: entering a financial in an attempt to profit from one’s expectations about a future price change; taking on risk as no one can predict the future  Both hedgers and speculators are necessary for a forward as they provide liquidity to operate efficiently -Quotations: 1,3,6,9, and 12 months or longer, terms are flexible, negotiable, read similar to spot quotes (direct/indirect and American/European); -Forward contracts are most popular for hedging for firms that has A/R or A/P in denominated in foreign currency -Forward Premium/Discount: the annualized percentage deviation of forward rate from spot rate -“Long”: you agreed to buy -“Short”: you agreed to sell -Payoff for forward contract is a zero-sum game (a gain to one is a loss to the other) -Non-deliverable forward contracts: currencies of some emerging countries are not freely traded due to gov. capital controls; therefore, these currencies can be treaded in non-deliverable forward contracts (NDF) -Settlement is in cash, especially in $USD. (settlement = [future price – future spot price] contract size) SWAPs: looking from the bank’s perspective -Outright forward transaction (15% of FX trading): an uncovered speculative position in a currency (i.e. the bank just take the other position of the customer who could either be hedger or speculator) -Swap transaction (50% of FX trading): provides a way for the bank to mitigate the FX exposure of a forward trade (simultaneous spot market purchase [sale] of X units of foreign currency and forward sale [purchase] of X units of the same foreign currency. Banks do this most of the time to mitigate risk. Exchange-Traded Funds (ETF): portfolio of financial assets in which shares representing fractional ownership of the fund traded on an organized exchange; use Net Asset Value to reflect spot dollar value

Parity Conditions: no arbitrage, equilibrium relations that should (in theory) hold in financial markets; related to law of 1 price; arbitrage is possible if a parity condition is violated -Interest Rate Parity: a no arbitrage equilibrium state in which the forward rate differs from the spot rate sufficiently to offset the interest rate differential between two currencies; If IRP is violated, unlimited profit can be made by exploiting the arbitrage opportunity -IRP tends to hold, but not always -If IRP is holding, interest rate differential will be offset by a difference in the forward rate than the spot rate, so returns are the same across investment in the currencies -Covered Interest Arbitrage: capitalizing on the interest rate differential between 2 currencies while covering exchange rate risk with a forward contract Prices will adjust to move the market back to equilibrium where IRP holds -There are multiple ways to hedge currency FX risks: -Establish a long position in the forward -Perform a money market hedge: borrow today and buy PV of the foreign currency payable, translate to the foreign currency and invest in the foreign country. At time, take from bank and pay for the payable; pay interest / opportunity cost in home country (SPOT RATE is the only rate that matters) To use MM hedge to eliminate FX risk from a foreign currency denominated payable (or receivable), the firm should lend in the foreign currency today [we deposit in the foreign bank] -Reasons for Deviations from IRP: (1) Transaction costs: bid-ask spreads (2) Capital controls: governments sometimes restrict import/export of money through taxes or outright bans (China, Russia) -Purchasing Power Parity: In theory, price levels should be equal worldwide when expressed in a common currency i.e. a unit of home currency should have the same purchasing power around the world; The exchange rate between 2 countries should equal the ratio of the countries’ price levels -Price level measures all the goods in the basket at a given point in time -The absolute version of PPP ignores (1) transaction costs, (2) gov. restrictions [tariff, quotas], (3) product differential -There is a relationship: the price level and exchange rate between that country’s currency and other’s currency tend to move in opposite direction. If price level increases, that currency tends to depreciate against other currencies -Relative PPP states that the rate of change in the exchange rate roughly equal to differences in the rates of inflation -Even if absolute PPP does not hold, relative PPP may hold -We typically see people use interest rate differential to estimate inflation rate differential as banks set interest rate after they expect inflation -Evidence PPP:

-Big Mac Index: measures PPP, don’t put to much weight, although on average may have some implications -Arbitrage is not possible with non-tradable commodities, high transaction costs, and regulations -Forecasting Exchange Rates: (1) Efficient Market Hypothesis (EMH): financial markets are efficient if prices reflect all available and relevant information; “Random Walk” -Forward price supports future spot price -Predicting exchange rates using EMH approach is affordable and hard to beat; nothing we have figured so far consistently outperform the EMH (2) Fundamental Approach: involves econometric to develop models that use a variety of explanatory variables (regression analysis) Step 1: Estimate structural model to determine parameter values Step 2: Estimate future values of the independent variables Step 3: Use the model to develop forecasts -However, these models do not consistently work any better than forward rate model or the random walk model (3) Technical analysis: patterns and past behaviors; “history repeats itself,” at odds with the efficient markets approach

Derivatives Securities: a financial instrument whose value depends on the value of some other, more basic underlying asset  Derivative’s value is derived from the value of the underlying asset -Can either be OTC and exchange-traded -Important for (1) hedging, (2) speculating, and (3) arbitrage (IRP, covered interest arbitrage) -Forward contract: an agreement to buy (long position) or sell (short position) foreign currency at a certain future time for a specified delivery price; forward exchange rate depends on the spot exchange rate, the domestic and foreign interest rates, and the time to maturity -Futures contracts: similar to forward with few differences. -Standardized: contract size, delivery date, daily settle “marked to market” (to prevent building up losses and default) -Initial performance bond; maintenance bond: if falls below the maintenance level, must bring up to initial performance bond (typically 2 percent of contract value); if fails to do so, the account will be closed out with an offsetting short position -CME Group is the world’s largest currency futures market

-Open interest: the number of contracts outstanding for a particular delivery month  good proxy for demand for a contract; greatest in the nearby contract; typically decreases with term to maturity of most futures contracts...