12 octobre = mid-term exam

19 novembre = deadline pour completer le BMC, voir cours moodle Exchange Markets

SESSION 1

FOREX = it’s the market in which the money of one country is exchanged against the money of
another country.

A forex transact is an agreement btw buyer & seller that a fixed amount of currency will be delivered
for some other currency at a specified rate

FOREX doesn’t exist physically (OTC): it is a network in which participants are connected by
computers

Forex = OTC = not organized, Stock market = organized

Major pairs = currencies with USD on one side

EUR CAD GBP CHF JPY AUD NZD
- most exchanged currency pairs globally and therefore, they are usually the most liquid and
with the lowest spreads.

Minor = include any two of the major currency except the USD
EUR/CAD GPB/CHF etc
- minor currency pairs are also well liquid, and their spreads are not usually high

Exotic = includes a major currency and the currency from an emerging economy
USD/BRL CHINA YUAN = EXOTIC
- not generally liquid as they are not too much traded. It results in spreads higher than those
of the major and minor pairs.

Most exchange of currencies are made through bank deposits that are transferred electronically
from one account to another.

FOREX = continuous market = 24/7. When one major market is closed another one opens to facilitate
trades

FOREX = 6600 billion $ per day in December 2019.

FOREX = largest and most liquid financial market in the world

Traders: commercial banks

- they act as market makers who quote a buy and sell price on a currency hoping to make a
profit on a spread which is the difference between the buying and selling price

Brokers:
- They act as middleman between commercial banks: they inform banks about buying and
selling prices
- They have very close contacts with both commercial banks and customers.
  Traders make profit for themselves or the institution for which they work. Brokers make
profit for their customers.

Central banks:
- To support the value of their currency because of their gov’s policies
- They use the market to influence the price at which their own currency trades

Individuals and firms conducting commercial / investment transactions:

- To execute commercial / investment transactions

Speculators and arbitragers:

- Seek to profit from trading in the market.
- They operate for their own interest, without need or obligation to serve customers.

Derivatives = instrument used to hedge

Hedge = protect yourself against the exchange risk

Speculators = very risky. You buy one currency, and you expect the market to rise in the next few
days. Seek all their profit from exchange rates over time.

Arbitrage = zero risk. You buy one currency at one price today and sell the same currency at a higher
price at the same time. Try to profit from simultaneous differences in exchange rates in different
markets.

 Exchange rate regime = the way a central bank manages the price of its currency against
other currencies.
- Fixed exchang rate = govs try to keep the value of their currencies constant against another
one. Decided in terms of a basket of currencies or gold. Most countries fix the rate against a
major currency (mostly USD).
- Floating (or flexible) exchange rate = exclusively supply & demand

The central banks are always influencing the rates = managed floating, there is no free movement of
currencies, there are always interventions from the central bank to support the currency

- Forex trading and derivatives are prohibited in Islamic finance, since they do not comply with
Islamic rules.
- In Islamic finance, trading should be physically (hand-to-hand) and at the time of the
transaction (not delayed).

Why? by hedging, the exchange risk is transferred from one party to another. But Islamic finance is
based on the principle of profit and risk sharing. And the uncertainty involved in the future delivery
of the currency. In Islamic finance, both parties should take possession of the funds.

Each country has a currency in which prices of goods and services are quoted.
An exchange rate is the price of one currency in terms of another one. It is the nominal exchange
rate.
Direct quote (American terms)
- Is a national currency price of a unit of a foreign currency. How many units of national
currency do we need to buy a unit of foreign currency? ($/€ = 1.0003)
Indirect quote (European terms)
- Is a foreign currency price in unit of a national currency. How many units of foreign currency
do we need to buy a unit of national currency? (€/$ = 0.9997).

Direct and indirect quotes are reciprocals: indirect quote = 1/direct quote

An appreciation/depreciation of the EUR against the USD means that the price of EUR in terms of
USD has gone up/fallen.

If the EUR appreciates against the USD, the USD depreciates against the EUR.

SESSION 2

Theta = real exchange rate = real exchange rate includes the price of goods.

Example: If Peugeot = 32K EUR and Ford = 35K USD.

If EUR/USD = 0.9979:

32K*0.9979 = 31 932.8
31 932.8/35K = 0.9124

Peugeot = 0.9124 Ford.

The real exchange rate (Theta) gives the price of a unit of a domestic good, in terms of the price of
foreign goods.

Price EUR
Formula: EUR /USD ×
Price USD

Is equal to:

E = nominal exchange rate

P: price of domestic goods in domestic currency
Pf: price of foreign goods in foreign currency

P
Theta = E ×
Pf

Theta increases if: E increases, P increases, Pf decreases

When Theta increases domestic goods relative to foreign goods are more expensive hence exports
are less competitive, and imports become cheaper.

Theta decreases if: E decreases, P decreases, Pf increases

When Theta decreases, we say that the real exchange rate has depreciated. Domestic goods relative
to foreign goods are less expensive hence exports are more competitive, and imports become more
expensive.
Pip = percentage in point is a measurement of the smallest price change of a currency pair.
Most pairs: 1 pip = 0.0001
Few pairs: 1 pip = 0.01

Bid & Ask

Bid = BUY (Bid is the price at which banks buy currencies)

Ask = SELL (Ask is the price at which banks sell currencies)

Bid < Ask always

Exchange rate is written as [Bid – Ask]

Spread (or profit) formula = Ask – Bid

Bid = buying price for the bank = selling price for the customer
Ask = selling price for the bank = buying price for the customer

Spot & Forward

Spot = rate of a foreign-exchange contract for immediate delivery.

Spot transaction = delivery & payment between banks take place on the second following business
day.

Forward = the exchange rate is set today for a delivery at some future day.

Main purpose of forward rate = hedge the exchange risk:

Importer = appreciation of foreign currencies
Exporter = depreciation of foreign currencies

Forward rates are quoted for future dates of 1, 2, 3, 6, 9, 12 months.

You can sign a contract for any other number of months if you want but then you must decide of the
price.

Forward premium and discount:

Forward rate F−Spot rate S

Premium/Discount = × 100
Spot rate S

Positive variation = Premium P = the forward is trading at a higher price than the spot rate
Negative variation = Discount D = the forward is trading at a lower price than the spot rate

Example:

We are looking for the premium/discount.

S EUR/JPY = 143.27
F EUR/JPY = 143.35
 143.35−143.27
Premium/Discount =
143.27
×100 = 0.056%

The result is positive hence we have a premium of 0.056%.

We are looking for the Forward rate F

S EUR/USD = 1.0002
Discount = -0.17% = -0.0017

Forward rate F = Discount × Spot + Spot

= 1.0002 * -0.0017 + 1.0002

= 0.9985

The forward rate of EUR/USD is 0.9985.

We are looking for the premium/discount with bid & ask

 Use ask rate
S EUR/GBP = 0.9088 – 0.9103
F EUR/GBP = 0.9099 – 0.9105

0.9105−0.9103
Premium/Discount ask = ×100=0.02 %
0.9103

The result is positive hence we have a premium of 0.02%.

The change btw F and S when expressed in pips is called forward points. Forward points can be
positive and are added to S or negative and are subtracted from S.

If points rise from left to right, F = S + points

If points decline from left to right, F = S – points

Example:
S NZD/USD = 0.6692
Pips = -57
F = 0.6692 – 0.0057 = 0.6635

S USD/INR = 79.6735 – 79.6942

Pips = 20-21
F USD/INR = (79.6735+0.0020) – (79.6942+0.0021) = 79.6755 – 79.6963

S AUD/USD = 0.6831 – 0.6852

Pips = 2.35 – 1.55 (pips decline from left to right hence we compute S – points).
F AUD/USD = (0.6831-0.000235) – (0.6852-0.000155) = 0.6829 – 0.6850

Forex swap = combination of spot and forward transaction

An agreement where two parties exchange an amount of money (notional) in two currencies at the
spot exchange at the issue date. At maturity date, they swap back the notional according to the
forward exchange rate, which was agreed upon the issue date.

In April 2019, forex swaps total 49% of global forex trading volume.

Cross rates

Many currencies pairs are inactively traded, so their exchange rate is determined through a third
major currency.

USD/CNY = 6.9837
USD/INR = 79.8010

Cross rate (CNY/INR) = (CNY/USD) × (USD/INR)

 We have USD/INR but not CNY/USD, so we reverse USD/CNY to get CNY/USD

CNY/USD = 1/6.9837

Hence = 1/6.9837 * 79.8010 = 11.4268

A cross rate is implied exchange rate btw 2 currencies when both are quoted in terms of a common
third one (mostly USD).

EUR/CHF = 0.9535 – 0.9543

EUR/GBP = 0.8679 – 0.8683

GBP/CHF = GBP/EUR * EUR/CHF

Remember to switch Bid and Ask under the 1 for the first division

GBP/CHF Cross rate Bid = 1/0.8683 * 0.9535 = 1.0981

GBP/CHF Cross rate Ask = 1/0.8679 * 0.9543 = 1.0996

SESSION 3

Intermarket arbitrage = strategy in which one takes advantages of divergence of exchange rates in
different money markets by buying a currency in one market and selling it in another market.

- Buying the undervalued currency.

- Starting and ending with the same currency.

Example:
BNP = USD/EUR = 1.0003
HSBC = USD/EUR = 1.0012

Profit = 1.0012 – 1.0003 = 0.0009 EUR per 1 USD

You start with EUR and end with EUR.

New York: GBP/USD = 1.1505 – 1.1522

Texas: GBP/USD = 1.1420 – 1.1443

Profit = 100 * 1.1505 / 1.1443 = 100.54 – 100 = 0.54 USD

AMOUNT * HIGHEST BID / LOWEST ASK

Credit Suisse: EUR/CHF = 0.9527 – 0.9544

UBS: EUR/CHF = 0.9600 – 0.9631

Profit = 200 * 0.9600 / 0.9544 = 201.17 – 200 = 1.17 CHF

Triangular arbitrage = trading strategy that exploits an arbitrage opportunity resulting from a pricing
discrepancy among three different currencies.

EUR/USD = 0.9993, EUR/GBP = 0.8986, GBP/USD = 1.1489

Steps:

1) Compute implied cross rate and compare it with quoted rate to determine which currency is
undervalued

Implied cross rate = 1/0.8986 * 0.9993 = 1.1121

 GBP/USD Implied = 1.1121, quoted = 1.1489, GBP implied < quote = GBP implied
undervalued = second currency is GBP not USD. If implied > quote, start with the other
currency in the pair, here USD.

2) Exchange the initial currency for the second

1000 EUR = 898,6 GBP

3) Exchange the second currency for the third

898,6 GBP = 1032,4 USD

4) Exchange the third currency for the initial.

1032,4 USD = 1033,12 EUR

Triangular arbitrage with bid-ask quotes

Bank A: EUR/USD: 0.9985 – 0.9996

Bank B: GBP/USD: 1.1538 – 1.1540
Bank C: EUR/GBP: 0.8665 – 0.8718

1) GBP/USD implied ask = 1/0.8665 * 0.9996 = 1.1536

GBP/USD implied bid = 1/0.8718 * 0.9985 = 1.1453
1.1536 < 1.1540
 We only look at the ask price because we are going to buy GBP with our 100 EUR.

GBP is undervalued, we start with GBP.

2) 100 EUR*0.8665 = 86.65 GBP (we have EUR/GBP, so we multiply by the bid).
3) 86.65*1.1538 = 99.98 USD (we have GBP/USD, so we multiply by the bid).
4) 99.98/0.9996 = 100.02 EUR (we don’t have USD/EUR, so we divide by the ask of EUR/USD).

Profit = 100.02 – 100 = 0.02 EUR

Bank A: EUR/CHF: 0.9607 – 0.9615

Bank B: EUR/CAD: 1.3203 – 1.3213
Bank C: CHF/CAD: 1.3694 – 1.3700

1) EUR/CAD implied bid = 0.9607 * 1.3694 = 1.3156

EUR/CAD implied ask = 0.9615 * 1.3700 = 1.3173

1.3173 < 1.3213

EUR/CAD ask bid is undervalued so we buy EUR first

2) 200 CHF/0.9615 = 208.01 EUR (we don’t have CHF/EUR, so we divide by the ask of EUR/CHF).
3) 208.01*1.3203 = 274.64 CAD (we have EUR/CAD, so we multiply by the bid).
4) 274.64/1.3700 = 200.47 CHF (we don’t have CAD/CHF, so we divide by the ask of CHF/CAD).

Profit = 200.47 – 200 = 0.47 CHF

Bank A: USD/JPY: 143.48 – 143.51

Bank B: USD/AUD: 1.4890 – 1.4900
Bank C: AUD/JPY: 96.24 – 96.28

1) USD/AUD implied bid = 143.48/96.28 = 1.4902

USD/AUD implied ask = 143.51/96.24 = 1.4912

1.4912 > 1.4900

USD/AUD ask bid is overvalued so we buy AUD first

2) 1000 JPY/96.28 = 10.39 AUD (we don’t have JPY/AUD, so we divide by the ask of AUD/JPY).
3) 10.39/1.49 = 6.97 USD (we don’t have AUD/USD, so we divide by the ask of USD/AUD).
4) 6.97*143.48 = 1000.06 JPY (we have USD/JPY, so we multiply by the bid).

Profit = 1000.06 – 1000 = 0.06 JPY

In real life, triangular arbitrage opportunities do exist in the Forex market.

But these opportunities are very rare and last only for a few seconds.
The market will correct itself because of trading algorithms which execute trades in a split second.

Importers & Exporters

There is the quote A/B = Bid A – Ask A

If you receive money A

Choose Bid A

If you receive money B

Choose 1/Ask A

If you pay money A

Choose Ask A

If you pay money B

Choose 1/Bid A

SESSION 4

International parity theories.

Factors affecting exchange rates:

- Inflation rates
- Interest rates
- ESG (investors integrate country-level ESG score to decide whether they invest in one
currency).
- Demand & supply
- Volatility
- Political factors

Prices, interest rates & exchange rates

Inflation rates: Purchasing Power Parity (PPP)

Interest rates: Interest Rate Parity (IRP)

Purchasing Power Parity (PPP)

The idea was 1st proposed by Ricardo in 19th century, then expanded by Cassel in 1918.
It explains the movements in the exchange rate between two currencies by change in price levels in
corresponding countries.

PPP is based on the Law of One Price (LOP).

LOP = in absence of transportation costs, taxes and any import duties, the price of identical goods
should be the same in all countries once the price is adjusted to a common currency.
Example:
If EUR/USD = 1, a calculator that sells for 50 USD in New York must sell 50 EUR in Paris.

Implication: Theta (Real exchange rate) = 1

LOP = Price USD / Price EUR

PPP states that the exchange rate between two country’s currency should be equal to the ratio of
their price level.

PPP is a generalization of the LOP applied internationally to a basket of goods.

 LOP is applied on 1 good.

 PPP is applied on a set of common products with a price index.

Conditions of PPP:
- Homogeneity of goods
- No transportation costs
- No barriers to trade

Versions of PPP:
1) Absolute PPP
- Equalization of real price levels across countries. Basket of goods should cost the same in
country A and country B once you take the exchange rate into account.

2) Relative PPP
- Describes the linkage among domestic and foreign inflation, and exchange rates. Exchange
rate movements are explained by inflation rates.

Relative PPP Formula:

rd: domestic inflation rate

rf: foreign inflation rate
et: future spot rate
e0: spot rate

et 1+ rf
Formula: =
e 0 1+rd

et−e 0 rf −rd
Variation: = , or ¿
e0 1+rd

The percentage change in the value of a currency should equal the difference in the inflation rates
between two countries.

If domestic inflation is higher than foreign inflation, domestic currency should depreciate.
If domestic inflation is less than foreign inflation, domestic currency should appreciate.

Example:
Inflation on 1 year:
USr = 0.08
FRr = 0.05
e0 = 0.9999
et = ?

Spot rate in 1 year:

USr 1.08
et = × e 0= ×0.9999 = 1.0285
FRr 1.05

if UK = 10% and AU = 6%, the exchange rate of GBP/AUD will decrease by 3,64%.

Computation: ( 1.06
1.1
−1 )× 100 = -3.64% (Put the currency you want to calculate the variation of on
the bottom).

General implication of PPP = countries with high inflation rate will see their currencies depreciate
against those with low inflation rates.

Deviations from PPP

- Barriers to trade: transportation costs and custom tariffs

- Differentiated goods: countries use different products and services in their baskets or
indexes, and different weights are given to the same product or services.
- Not traded goods: housing services, health care services, …
- Variations in the exchange rate may be due to economic events such as a change in
government policy.

PPP empirical evidence

PPP is assumed to work better in the long run:

- In the long run, the LOP is expected to hold. If sometimes the LOP does not hold, then
arbitrage will make it hold.
- Absolute PPP and the LOP don’t seem to hold for many goods, but relative PPP seems to hold
better.

SESSION 5

Interest Rate Parity

The IRP theory was developed by Keynes. IRP provides the link between the foreign exchange
markets and the international money market.

Exchange rates movements are explained by interest rates.

→ It uses nominal interest rates to analyze a relationship between spot rate and forward rate.

Formula:
C = amount of money
S = S EUR/USD
F = F EUR/USD
Interest rate EUR = i EUR
Interest rate USD = i USD

Invest in the local market (EUR):

C x (1+ i EUR)

Invest in the US market:

1) Convert C EUR into USD at spot rate:

C × S EUR /USD

2) Multiply it by the interest rate in the US:

(C × S EUR /USD)(1+i USD)

3) Sell immediately one year forward at forward rate to get back to EUR:

(C × S EUR /USD)(1+i USD)

(F EUR /USD )

Hence, if both interest rates are equal, you get the same return whether you invest in the local
market or in the foreign market. The equation is:

(C × S EUR /USD)(1+i USD)

C (1+i EUR)=
(F EUR /USD)

Common way to write it:

F EUR /USD 1+iUSD

→ =
S EUR/USD 1+ i EUR

Example:

C = 1000 EUR
S = EUR/USD = 1.1853
F = EUR/USD = 1.1788
i EUR = 0.0069
i USD = 0.0014

Invest in French market:

1000*1.0069 = 1006.9 EUR

Invest in US market:
1) 1000*1.1853 = 1185.3 USD
2) 1185.3*1.0014 = 1186.96 USD
3) 1186.96/1.1788 = 1006.92 EUR
Conclusion: your profit is higher if you invest in the foreign market.

Interest rate parity formula with months/years (as seen above):

months
1+(i foreign × )
F d /f years
→ =
S d /f months
1+(idomestic × )
years

Always multiply the interest percentage by the months/years, it is safer.

Don’t forget to multiply only the interest percentage by the months/years.

Approximation:

F−S 1+i f
→ =
S 1+i d

Implications:

If i d < i f
Domestic currency should appreciate = trade at a forward premium (F > S).
If domestic currency does not trade at a forward premium, arbitrage opportunity exists for domestic
investors. Domestic investors can invest in the foreign market.

If i f < i d
Domestic currency should depreciate = trade at a forward discount (F < S).
If the domestic currency does not trade at a forward discount, arbitrage opportunity exists for
foreign investors. Foreign investors can invest in the domestic market.

If IRP holds, arbitrage is not possible: it doesn’t matter whether you invest in domestic country or
foreign country, your rate of return will be the same.

Versions of IRP:

1) Covered Interest Rate Parity

The F premium or discount is determined by interest rate differential according to the normal IRP
formula.

This version is called “covered” because investors are “covered” against uncertainty by using the
forward rate = hedging.

Example:

We are in Spain. Our currency is EUR.

F = 1.1200
S = 1.1078
i f = 0.02
i d = 0.0184

F 1+i f
The formula is =
S 1+id

F 1+i f
If IRP holds, should equal
S 1+ id

F 1.12
= = 1.011
S 1.1078

1+i f 1+0.02 1.02

= = = 1.0016
1+ id 1+ 0.184 1.0184

1.011 ≠ 1.0016, IRP doesn’t hold.

Now, we invest in the market that offers the highest interest return.

The interest return of domestic market in EUR: 1.84%

Now we calculate the return of foreign money in terms of EUR (basic algebra, just flip the equation to
find (1 + i d):

S
(1+i d)= × ( 1+i f )
F

1.1078
( 1+i d )= ×1.02
1.12

(1 + i d) = 1.0089. The return of foreign money in terms of domestic currency is 0.89%.

Hence, investing in the Spanish market is more profitable than investing in the US market.

(NOW IF YOU ARE IN THE US)  if you have 200 USD:

Domestic market: 200 ×1.02 = 204 USD

Foreign market:
F
( 1+i f )= × ( 1+i d ) × 200 USD
F

1.12
( 1+i f )= × ( 1.0184 ) ×200 USD
1.1078

(1 + i f) = 1.0296 x 200 = 205.92 USD.

Profit = 205.92 – 204 = 1.92 USD

This operation is called covered interest arbitrage. It is the transfer of liquid funds from one
monetary market to another to take advantage of higher interest rates.
Covered interest arbitrage continues until interest rate parity is re-established. Here, the domestic
rate (USD) will rise, and the foreign rate (EUR) will fall. The spot will rise, and the forward will fall.

2) Uncovered Interest Rate Parity

If investors are risk neutral, F will equal the expected future exchange rate.
This gives uncovered interest rate parity.

Uncovered IRP doesn’t use F but uses the expected future exchange rate.
Uncovered IRP uses estimation of the spot exchange rate in the future rather than the forward rate,
so it is risky.
It is called “uncovered” because investors are uncovered for the risk associated with the uncertainty
of the expected spot exchange rate in the following period.

Formula:
Replace F with S+1 in the Covered IRP formula

S +1 1+i f
→ =
S 1+i d

Example:
GBP i = 0.012
USD i = 0.009
S GBP/USD = 1.2821

1+ i f
→ S+1= 1+i d × S

1.009
S+1= × 1.2821 = 1.2783
1.012

Uncovered IRP doesn’t hold because it deals with forecasting. By contrast, Covered IRP is well
established.

IRP may not hold due to:

1) Capital controls: governments sometimes restrict imports and exports of money through
taxes.
2) Transaction costs

SESSION 6

Hedging Exchange risk:

- Exchange risk is the risk associated with the activities that involve a firm in currencies other
than its home currency.

The purpose of hedging is to reduce or eliminate risks arising from foreign exchange exposure, such
as receivables or payables denominated in foreign currency.
Types of foreign exchange exposure:

3 types:

1) Transaction exposure

Risk faced by any company engaged in current transactions involving foreign currencies.

Causes:
- Purchasing or selling on credit
- Borrowing or lending in foreign currency
- Acquiring assets / incurring liabilities in foreign currency

2) Economic exposure

Economic = “operating” exposure, it results from the “physical” entry and presence of a firm into a
foreign market.

It is the extent to which the firm’s future cash flows get affected due to the change in the exchange
rates.

Transaction = micro, at the level of the firm. Easy to measure.

Economic exposure = macro, at the level of the whole industry. Hard to measure.

Measuring exposure is difficult, since cash flows depends on the costs and the prices of the outputs,
and they can significantly change with exchange rates.

3) Translation exposure

Translation = “accounting” exposure.

It is linked to consolidation. Consolidation involves translating subsidiaries’ financial statements from

local currency to the home currency of the firm.

Gains & losses arising out of translation don’t significantly alter the value of the firm because such
exposure can be reversed in the next year translation if currency market moves in the favorable
direction. It doesn’t require too much management attention.

Long & Short exposure

One is long in a foreign currency if the value of receivables exceeds the value of payables.
One is short in a foreign currency if the value of receivables is less than the value of payables.

Hedging vs Speculating
Hedging consists in reducing or eliminating risks.
Speculating generates risk: it involves an attempt to make profit via the acceptance of greater risk.
Hedging instruments
There are a number of instruments that can be used to hedge foreign exchange risk:

- Forward
- Foreign currency futures
- Currency swaps
- Currency options

Forward exchange contract

It is an agreement between you and your bank to buy or sell foreign currency at a future date.

2 types of forward contracts:

- Forward purchase contract (importer)
- Forward sale contract (exporter)

Forward purchase contract:

Outflows (payables) in foreign currency:
It is a contract to buy the foreign currency at a specified rate to hedge against the appreciation of
value of the foreign currency (in terms of local currency).

1) Borrow domestic currency

2) Convert domestic into foreign currency
3) Invest the foreign currency in a bank deposit

At maturity date, withdraw the foreign currency deposit (which by the time equals the payable
amount) and make the payment.

Examples:
(Importer) US firm pay 300 000 AUD to an Australian supplier 3 months from now.
AUD may appreciate against USD in 3 months.

What to do to reduce the risk of spending more USD?

3 months i AUD = 0.0075

3 months i USD = 0.0175
S USD/AUD = 1.4461

1) Borrow domestic = borrow X USD

2) Convert it into foreign = X USD × S
3
3) Invest foreign currency (F) = X USD × S (1+0.0075 × )
12
3
4) Pay back the loan (D) = X USD (1+0.0175 × )
12

Forward rate =
 3
1+(0.0075 × )
12
1.4461 × = 1.4425
3
1+(0.0175 × )
12

F
Forward rate formula :
D

months
1+(i f × )
years
S×
months
1+(i d × )
years

Forward sale contract

(Exporter) Inflows (receivable) in foreign currency:
It is a contract to sell the foreign currency at a specified rate to hedge against the depreciation of
value of the foreign currency (in terms of local currency).

1) Borrow foreign currency

2) Convert it in domestic currency
3) Invest the domestic currency in a bank deposit

At maturity date, when the foreign currency is received, use it to pay back the foreign currency loan.

US firm receive 200 000 CAD from Canadian buyer 3 months from now.
CAD may depreciate against USD in 3 months.

What to do to reduce the risk of receiving USD?

3 months i CAD = 0.0125

3 months i USD = 0.0175
S USD/CAD = 1.3133

1) Borrow foreign = borrow X CAD.

= 200 000 / 1+(0.0125 * 3/12)
2) Convert it into domestic
X CAD 3
3) Invest domestic currency (D) = (1+0.0175 × )
S 12
3
4) Pay back the loan (F) = X CAD (1+0.0125 × )
12

F
Forward rate formula = :
D
months
1+(i f × )
years
S×
months
1+(i d × )
years
Forward contracts

Advantages:
- The company is protected against unfavorable exchange rate fluctuations.
- The exact value in home currency of the export and import order can be calculated on the
day it is processed.
- Can be written for any amount and any maturity.

Disadvantages:
- Because the rate is fixed, you can’t benefit from any favorable movement in the exchange
rate.
- They are unregulated: negotiated on the OTC market.

Non-deliverable forwards (NDFs)

NDF = OTC too
Mostly used in low liquidity or capital-controlled markets, where currencies are non-convertible.

NDF similar to regular forward, but NDF doesn’t include physical delivery. Instead, the whole
transaction is settled in the convertible currency such as USD, EUR, GBP or CHF.

NDF is an efficient way to hedge an exchange risk involving a non-convertible currency.

NDF structure
- Currency pair = exotic pair (major currency/currency from emerging country)
- Notional amount = a face value in non-convertible currency that both parties agree upon.
- NDF rate = the rate that is agreed upon on the date of the transaction. It is the forward rate
of the currencies involved in the exchange.
- Fixing rate = spot rate provided by the central bank.
- Fixing date = an agreed upon date when the fixing rate and NDF are compared.
- Settlement date = the date by which one party pays the other party the difference between
the pre-agreed NDF rate and the fixing rate.

NDF are settled with cash in the convertible currency. The notional amount is never exchanged.

(To calculate the NDF rate, we can use the same formula as in the normal forward country).

Example:
A US company will receive 5 M BRL in 3 months. To hedge against a depreciation of the BRL, the
company signs an NDF contract with the bank (exporter).

Currency pair = USD/BRL

Notional amount = 5 M BRL
NDF rate = USD/BRL = 5.4000
Settlement date = 3 months
Fixing date = 3 months – 2 days

The NDF contract guarantees the company to receive 925 926 USD.
Case 1: if fixing rate (USD/BRL) = 5.4500 (rate is higher)
In the spot market, the company obtains 5 000 000/5.4500 = 917 431 USD.
Since the contract guarantees the company to receive specifically 925 926 USD, the company will
receive the difference between the two prices hence 925 926 – 917 431 = 8 495 USD.

Case 2: if fixing rate (USD/BRL) = 5.3600 (rate is lower)

In the spot market, the company obtains 5 000 000/5.3600 = 932 836 USD.
Since the contract guarantees the company to receive specifically 925 926 USD, the company will pay
the difference between the two prices hence 932 836 – 925 926 = 6 910 USD.

Case 3: if fixing rate (USD/BRL) = 5.4000 (rate is the same)

In the spot market, the company obtains 5 000 000/5.4000 = 925 926 USD.
Since it is the same amount promised by the NDF contract, there is no payment.

SESSION 7

Foreign currency futures

A foreign currency futures is a contract that specifies the price at which a currency can be bought or
sold at a future date.

A futures contract is an alternative to a forward contract.

Some futures markets: IMM, NYSE, LIFFE, SIMEX

Buy & Sell

Buying futures contract on foreign currency: hedging against appreciation of the foreign currency
(Importer)

Selling futures contract on foreign currency: hedging against depreciation of the foreign currency
(Exporter).

Long & Short

One goes long when he buys a futures contract.

One goes short when he sells a futures contract.

Futures vs Forward

The principle of hedging with futures is the same as with forwards. Both contracts lock in a price
today for the purchase or sale of a currency in a future time period.

However, there are some divergences in the specifications of each contract.

 Futures contract Forward contract

Standardized product (amount, maturity date) Customized, negotiable (amount, maturity date)

Traded on an organized market, between a Traded on OTC market, negotiated between

customer and the clearing house individual parties, usually between a bank and a
customer

High liquidity (opposite counterparty in the Low liquidity (difficult to find a counterparty
clearing house) with opposite contract: same amount, same
maturity date, etc.…)

Initial margin payment required (a sum of Usually, no initial payment required

money should be deposited as an initial margin
or guarantee to ensure the execution of the
contract)

Daily settlement of profits and losses (the value Profits and losses are settled only at the maturity
of the contract is marked to market) date

Marking to market
Marking to market is a process through which the value of the contract is revalued daily using the
closing price of the day.

What’s a clearing house?

A clearing house is an intermediary between buyers and sellers in the derivative market.

Types of margins:
Initial margin
- The initial margin is the money that should be deposited into an account when establishing a
futures position.

Maintenance margin
- It is the minimum amount of money that should be kept in your account.

Margin amounts are paid by customers to clearing members, who, in turn, transmit these amounts
to the clearing house.

Margin requirements vary by product and reflect changes in market volatility.

Example:
Futures EUR/USD = 1.5185
Amount = buy 125 000 EUR
Deposit (initial margin) = 2 835 USD
Maintenance margin = 2 100 USD

Since the exchange rate changes every day, the contract is revalued every day. If you make a profit, it
is added into your margin account. If you make a loss, it will be deducted from your margin account.
In all cases, the account balance should not fall below the maintenance margin, which equals 2 100
USD. If the account balance falls below the maintenance margin, you should deposit additional funds
to bring the account back up to the initial margin (margin call).

Price of contract at maturity date = 125 000 * 1.5185 = 189 812.5 USD
The importer doesn’t pay this total amount yet, he pays just 2 835 USD = initial margin.

Date Euro futures price Contract price Loss or gain Account balance
February 29th 1 EUR = 1.5185 USD 125 000 * 1.5185 = None 2 835 USD
189 812.5 USD

March 3rd 1 EUR = 1.5140 USD 125 000 * 1.5140 = Loss 2 835 - 562.5
189 250 USD -562.5 USD = 2 272.5 USD

March 4th 1 EUR = 1.5100 125 000 * 1.5100 = Loss 2 272.5 - 500
188 750 USD -500 = 1 772.5 USD

On March 4th, the balance is below the maintenance margin of 2100 USD. The importer is asked to
bring up the account up to 2835 USD. A margin call of 2835 – 1772.5 = 1062.5 USD is triggered.

Date Euro futures price Contract price Loss or gain Account balance
March 5th 1 EUR = 1.5130 USD 125 000 * 1.5130 = Gain 2 835 (margin
189 125 USD +375 USD call) + 375 = 3 210
USD
Maturity date 1 EUR = 1.5160 USD 125 000 * 1.5160 = Gain 3 210 + 375
189 500 USD +375 USD = 3 585 USD

The importer has already paid 2835 + 1062.5

Lost: 562.5 + 500
Gain: 375 + 375
Purchased contract: 189 500 – 2835 – 1062.5

Total amount = 2835 + 1062.5 + 562.5 + 500 – 375 – 375 + 189 500 – 2835 – 1062.5
= 189 812.5 USD

If a firm that buys a currency futures contract decides before the settlement date that it no longer
wants to maintain the position, it can close out the position by selling an identical futures contract.

Futures AUD/USD = 0.53

Amount = 100 000 AUD
Settlement date payment = 0.53 * 100 000 = 53 000 USD

Now: AUD/USD = 0.5

At settlement date, the firm will receive 0.5 * 100 000 = 50 000 USD.

So, the firm incurs a loss of 53 000 – 50 000 = 3000 USD.

The major users of futures contracts are speculators:
- Hedgers prefer forward contracts because of their simplicity of use.
- Speculators prefer futures contracts because of the liquidity of the market.

Futures advantages:
- Protection against unfavorable variations of exchange rates.
- Elimination of counterparty default risk.
- Futures positions can be closed out with great ease, because of the liquidity of the market.

Futures disadvantages:
- Standardization: it’s not possible to obtain a perfect hedge in terms of amount and timing.
- A margin deposit must be maintained daily.
- Limited number of currencies.

Currency Swaps

A currency swap is an agreement between two parties to exchange principal and fixed interest in one
currency for principal and fixed interest in another currency.

1) Exchange at the beginning two initially equivalent principals denominated in different

currencies at the prevailing exchange rate (spot rate).
2) Make periodic interest payments to each other based on a predetermined pair of interest
rates
3) At the maturity date, re-exchange the original currencies to each other at a forward rate
fixed at the beginning of the contract.

With Forex swaps, there is no interest payment.

Example:
US firm borrow 13 M EUR for 5 years at 6%.

Swap contract:
i EUR = 0.06
i USD = 0.07
S = 5 years F = USD/EUR = 0.8

1) Firm gets 13 M /0.8 = 16.25 M USD

Bank gets 13 M EUR
2) Firm receives every year: 13 M * 0.06 EUR
Bank receives every year: 16.25 M * 0.07 USD
3) Firm receives from bank 13 M EUR
Bank receives from firm 16.25 M USD

Swaps advantages:
- Low transaction costs
- Very long time period hedge possible
Swaps disadvantages:
- Unregulated: negotiated on OTC
- Default risk: there is a risk that one party of the contract might default on the arrangement.

Currency options

A currency option is a contract that gives the holder the right but not the obligation to buy or sell a
given amount of currency at a fixed price for a specific time period.

Currency options are traded on OTC market as well as on organized exchanges.

OTC options
They are most frequently used by individuals and banks. They are customized in terms of amount,
strike price and maturity. The counterparty risk exists.

Philadelphia Stock exchange started trading currency options in 1982.

Organized markets options

Greater security. The clearing house acts as the counter party to each transaction, no default risk.
Fixed contract terms which are not as flexible as OTC market.

The buyer of an option is termed the holder.

The seller of an option is called the writer or the grantor.

Call: option giving the holder the right to buy foreign currency.
Put: option giving the holder the right to sell foreign currency.

American options: may be exercised at any time between the date of writing and the maturity date.
European options: can be exercised only on its expiration date.

These designations have nothing to do with where they trade. Both types are traded everywhere
around the world.

A currency option contract is characterized by 5 elements:

- Type of contract: call or put
- Size or amount of contract
- Maturity or expiration date
- Exercise or strike price
- The premium: the cost of the option. It’s always paid by the buyer to the seller.

In OTC markets, premiums are quoted as a percentage of the transaction amount. In the exchange,
premiums are quoted as a domestic currency amount per unit of foreign currency.

Depending on the movement of exchange rates, an option may be:

At the money: strike price = spot rate

In the money: when option is exercised
- Call: when spot rare > strike price
- Put: when spot rate < strike price

Out of the money: when option is not exercised

- Call: when spot rate < strike price
- Put: when spot rate > strike price

Premium pricing

Total value = Intrinsic value + Time value

The intrinsic value = difference between the actual price and the strike price.

Call premium: Spot rate (S) – Strike price (X) (if S > X), or 0 otherwise
Put premium: Strike price (X) – Spot rate(S) (if X > S), or 0 otherwise

The time value reflects the time remaining until the expiration of the option contract. The longer the
time between the signature date and the maturity date, the higher the time value.

Time value = Total value – Intrinsic value.

Factors influencing options premium

- The trend of the currency price (the spot rate).

 If the spot rate is rising, the value of a call increases and the value of a put decreases.
If the spot rate is falling, the value of a call increases and the value of a put decreases.

- The strike price

An option premium generally increases when the option is estimated to be in the money
and decreases when the option is estimated to be out of the money.

- The time until expiration

Generally, as expiration approaches, the option time value decreases for both calls and
puts. At maturity date, time value = 0.

4 options strategies to hedge:

- Buying a call
- Selling a call
- Buying a put
- Selling a put

Some principles:

- The premium is always paid by the buyer to the seller.

 - Only the buyer has the choice to exercise of not the option. The seller is obligated to
perform.

S = spot rate
X = exercise price
P = premium
P/L = profit or loss

Buying a call gives the holder the right to buy a stated amount of currency at a given price over a
time period or at a specific date. This strategy is used by hedgers in the case of appreciation of
foreign currency.

1st case: S > X, the buyer exercises the option, the option is called ITM
- P/L = S – X – P
- The P/L becomes a profit when (S – X) exceeds the premium amount (S – X > P)

2nd case: S < X, the buyer does not exercise the option, the option is called OTM.
- P/L = - P. You lose the premium.

3rd case: S = X. The buyer is indifferent between exercising or not exercising the option, the option is
called ATM.
- P/L = - P. You lose the premium.

The break-even price is the price at which the buyer/seller neither gains nor loses on exercise of the
option (by the buyer).

Break-even price = strike price + premium = X + P

Selling a call. The seller is committed to deliver a quantity of currency at the strike price if the Call
option is exercised by the buyer. The strategy is used by speculators in case of depreciation of foreign
currency.

1st case: S > X, the buyer exercises the option, the seller is obligated to deliver the currency at the
strike price.
- P/L = P – (S – X).
- What the buyer gains, the seller loses, and vice versa.

2nd case: S < X, the buyer does not exercise the option.
- P/L = P.

3rd case: S = X, the buyer is indifferent between exercising or not exercising the option.
- P/L = P.

Buying a put gives the holder the right to sell a stated amount of currency at a given price over a
time period or a specific date. This strategy is used by hedgers in case of depreciation of foreign
currency.
1st case: S > X, the buyer doesn’t exercise the option, he sells the foreign currency at the spot rate,
the option is OTM.
- P/L = - P. You lose the premium.

2nd case: S < X, the buyer exercises the option. This case corresponds to the expectations of the
buyer, the option is called ITM.
- P/L = X – S – P
- The P/L becomes a profit when (X – S) exceeds the premium amount (X – S > P)

3rd case: S = X, the buyer is indifferent between exercising or not exercising the option, the option is
ATM.
- P/L = - P. You lose the premium.

Break-even price = strike price – premium = X – P

Selling a put. The seller is committed to buy a quantity of currency at the strike price if the Put option
is exercised by the buyer.

This strategy is used by speculators in the case of appreciation of foreign currency.

1st case: S > X, the buyer doesn’t exercise the option.

- P/L = P.
- What the buyer gains, the seller loses, and vice versa.

2nd case: S < X, the buyer exercises the option, the seller is obligated to buy currency at the strike
price.
- P/L = P – (X – S).
- The P/L becomes a profit when the premium exceeds X – S, when P > X – S.

3rd case: S = X, the buyer is indifferent between exercising or not exercising the option.
- P/L = P.

Buying a call/put are strategies suitable for hedgers.

Selling a call/put are strategies suitable for speculators.

Profit or loss of Call buyer = loss or profit of Call seller

Profit or loss of Put buyer = loss or profit of Put seller

When buying calls or puts, the potential loss is limited to the premium amount, whereas the
potential profit is unlimited.
When selling calls or puts, the potential loss is unlimited, whereas the potential profit is limited to
the premium amount.

Currency option combinations

It involves simultaneous Call and Put option positions to construct a unique position to suit the needs
of hedgers or speculators.
The two most popular currency option combinations are straddles and strangles.

A straddle is an option strategy with which the investor holds a position in both a call and put with
the same strike price and the expiration date.

An investor can either buy a straddle or sell a straddle.

Buying a straddle

Buying a straddle involves buying both a call and a put with the same strike price and expiration date.

Buying a straddle is a good strategy for the investor who believes that the price of a foreign currency
will move significantly (high volatility), but he is unsure as to which direction.

Advantages: a call option is profitable if the currency appreciates, and a put is profitable if the
currency depreciates, hence buying a straddle is profitable whatever the trend of the foreign
currency.
Disadvantages: it is expensive, it requires the payment of two premiums (call + put).

1st case: S > X, only the call is exercised. The call is ITM and the put is OTM.
- P/L = S – X – (PC + PP)
- The P/L becomes a profit for the buyer when S – X > PC + PP

2nd case: S < X, only the put is exercised. The call is OTM and the put is ITM.
- P/L = X – S – (PC + PP)
- The P/L becomes a profit for the buyer when X – S > PC + PP

3rd case: S = X, the buyer is indifferent between exercising or not exercising the call and/or the put;
both options are ATM.
- P/L = - (PC + PP). You lose both premiums.

There are two break-even prices: one below the strike price and one above the strike price.
Lower break-even price: Strike - Both premiums = X – (PC + PP)
Higher break-even price: Strike + Both premiums = X + (PC + PP)

Selling a straddle

Selling a straddle involves selling both a call and a put with the same strike price and expiration date.

This strategy is used when the investor believes that the price of foreign currency will move modestly
(low volatility) in either direction.

Advantages: it provides the option seller with income from two separate options (two premiums paid
by the buyer)
Disadvantages: the possibility of substantial losses if the underlying currency moves substantially
away from the strike price.

1st case: S > X, only the call is exercised. The seller is obligated to follow the decision of the buyer.
- P/L = PC + PP – (S – X)
 - The P/L becomes a profit for the seller when PC + PP > S – X

2nd case: S < X, only the put is exercised. The seller is obligated to follow the decision of the buyer.
- P/L = PC + PP – (X – S)
- The P/L becomes a profit for the seller when PC + PP > X – S

3rd case: S = X, the buyer is indifferent between exercising or not exercising the call and/or the put;
both options are ATM.
- P/L = PC + PP

Buying a strangle

A strangle is an option strategy that involves both a call and a put with the same expiration date, but
the strike price for the call option is higher than the current spot rate, while the strike price for the
put option is less than the current spot rate.

Buying a strangle is when the investor expects a substantial currency fluctuation but is unsure of the
direction.

Advantages: buying a strangle is less expensive than a straddle: since the call strike price is higher,
the call premium is lower.

1st case: S < Xput, only the put is exercised. The call is OTM and the put is ITM.
- P/L = Xput – S – (PC + PP)
- The P/L becomes a profit for the buyer when Xput – S > PC + PP

2nd case: S > Xcall, only the call is exercised. The call is ITM and the put is OTM.
- P/L = S – Xcall – (PC + PP)
- The P/L becomes a profit for the buyer when S – Xcall > PC + PP

3rd case: Xput < S < Xcall, neither the call nor the put is exercised. Both options are OTM.
- P/L = - (PC + PP). You lose both premiums.

Lower break-even price: Strike put – Both premiums = Xput – (PC + PP)
Higher break-even price: Strike call + both premiums = Xcall + (PC + PP)

Disadvantages: the probability of incurring the maximum loss (PC + PP) is higher. With a strangle, the
maximum loss occurs at a whole range of prices, between the two strike prices, whereas in a
straddle, it only occurs at one point when S = X.

Selling a strangle

Selling a strangle is when the investor anticipates low volatility of the currency, he believes the
currency price will stay within a range of prices.

Disadvantages: it provides the seller with less income, since the call premium is lower.

1st case: S < Xput, only the put is exercised by the buyer. The seller is obligated to follow the decision
of the buyer.
 - P/L = PC + PP – (Xput – S)
- The P/L becomes a profit for the seller when PC + PP > Xput – S

2nd case: S > Xcall, only the call is exercised. The seller is obligated to follow the decision of the buyer.
- P/L = PC + PP – (S – Xcall)
- The P/L becomes a profit for the seller when PC + PP > S – Xcall
3rd case: Xput < S < Xcall, neither the call nor the put is exercised. Both options are OTM
- P/L = PC + PP

Advantages: the probability of incurring the maximum profit (PC + PP) is higher. With a strangle, the
maximum profit occurs at a whole range of prices, between the two strike prices, whereas in a
straddle, it only occurs at one point when S = X.