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Summary Financial Risk Management Ch 5 - 11
- Instelling
- Avans Hogeschool (Avans)
Summary for the course financial risk management for the studies Finance & control International for the year 4, quarter 2.
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Financial risk management(Ch 5 tm 11)
Chapter 5. The Foreign Exchange Market
A spot transaction is the purchase of foreign exchange with delivery and payment between banks
taking place normally on the second following business day. The date of settlement is referred to as
the value date.
Foreign exchange operations are defined by the timing—the future date —set for delivery. There are
in principle three major categories of over-the-counter transactions categorized by future delivery:
spot (which may be overnight), forward (including outright forward), and swap transactions
A foreign exchange rate is the price of one currency expressed in terms of another currency. A
foreign exchange quotation (or quote) is a statement of willingness to buy or sell at an announced
rate.
CUR1/CUR2
CUR1 = the base unit and CUR2= the price or quote currency
A direct quote is a home currency price of a unit of foreign currency
An indirect quote is a foreign currency price of a unit of home currency
Interbank quotations are given as a bid and ask. A bid is the price in one currency at which a dealer
will buy another currency. An ask is the price at which a dealer will sell the other currency.
Dealers bid at one price and ask at a slightly higher price, making their profit the pread between the
buying and selling prices.
The mid-rate is the average between the bid and ask rate.
Triangular arbitrage = making a profit or a loss by going through three exchanges with different
exchange rates
,Forward quotations
Spot rates are typically quoted on an outright basis (meaning all digits expressed) whereas forward
rates are typically quoted in points or pips (the last digits of a currency quotation).
Forward rates of one year or less maturity are termed cash rates; for longer than one-year they are
called swap rates.
Chapter 6. International Parity Conditions
If the identical product or service can be:
- sold in two different markets; and
- no restrictions exist on the sale; and
- transportation costs of moving the product between markets are equal, then
- the product’s price should be the same in both markets
This is called the law of one price
Relative Purchasing Power Parity
Relative PPP holds that PPP is not particularly helpful determining what the spot rate is today, but
that the relative change in prices between two countries over a period of time determines the
change in the exchange rate over that period.
“If the spot exchange rate between two countries starts in equilibrium, any change in the differential
rate of inflation between them tends to be offset over the long run by an equal but opposite change
in the spot exchange rate.”
Exchange rate indices: real and nominal
,Individual national currencies often need to be evaluated against other currency values to determine
relative purchasing power to discover whether a nation’s exchange rate is “overvalued” or
“undervalued” in terms of P P P.
This problem is often dealt with through the calculation of exchange rate indices, such as the
nominal effective exchange rate index.
Purchasing power parity exchange rate forecast ($=€1.00)
Spot (one year) = spot x (1 + US$ inflation) / (1 + French inflation)
The fisher effect states that nominal interest rates in each country are equal to the required real rate
of return plus compensation for expected inflation
Where I = nominal interest rate, r = real interest rate and π = expected inflation
The relationship between the percentage change in the spot exchange rate over time and the
differential between comparable interest rates in different national capital markets is known as the
international Fisher effect.
“Fisher-open,” as it is termed, states that the spot exchange rate should change in an equal amount
but in the opposite direction to the difference in interest rates between two countries
A forward rate is an exchanger ate quoted for settlement at some future date
A forward exchange agreement between currencies states the rate of exchange at which a foreign
currency will be bought forward or sold forward at a specific date in the future.
The forward premium or forward discount is the percentage difference between the spot and
forward exchange rate, stated in annual percentage terms.
This is the case when the foreign currency price of the home currency is used. (SF/$)
;trage Rule of Thumb: If the difference in interest rates is greater than the forward
premium/discount, or expected change in the spot rate for UIA, invest in the higher interest yielding
currency. If the difference in interest rates is less than the forward premium (or expected change in
the spot rate), invest in the lower yielding currency.
Interest Rate Parity (IRP)
, Covered Interest Arbitrage (CIA)
Answer to q: Heidi Høi Jensen generates a covered interest arbitrage (CIA) profit because she is able
to generate an even higher interest return in Danish kroner than she "gives up" by selling the
proceeds forward at the forward rate.
Uncovered Interest Arbitrage (UIA)
Forward rate as an unbiased predictor of the future spot rate
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