FINA3020

International
Finance
Dr. Anson C. K. AU YEUNG
Contents
1 Topic 1 – Introduction to International Finance ................................................................ 9

1.1 The Challenges of Managing a Multinational Corporation ............................... 9

1.2 Distinguishing Features of International Finance ............................................ 10

1.2.1 Foreign Exchange Risk ............................................................................ 10

1.2.2 Political Risk ............................................................................................ 10

1.2.3 Credit Risk ............................................................................................... 10

1.2.4 Tax System............................................................................................... 11

1.3 Issues on International Finance ........................................................................ 11

1.4 Overview of the Course ................................................................................... 11

1.4.1 Part I: International Financial Markets and Instruments.......................... 11

1.4.2 Part II: Exchange Rate Determination and Forecasting ........................... 12

1.4.3 Part III: International Risk Management ................................................. 12

2 Topic 2 – Spot Exchange Markets ................................................................................... 14

2.1 Definition of Exchange Rates .......................................................................... 14

2.1.1 Our Convention: Home Currency per Unit of Foreign Currency ............ 14

1.1.1 The Indirect Quoting Convention ............................................................ 15

2.2 Market Conventions ......................................................................................... 17

2.2.1 Swift Codes .............................................................................................. 17

2.2.2 Pips and Big Figure .................................................................................. 18

2.2.3 Bid and Ask Rates .................................................................................... 18

2.2.4 Inverting Exchange Rates in the Presence of Spread............................... 20

2.3 Exchange Rate Movements.............................................................................. 21

2.3.1 Currency Appreciation and Depreciation ................................................ 21

2.3.2 Measuring Fluctuations ............................................................................ 22

2.4 Major Markets for Foreign Exchange .............................................................. 23

2.4.1 How Exchange Markets Work? ............................................................... 23

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 2.4.2 Reuters Conversation ............................................................................... 24

2.4.3 Broker ...................................................................................................... 25

2.4.4 Markets by Location and by Currency..................................................... 26

2.4.5 Markets by Delivery Date ........................................................................ 28

2.5 The Law of One Price for Spot Exchange Quotes ........................................... 28

2.5.1 Arbitrage across Market Makers .............................................................. 30

2.5.2 Least Cost Dealing across Market Makers .............................................. 31

2.6 Triangular Arbitrage and Least Cost Dealing .................................................. 33

2.6.1 Computing Synthetic Cross-Rates ........................................................... 34

2.6.2 Triangular Arbitrage with Transactions Costs ......................................... 36

2.7 Implications for the Treasurer .......................................................................... 37

3 Topic 3 – Understanding Forward Exchange Contracts .................................................. 38

3.1 Introduction to Forward Contracts ................................................................... 38

3.1.1 Market Conventions for Quoting Forward Rates..................................... 38

3.1.2 Forward Premiums and Discounts ........................................................... 39

3.2 The Relationships between Exchange and Money Markets ............................ 40

3.2.1 Spot and Forward Markets ....................................................................... 40

3.3 Money Markets as Links between Spot and Forward Markets........................ 41

3.3.1 Our Definition of Returns on Investments ............................................... 41

3.3.2 Money Market Operations ....................................................................... 43

3.3.3 Money Market and Exchange Operations................................................ 44

3.4 Arbitrage and Interest Rate Parity.................................................................... 47

3.4.1 Two-way Arbitrage and Interest Rate Parity ........................................... 47

3.4.2 Synthetic Forward .................................................................................... 50

3.4.3 One-way Arbitrage................................................................................... 52

3.4.4 Convergence ............................................................................................ 53

3.4.5 Interest Rate Parity and Causality ............................................................ 53

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 3.5 Swap Rates ....................................................................................................... 54

3.5.1 Market Practice ........................................................................................ 55

3.6 The Market Value of an Outstanding Forward Contract ................................. 57

3.6.1 The Replication Approach ....................................................................... 58

3.6.2 The Hedging Approach ............................................................................ 59

3.6.3 Implications.............................................................................................. 60

3.7 Summary .......................................................................................................... 65

3.8 The Forward-Forward and the Forward Rate Agreement................................ 66

3.8.1 Forward-Forward ..................................................................................... 66

3.8.2 Forward Rate Agreement ......................................................................... 68

4 Topic 4 – Currency Swaps ............................................................................................... 75

4.1 Earlier Swap-like Contracts ............................................................................. 75

4.1.1 The Short-term Currency Swap ............................................................... 75

4.1.2 Back-to-Back and Parallel Loans............................................................. 78

4.2 The Fixed-for-Fixed Currency Swap ............................................................... 79

4.2.1 Characteristics of the Modern Currency Swap ........................................ 80

4.2.2 Motivations for Fixed-for-Fixed Currency Swap .................................... 83

4.2.3 Valuing an Outstanding Fixed-for-Fixed Currency Swap ....................... 85

5 Topic 5 – Currency Options ............................................................................................. 88

5.1 An Introduction to Currency Options .............................................................. 88

5.1.1 Call Options ............................................................................................. 88

5.1.2 Put Options............................................................................................... 88

5.1.3 Forward versus Options ........................................................................... 89

5.1.4 Option Premiums and Option Writing ..................................................... 89

5.2 Graphical Analysis of European Options ........................................................ 89

5.2.1 Payoffs of Forward Contracts .................................................................. 89

5.2.2 Payoffs of a Call....................................................................................... 90

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 5.2.3 Payoffs of a Put ........................................................................................ 91

5.2.4 Buy a Put and Sell a Call: A Synthetic Forward Sale .............................. 92

5.2.5 Synthetic Contracts, Arbitrage and Put-Call Parity ................................. 93

5.3 Institutional Aspects of Options Markets ........................................................ 95

5.3.1 Traded Options......................................................................................... 95

5.3.2 Over the Counter (OTC) Markets ............................................................ 95

5.4 Bounds on Option Values ................................................................................ 95

5.4.1 Intrinsic Value and Time Value ............................................................... 95

5.4.2 Early Exercise Rules of American Options ............................................. 96

5.4.3 Lower Bounds on Option Prices .............................................................. 97

5.5 Options as Hedging or Speculating Devices .................................................... 98

5.5.1 Hedging the Downside Risk Only ........................................................... 98

5.5.2 Hedging Positions with “Reverse” Risk .................................................. 99

5.5.3 Speculating on Changes in Exchange Rates .......................................... 100

5.5.4 Speculating on Changes in Volatility .................................................... 101

5.6 Currency Option Valuation ............................................................................ 101

5.6.1 The Replication Approach ..................................................................... 103

5.6.2 The Hedging Approach .......................................................................... 104

5.6.3 The Risk-adjusted Probabilities ............................................................. 104

5.6.4 Notation and Assumptions for the Multiperiod Binominal Model ........ 106

5.6.5 The One-Period European Currency Call .............................................. 108

5.6.6 The N-Period European Call .................................................................. 110

5.6.7 A Shortcut for European Options .......................................................... 111

5.6.8 Black-Merton Scholes Equation ............................................................ 112

5.6.9 Conclusion ............................................................................................. 114

6 Topic 6 – Purchasing Power Parity................................................................................ 116

6.1 Commodity Price Parity (CPP) ...................................................................... 116

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 6.1.1 The Concept of CPP............................................................................... 116

6.1.2 Implications of CPP ............................................................................... 116

6.1.3 Empirical Tests of CPP .......................................................................... 117

6.1.4 Why CPP May Not Hold?...................................................................... 119

6.2 Absolute Purchasing Power Parity (APPP) ................................................... 120

6.2.1 The Real Exchange Rate and the Effective Real Exchange Rate .......... 120

6.2.2 Link between APPP and CPP ................................................................ 121

6.2.3 The Implications of APPP ..................................................................... 122

6.2.4 Empirical Tests of APPP ....................................................................... 123

6.2.5 Why APPP May Not Hold? ................................................................... 124

6.3 Relative Purchasing Power Parity (RPPP) ..................................................... 124

6.3.1 The Links between RPPP, APPP and CPP ............................................ 126

6.3.2 The Implications of RPPP ...................................................................... 126

6.3.3 Empirical Tests of RPPP ........................................................................ 127

6.3.4 Conclusion ............................................................................................. 127

6.4 Evaluation of PPP as a Theory of Exchange Rate Determination ................. 127

6.5 Implications of the Evidence on PPP for Financial Managers ...................... 128

7 Topic 7 – The Balance of Payments .............................................................................. 129

7.1 What is the Balance of Payments? ................................................................. 129

7.2 Balance of Payments: Overview .................................................................... 130

7.2.1 Current Account (CA) Balance .............................................................. 130

7.2.2 Capital Account (KA) Balance .............................................................. 131

7.2.3 Changes in Official Reserves (ΔRFX) ................................................... 132

7.2.4 Errors and Omissions ............................................................................. 133

7.3 The BOP Approach to Exchange Rate Determination .................................. 134

7.3.1 Adjustment under Fixed Exchange Rates .............................................. 136

7.3.2 Adjustment under Flexible Exchange Rates .......................................... 137

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 7.4 Evaluation of the BOP Theory of Exchange Rate Determination ................. 137

7.5 Relationship between the BOP and Fiscal Policy .......................................... 138

7.5.1 Relationship between Current Account and Domestic Absorption ....... 138

7.5.2 Relationship between Current Account and Budget Deficit .................. 139

8 Topic 8 – Asset Approach of Exchange Rate Determination ........................................ 141

8.1 Monetary Theory of Exchange Rate Determination ...................................... 141

8.1.1 The Monetary Model ............................................................................. 142

8.1.2 Relationship between the Exchange Rate and the Money Supply ......... 143

8.1.3 Relationship between the Exchange Rate and Real Activity ................. 143

8.1.4 Relationship between the Exchange Rate and Budget Deficits ............. 144

8.1.5 Evaluation of the Monetary Theory of Exchange Rates ........................ 144

8.2 The Portfolio Theory of Exchange Rate ........................................................ 145

8.2.1 The Expected Return on a Portfolio....................................................... 145

8.2.2 The Variance of the Return on a Portfolio ............................................. 146

8.3 Mean-Variance Portfolio Choice ................................................................... 146

8.3.1 Descriptive Explanation of Equilibrium in World Capital Markets ...... 147

8.3.2 Analytical Derivation of Optimal Portfolio Weights ............................. 148

8.3.3 Equilibrium in the World Capital Markets ............................................ 149

8.3.4 Applying the Portfolio Theory of Exchange Rates ................................ 150

8.3.5 Comparing the Portfolio Theory with Other Approaches...................... 151

9 Topic 9 – Risk and Return in Forward Markets ............................................................ 152

9.1 The Unbiased Expectations Hypothesis (UEH) ............................................. 152

9.1.1 The Certainty Case ................................................................................. 152

9.1.2 Under Uncertainty.................................................................................. 153

9.1.3 Implications for Exchange Rate Determination ..................................... 154

9.2 Regression Tests of the UEH ......................................................................... 155

9.3 Can Risk Premiums Explain Violations of UEH? ......................................... 156

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 9.3.1 Regression Tests of Risk Premium ........................................................ 158

9.3.2 Other Tests of the Risk Premium ........................................................... 159

9.3.3 Trading Rules Based on the Forward Bias ............................................ 160

9.4 Other Explanations for Violations of the UEH .............................................. 161

9.4.1 Errors in Forming Expectations ............................................................. 161

9.4.2 Peso Problem ......................................................................................... 161

9.5 Real and Nominal Returns: International Relationships ................................ 162

9.5.1 The Fisher Relationship ......................................................................... 163

9.5.2 A General Evaluation ............................................................................. 166

9.6 Implications for Financial Decision Making ................................................. 167

10 Topic 10 – Contractual Exposure to Exchange Rate ............................................. 169

10.1 Motivating Problem ....................................................................................... 169

10.2 The Concepts of Risk and Exposure .............................................................. 170

10.2.1 Definition of Risk and Exposure............................................................ 170

10.3 Managing Contractual Exposure.................................................................... 172

10.3.1 Measuring Contractual Exposure ........................................................... 172

10.3.2 Managing Contractual Exposure............................................................ 173

10.4 Aggregate Contractual Exposure ................................................................... 176

10.4.1 When Interest Rates are Zero ................................................................. 176

10.4.2 When Interest Rates are Positive but Certain ........................................ 176

10.4.3 When Interest Rates are Uncertain ........................................................ 177

10.5 Comprehensive Example ............................................................................... 180

11 Topic 11 – Operating Exposure to Exchange Rate ................................................ 184

11.1 Introduction to Operating Exposure............................................................... 184

11.1.1 Definition of Operating Exposure.......................................................... 184

11.1.2 The Sources of Operating Exposure ...................................................... 185

11.2 The Importance of the Economic Environment ............................................. 185

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 11.2.1 Scenario 1: Perfectly Closed Economy.................................................. 186

11.2.2 Scenario 2: Perfectly Open Economy .................................................... 186

11.2.3 Scenario 3: Sticky Prices and Price Discrimination .............................. 186

11.2.4 Scenario 4: Pass-through Pricing ........................................................... 187

11.2.5 Scenario 5: International Price-takership ............................................... 188

11.3 Measuring and Hedging Operating Exposure ................................................ 190

11.3.1 The Approach to Measuring and Hedging Linear Operating Exposure 190

11.3.2 Exposure Measurement with Two Possible Future Exchange Rates ..... 190

11.3.3 Problem with Residual Risk................................................................... 192

11.4 Implications for Treasury Management ......................................................... 193

12 Topic 12 – Accounting Exposure to Exchange Rate ............................................. 195

12.1 Why Do We Care about Translation? ............................................................ 195

12.2 Accounting Exposure ..................................................................................... 195

12.3 The Current Rate Method .............................................................................. 197

12.4 The Current / Non-Current Method ............................................................... 198

12.5 The Monetary / Non-Monetary Method ........................................................ 200

12.6 The (Ir)relevance of Translation Exposure .................................................... 201

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1 Topic 1 – Introduction to International Finance

We are now living in a highly globalized and integrated world economy. Chinese consumers,
for example, purchase wine from France, iPhone from U.S., and natural gas form Russia.
Foreigners, in turn, purchase Chinese-made clothing, machine, and other equipment.
Continued liberalization of international trade is certain to further internationalize
consumption patterns around the world.

Meanwhile, the global financial markets have become highly integrated. This development
allows investors to diversify their investment portfolios internationally. Over the past decade,
U.S. investors have poured buckets of money into overseas markets, in the form of
international mutual funds. At the same time, many Chinese corporations, such as Alibaba
and Petro China, have their shares cross-listed on foreign stock exchanges, thereby rendering
their shares internationally tradable and gaining access to foreign capital as well. Capital
moves around the world in huge amount. Corporations are free to access different markets
for raising finance. The enormous opportunities of investments, savings, consumption and
market accessibility have given rise to big institutions, financial instruments and financial
markets.

1.1 The Challenges of Managing a Multinational Corporation

What does financial manager need to know to operate in a global setting? This course has
been developed to address this question. The aim of this course is to provide a framework for
analyzing financial decisions asked from an international finance manager. In the process,
the course materials will provide you with the analytical tools to become a financial manager
within a multinational firm.

The financial management of a multinational corporation (MNC) is a very complex task. The
fundamental investment and financing decisions that are the core issue of corporate finance
become new again in the cross-border setting of the multinational firm. Financial managers
are faced with numerous questions that require well-developed intuitions from a domestic
setting to be reinvented in an international setting. Rather than simply considering how to
make aggregate capital structure and dividend decisions, CFOs must also wrestle with
decisions regarding the capitalization and repatriation policies of their many subsidiaries.
Capital budgeting decisions must not only reflect divisional differences but the complications
introduced by currency, tax, and country risks. More generally, valuation decisions must
now take into account how to value assets that are exposed to different country risks and
currencies. Incentive compensations systems must consider how to measure and reward
managers who are operating in very different economic and financial settings.

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1.2 Distinguishing Features of International Finance

Associated with the above mentioned distinctive international features, they complicate the
work of an international financial manager. International finance is a distinct field of study
and certain features set it apart from other fields. The important distinguishing features of
international finance from domestic financial management are discussed below.

1.2.1 Foreign Exchange Risk

An understanding of foreign exchange risk is essential for managers and investors in the
modern day environment of unforeseen changes in foreign exchange rates. In a domestic
economy this risk is generally ignored because a single national currency serves as the main
medium of exchange within a country. When different national currencies are exchanged for
each other, there is a definite risk of volatility in foreign exchange rates. This variability of
exchange rates is widely regarded as the most serious international financial problem facing
by corporate managers.

1.2.2 Political Risk

Another risk that firms may encounter in international finance is political risk. Political risk
ranges from the risk of loss from unforeseen government actions or other events of a political
character. One example is imposing currency controls, that is, blocking some or all exchange
contracts, so that the money of a firm having in a foreign bank account is restricted from
purchase or sale. Another example is expropriation or nationalization, overtly or by stealth.
MNCs therefore must assess the political risk not only in countries where they are currently
doing business but also where they expect to establish subsidiaries.

1.2.3 Credit Risk

If a domestic customer does not pay, you resort to legal redress, and the courts enforce the
ruling. Internationally, one problem is that at least two legal systems are involved, and they
may contradict to each other. This has given rise to private-contract solutions: MNCs seek
guarantees from specialized financial institutions that are better placed to deal with the credit
risk. Financial manager needs to understand where some payment options such as documents
against acceptance (D/A), documents against payment (D/P), and letter of credit (L/C) come
from, and why and how they make sense.

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1.2.4 Tax System

International taxation is complex. When a British corporation sets up shop in Japan, the
subsidiary is taxed there on its profits. It is understandable. But when that company then
pays a dividend to its parent, both Britain and Japan may want to tax the parent company.
This gives rise to the issue of double taxation. Fortunately, legislators everywhere agree that
double or even triple taxation may be somewhat overdoing things, so they advocate neutrality.
However, there is no agreement as to how a “neutral” system can be defined, let alone how it
is to be implemented. This makes life for the CFO complicated. But it also makes life
exciting, because of the loopholes and clever combinations that can substantially affect the
tax burden.

1.3 Issues on International Finance

This is a course on international finance. Thus, it does not address issues of multinational
corporate strategy, and the discussion of international macroeconomics is kept to a minimum.
The discussion will focus on understanding and managing foreign exchange and political
risks and coping with market imperfections. International finance is designed to provide
today’s financial managers with an understanding of the fundamental concepts and the tools
necessary to be effective global managers. Throughout, the course emphasizes how to deal
with exchange risk and market imperfections, using various instruments and tools that are
available.

1.4 Overview of the Course

We divide the course into three parts: (I) International financial markets and instruments; (II)
Exchange rate determination and forecasting; and (III) International risk management.

1.4.1 Part I: International Financial Markets and Instruments

The first part of the course describes the currency market in its widest sense, that is, including
all its satellites or derivatives. Topic 2 describes the spot markets. Forward markets, where
price and quantity are contracted now but delivery and payment take place at a known future
moment, are introduced in Topic 3. It also shows how and when to use contracts in reality.
Currency swaps, which are closely related to forward transactions, are discussed in Topic 4.
Topic 5 introduces currency options and shows how these options can be hedge against
foreign exchange risk. How currency options are priced is explained in this topic. We
mostly use the so-called binominal approach but also link it to the famous Black-Scholes
model.

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1.4.2 Part II: Exchange Rate Determination and Forecasting

The value of the financial instruments discussed in Part I can be determined without
knowledge of why the spot rate was set at its current level – we use arbitrage arguments that
take the spot rate as given. In Part II, then, we address the issue of what determines the spot
rate. The traditional view, presented in Topic 6, is Purchasing Power Parity: exchange rates
are set so as to equate the values of goods across countries. Although Purchasing Power
Parity is undeniably present in the long-run, its short-run explanatory power is extremely low.
As Keynes said, the exchange rate is not set in the commodity markets, but on the Exchange.
That is, the supply and demand for currencies is related not just to commodity trade, but
mainly to capital transactions. We discuss the Balance of Payments and the Keynesian view
of exchange rates in Topic 7.

Given the state of economic and financial theory at that time, Keynes did not model
uncertainty, and provided no explicit asset pricing model. The first asset-type theory with a
nice, explicit pricing formula is the Monetary Model, which relates the exchange rate to the
transactions demand for money. But this model attempts to price exchange rates in isolation,
as if there were just one asset. The Portfolio Model, an extension of the Monetary Model,
points out that one cannot price an asset, like foreign exchange, in isolation from other assets.
These asset pricing models of exchange rate determination are described in Topic 8. In Topic
9, we examine the link between the forward rate and future spot rate.

1.4.3 Part III: International Risk Management

Part III considers risk management. The first type of risk we consider is exchange risk.
Topic 10, 11, and 12 explain how to measure the impact of exchange rate changes on the
value of contracts fixed in terms of foreign currency, on operational cash flows, and on
consolidated financial statements, respectively. We also show how to hedge these exposures
using the instruments described in Part I.

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 Part I

International Financial Markets and Instruments

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2 Topic 2 – Spot Exchange Markets

In this topic, we study the mechanics of the spot exchange market.

2.1 Definition of Exchange Rates

An exchange rate is the amount of currency that one needs in order to buy one unit of another
currency, or it is the amount of a currency that one receives when selling one unit of another
currency.

Which money is being bought or sold?

Example 2.1

In a bank, a tourist hands over USD 1,000 to the bank teller and receives CAD 1,250 in return.
This event would be described differently depending on whether the person is an American,
or a Canadian.

• The American tourist would view this as a purchase of CAD 1,250 at a cost of USD
1,000, implying a unit price:

• The Canadian tourist would view this as a sale of USD 1,000 at a return of CAD
1,250, implying a unit price:

This example shows that exchange rates can be quoted in different ways.

2.1.1 Our Convention: Home Currency per Unit of Foreign Currency

Our exchange rate convention: the price in units of home currency (HC) per unit of foreign
currency (FC) – or HC/FC.

It is the easiest convention to work with since we always express goods prices in units of
home currency too.

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For example, we say “the price is HKD 5 per apple” (HC/apple); not “with HKD 1 you can
buy one-fifth of an apple” (apple/HC).

Our convention (HC/FC) is called the “direct” quote, or the “right” quote. In the United
States, a price with dimension USD/FC is called “American Terms”.

As we shall see, some countries do it differently. The alternative (FC/HC) is called the
“indirect” quote, or the “left” quote. In the United States, a price with dimension FC/USD is
called “European Terms”.

1.1.1 The Indirect Quoting Convention

1. Against USD:

• Traders need a unique language. Between 1944 and the mid-80s, each and every
exchange went through the USD. Even when a German needed to buy CHF, the
DEM would first be converted into USD and these dollars were then exchanged for
CHF.
• European governments had officially fixed the rate as for example DEM/USD 4, their
own natural quote.

2. Against GBP:

• The pound used to be intractably non-decimal until 1967. One pound consisted of
four crowns, each crown worth five shillings, and each shilling worth twelve pence.
It is much easier to multiply or divide by a decimal number, say FC/GBP 0.79208,
than with a number like £1/s5/d3 (one pound, five shillings, three pence).
• The pound used to play the key role taken by USD after World War II.
• Some former British Commonwealth countries (for instance Australia, New Zealand,
Ireland, and South Africa) use FC/HC.

3. Against EUR:

• The EUR used to be “foreign” even for Euro landers.

• Europe thought the indirect quote was posher.

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Example 2.2

Look at the Financial Times Europe (10 May 2013) excerpt above. It conveniently shows
three quotes: the value of USD or EUR or GBP in one unit of the foreign currency.

What is the dollar equivalent of one Euro, according to the quotes in the Financial Times?

Determine the amount Peru New Sol per Euro?

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2.2 Market Conventions

Below is the Reuters screen which shows spot rates for various currencies against the USD.

2.2.1 Swift Codes

Each currency can be identified by a three-letter code. The first two letters refer to the name
of the country. The third letter refers to the name of the currency. These codes are used by
the Swift message system and have become international accepted standards.

For some currencies nicknames are rather common among dealers. For example:

• GBP/USD: Cable
• CHF/USD: Swissi
• SEK/USD: Stocki
• AUD/USD: Aussi
• NZD/USD: Kiwi

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2.2.2 Pips and Big Figure

An FX quote usually consists of five digits:

• EUR/USD 1.1510
• USD/CHF 1.3160
• AUD/USD 0.6455
• USD/JPY 117.15
• USD/CZK 27.323

The last two digits of the spot rate are the pips (price interest points). The rest of the spot
quotation is called big figure.

In day-to-day trading, spot dealers assume that, every counterpart knows the big figure of the
given quotation. Hence, spot rates are often quoted only with their pips.

2.2.3 Bid and Ask Rates

When you deal with foreign currency, you will discover that you pay a higher price at the
time of purchase than when you sell one currency for another.

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For example, if you wish to buy AUD, you will be quoted at HKD 7.6930. However, if you
wish to sell AUD, you will be quoted at HKD 7.6550.

• The rate at which the bank will buy a currency from you is called the bid rate.
• The rate at which the bank will sell a currency to you is called the ask rate.

Note that the ask rate is always greater than the bid rate (Ask – Bid ≥ 0). The difference
between the buying and selling rates is called the spread. You can think of the bank’s
implicit commission as being equal to half the spread.

Example 2.3

Suppose that you buy AUD at HKD/AUD 7.6930, and sell AUD at HKD/AUD 7.6550. With
these rates, the spread is:

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 7.6930  7.6550
You can think of a purchase as occurring at the midpoint rate  7.6740 ,
2
grossed up with a commission of 0.019. Likewise, a sale can be thought of as a sale at the
midpoint rate 7.6740, from which the bank withholds a commission of 0.019.

Thus, the commission is the difference between the bid or ask and the midpoint rate, that is,
half the spread.

The bid-ask spread depends on:

1. Retail:

• Spread falls with order size.

2. Wholesale:

• Spread falls when risk of posting a quote is lower. That is, during the time of high
liquidity / low volatility.

2.2.4 Inverting Exchange Rates in the Presence of Spread

The rule is:

1 1
 ask ;  bid
bid ask

This is because an inverse of a smaller rate becomes larger, and vice versa.

Example 2.4

An Indian investor wants to convert her CAD into USD and contacts her house bank,
Standard Chartered. Being neither American nor Canadian, the bank has no natural
preference for either currency and might quote the exchange rate as either USD/CAD or
CAD/USD. The bank would make sure that its potential quotes are perfectly compatible.

The bank’s alternative ways of quoting will be fully compatible if:

1
CAD /USD
Sbid ,t  USD / CAD
S ask ,t

1
CAD /USD
S ask ,t  USD / CAD
S bid ,t

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Suppose the quote of on the Reuters’ screen is: USD/CAD 1.000 – 1.005.

What is the bank’s buying and selling rate for CAD?

• The bank’s buying rate (bid) for CAD is

• The bank’s selling rate (ask) for CAD is

What is the bank’s buying and selling rate for USD?

• The bank’s buying rate (bid) for USD is

• The bank’s selling rate (ask) for USD is

2.3 Exchange Rate Movements

Prices of currencies can fluctuate just as prices of goods can fluctuate. We are going to
examine currency appreciations and depreciations, how currency fluctuations are measured,
and the meaning of changes in exchange rates.

2.3.1 Currency Appreciation and Depreciation

The purchasing power of one currency relative to another currency can appreciate or
depreciate. When a currency increases in value relative to other currencies, it is said to
“appreciate”; when a currency decreases in value, it is said to “depreciate”. For example, if
the GBP appreciates relative to the USD, then the British pound can buy more U.S. dollars
and a U.S. dollar can buy fewer British pounds.

Example 2.5

Examine the exchange rate on two different dates:

Date Exchange Rate

April 20, 2016 EUR/USD 0.92109
April 24, 2016 EUR/USD 0.90570

According to these rates, on April 20, 2016, USD 100 could buy EUR 92.11; while on April
24, 2016, USD 100 could only buy EUR 90.57, 1.54 fewer euros than before.

Since the U.S. dollar buys less on April 24, 2016, its purchasing power has decreased and the
dollar is said to have depreciated. Because the euro now has more value relative to the U.S.
dollar, the euro is said to have appreciated.

21
To determine whether a currency has appreciated or depreciated, follow these simple rules.

Given that:

• Previous exchange rate = X (Currency A / Currency B)

• Current exchange rate = Y (Currency A / Currency B)

If X > Y, Currency A has appreciated and Currency B has depreciated, relative to one another.
If X < Y, Currency A has depreciated and Currency B has appreciated, relative to one another.

2.3.2 Measuring Fluctuations

Exchange rate fluctuations are often presented in percentage terms, relative to some reference
currency. For example, the Mexican peso could depreciate 25% relative to the U.S. dollar or
the euro could appreciate 10% relative to the British pound. Calculating these fluctuations
correctly can be confusing, so it is important to set up the problem correctly.

Example 2.6

Consider the movement of the MXN/USD from 10 to 20:

MXN 10 MXN 20

USD 1 USD 1
Previous Exchange Rate Current Exchange Rate

To calculate its percentage fluctuation, follow the steps below.

Benchmark Currency
Step 1: Convert exchange rates into a form of:
Fluctuating Currency

We are interested in the fluctuation of the Mexican peso, so we rearrange the exchange rates
in terms of benchmark currency / fluctuating currency. The benchmark currency is the U.S.
dollar and the fluctuating currency is the Mexican peso.

USD 1 USD 1

MXN 10 MXN 20
Previous Exchange Rate Current Exchange Rate

USD MXN 0.10  USD MXN 0.05

22
Step 2: Determine if the fluctuating currency has appreciated or depreciated.

In this case, the USD has appreciated and the MXN has depreciated.

Step 3: Calculate the change as a percentage of the original exchange rate.

Amount Change
100  % Change
Original Exchange Rate
0.05
100  50% depreciation
0.10

It indicates that the Mexican peso depreciated 50% against the U.S. dollar.

To measure the percentage appreciation of the U.S. dollar:

Amount Change
100  % Change
Original Exchange Rate
10
100  100% appreciation
10

The U.S. dollar has appreciated 100% against the Mexican peso.

2.4 Major Markets for Foreign Exchange

2.4.1 How Exchange Markets Work?

The foreign exchange market is not an organized market (no fixed opening hours, less
centralized mechanism to match supply and demand, no official publication channel for data
on volumes and prices). In contrast, it has two tiers – a wholesale tier and a retail tier.

1. Wholesale tier:

• It is an informal network of about 500 banks and currency brokerages that deal with
each other and with large corporations.
• It has two kinds of professionals: market makers and brokers.
• Market makers give two-way quotes binding up to an agreed limit (e.g. USD 10
million).
• Brokers will shop around to find takers for your offer. Nowadays, Reuters and EBS
run limit-order books for this purpose, and brokers just do the special deals (e.g.
“large” or “structured”).
• It opens twenty-four hours a day.

23
2. Retail tier:

• You and I buy and sell foreign exchange.

2.4.2 Reuters Conversation

Here you can see a typical Reuters conversation in the FX spot market:

#USD EUR 10
12 14
#URS
OK TO CONFIRM I BUY EUR 10 MIO AGAINST USD AT 1.1512
MY EUR DIRECT PLS
#TO CONFIRM I SELL EUR 10 MIO AGAINST USD AT 1.1512
#MY USD TO CITI N.Y. PLS
#THKS VM AND BIBI
#END REMOTE

Explanation:

A hash (#) at the beginning of a line marks your own text.

#USD EUR 10

This bank is asking for a rate for EUR 10m against USD. Usually you do not tell if you want
to buy or sell.

12 14

This bank is quoting the pips of bid and ask rate (market maker). As market participants
normally know the big figure, it is left out when quoting so you can save time. In this case
we assume that the regular rate is 1.1512 – 1.1514.

#URS

The asking bank deals and sells EUR 10m at the bid rate (market user). At the same time it
buys USD at 1.1512. That is, 10,000,000 × 1.1512 = USD 11,512,000. “URS” is a common
abbreviation for “yours” which means “I sell” (opposite “mine” for “I buy”).

24
 OK TO CONFIRM I BUY EUR 10 MIO AGAINST USD AT 1.1512
MY EUR DIRECT PLS

The quoting bank confirms the deal and gives payment instructions for the EUR it receives.

#TO CONFIRM I SELL EUR 10 MIO AGAINST USD AT 1.1512

#MY USD TO CITI N.Y. PLS
#THKS VM AND BIBI
#END REMOTE

The asking bank confirms the deal as well and gives payment instructions for the USD it
receives. The bank thanks for the deal and the conversation is ended.

2.4.3 Broker

Banks can trade directly with each other and also via a broker. A broker acts as an agent for
the two counterparties and receives a brokerage for his service. This brokerage depends on
the traded volume. The broker’s advantage is to provide a bigger market depth compared to
the one-to-one direct trading in the interbank market. In contrary to his banking clients, the
broker never takes trading positions.

We can distinguish between voice brokers and electronic brokers broking systems. A voice
broker is a person who trades with banks via open telephone line or Reuters conversation.
He informs his customers the actual quotes all the time. If a bank trades on a broker’s price,
a deal is done between this bank and the bank which quoted the price. The broker then
confirms the deal with both of them and additionally sends a written confirmation to both
counterparts as well.

An electronic broker is an electronic broking system which works like a voice broker but the
quotes and deals are done through a special system. The best known systems are Reuters
3000 and EBS. These systems check if both banks have enough limits to deal with each other.

25
2.4.4 Markets by Location and by Currency

According to the BIS “Triennial Central Bank Survey of Foreign Exchange and Derivatives
Market Activity in 2013”, the daily volume of trading was estimated at more than USD 5.3
trillion.

The major markets were in order of importance: London, New York, Singapore, Tokyo and
Hong Kong.

Banks located in the United Kingdom accounted for 41% of all foreign exchange market
turnovers, followed by the United States (19%), Singapore (5.7%), Japan (5.6%), Hong Kong
SAR (4.1%).

The most important markets, per currency, are the USD/EUR and the USD/JPY markets;
together they represent almost half of the world’s trading volume.

26
27
2.4.5 Markets by Delivery Date

The exchange market consists of two core segments: the spot exchange market and the
forward exchange market.

1. Spot (rate: St )

• It is the exchange market for “quasi-immediate” payment in home currency and

delivery of foreign currency.

2. Forward (rate: Ft ,T )

• It is the exchange market for payment and delivery of foreign currency at some future
date, T – e.g. three months from now.
• The most active forward markets are for 30, 90, 180, 270, and 360 days, but
nowadays bankers routinely quote rates up to ten years forward.

2.5 The Law of One Price for Spot Exchange Quotes

Below is the JPY quotation from the main banks in Hong Kong on March 14, 2016. What
happened to Treasurer of Fubon Bank?

28
In general, the Law of One Price is enforced by two mechanisms:

1. Arbitrage:

• Buy the underpriced, (short) sell the overpriced.

• Arbitrage yields a sure profit without requiring any additional investment (no change
in the net position).
• Arbitrage limits the price difference to the sum of the transaction costs as you buy and
sell.

2. Least cost dealing:

• The investor’s intent is to change a position.

• When buying, investor buys the underpriced asset rather than the more expensive one.
• When selling, investor sells the overpriced one rather than the one that is relatively
cheap.
• The dealing goes on as long as the price difference exceeds the difference of the
transaction costs and as long as there are investors who want to make that particular
transaction.

Although the arbitrage and least cost dealing mechanisms both tend to enforce the Law of
One Price, there are two differences between these mechanisms.

1. Arbitrage transaction is a round-trip transaction. That is, you buy and sell, thus ending up
with the same position with which you started. As arbitrage requires a two-way
transaction, its influence stops as soon as the price difference is down to the sum of the
transaction costs (buying and selling). In contrast, in least cost dealing one wishes to
make a particular transaction, and the issue is which of the two assets is cheaper to trade.
As a result, the influence of least cost dealing can go on as long as the price difference
exceeds the difference of the two transactions costs.

2. Arbitrage is a strong force because it does not require any capital. In contrast, least cost
dealing will be a price-equilibrating mechanism only if there are investors who wish to
make that particular transaction.

29
Example 2.7

If HSBC quotes HKD/EUR 9.9610, while BOCHK quotes HKD/EUR 9.9590, both at zero
spreads, then there are two possibilities:

• There is an arbitrage opportunity. You can buy cheap EUR from BOCHK and
immediately sell to HSBC, netting HKD 0.002 per EUR. You will, of course, make
as many EUR transactions as you can. So will everybody else. The effect of this
massive trading is that either HSBC or BOCHK, or both, will have to change their
quotes so as to stop the rapid accumulation of long or short positions. Situations with
arbitrage profits are inconsistent with equilibrium, and are eliminated very rapidly.
• There is also a least cost dealing pressure. All buyers of EUR will buy from BOCHK,
and all sellers will deal with HSBC.

2.5.1 Arbitrage across Market Makers

Suppose HSBC quotes you HKD/GBP 12.150 – 12.158 while BOCHK quotes HKD/GBP
12.160 – 12.168.

If you see such quotes,

• Buy GBP from

• Sell it immediately to
• Pocket a profit worth
• No risk and no net investment.

If such quotes are found in the exchange market, large trades by a few alert dealers would
immediately force prices back into line.

In equilibrium, the arbitrage argument says that you cannot make money without investing
capital and without taking risk.

30
Graphically, any empty space between the two quotes would correspond to an arbitrage profit.

2.5.2 Least Cost Dealing across Market Makers

Suppose HSBC quotes you HKD/GBP 12.150 – 12.158 while ICBC quotes HKD/GBP
12.154 – 12.162.

There is no scope for arbitrage, but:

• All buyers buy GBP from

• All sellers sell GBP to

It is conceivable that these banks actually want this to happen. For instance, if HSBC has an
excess of GBP and ICBC is short of GBP and wants to replenish its FC inventory.

But if both banks want to be in the market for selling and buying, their quotes have to be
equal.

31
Graphically, any two banks’ quotes should overlap by at least one point.

Example 2.8

Suppose you see five banks quoting EUR against USD as follows:

Citibank USD/EUR 1.3450 – 52

HSBC USD/EUR 1.3450 – 52
Hang Seng Bank USD/EUR 1.3451 – 53
Standard Chartered Bank USD/EUR 1.3450 – 52
Bank of China USD/EUR 1.3449 – 51

Which bank is keen on buying EUR?

Which bank is keen on selling EUR?

Why does Hang Seng Bank raise both its bid and its ask, rather than just its bid?

32
If we were to look at these banks’ quotes every five minutes, would we always expect to see
the same pattern, i.e., Hang Seng Bank quoting higher and Bank of China quoting lower than
the majority?

2.6 Triangular Arbitrage and Least Cost Dealing

Now that we know how exchange rates are quoted and what arbitrage means, let us look at
the relationships that exist between spot rates quoted in various currencies.

1. Triangular arbitrage:

• Try to make money by sequentially buying and selling three currencies, ending with
the original currency.

Example 2.9

Suppose HSBC gives the current exchange rates of currency pairs: JPY/USD 100; USD/GBP
1.60; and JPY/GBP 140.

Take the first two quotes. The implied no-arbitrage JPY/GBP quote should be:

HSBC undervalues GBP against JPY. If you see such quotes, you buy undervalued GBP
with the overvalued JPY:

• Borrow
• Sell
• Sell
• Sell

This would yield a profit of USD 0.1429 (14.29% per USD borrowed).

33
2. Triangular least cost dealing:

• It is the search for the best way to achieve a desired conversion.

Example 2.10

Using the same quotes above, suppose you want to buy USD 10,000.

• Buy

Or:

• Buy
• You saved

2.6.1 Computing Synthetic Cross-Rates

A synthetic version of a contract is a combination of two or more other transactions which

achieves the same purpose as the original contract.

Example 2.11

Find the synthetic JPY/GBP rates if JPY/USD 101.07 – 101.20; and USD/GBP 1.3840 –
1.3850.

Step 1: Multiply or Divide?

The dimension of the rate we are looking for is JPY/GBP. Because the dimensions of the two
quotes given to us are USD/GBP and JPY/USD, the way to obtain the synthetic rate is to
multiply the rates, as follows:

34
Step 2: Bid or Ask?

• Use the rip-off rule. At every single transaction we get the worse rate – “high” for
buy and “low” for sell.
• In a chain of transactions one always ends up with the worst possible combination.

The synthetic bid is the lowest product:

The synthetic ask is the highest product:

Example 2.12

Find the synthetic JPY/GBP rates if JPY/USD 101.07 – 101.20; and GBP/USD 0.72202 –
0.72254.

Step 1: Multiply or Divide?

Look at the dimension:

35
Step 2: Bid or Ask?

The synthetic bid is the lowest quotient:

The synthetic ask is the highest quotient:

2.6.2 Triangular Arbitrage with Transactions Costs

Now that we fully understand synthetic quotes, we can derive bounds imposed by arbitrage
and least cost dealing on quotes in the market.

Just think of the direct quotes as the quotes from Bank X, and think of the synthetic quotes as
the quotes from Bank Y.

36
1. X versus Y:

• There is arbitrage possibility.

• At least one set of rates has to change.

2. X’ or X” versus Y:

• No arbitrage possibilities.
• X’ will see only buyers – no sellers. This is not a long-run phenomenon.
• Only X” will have both buyers and sellers.

2.7 Implications for the Treasurer

1. Arbitrage consists of buying and immediately reselling, thus taking no risk and engaging
no capital.

• In practice, the likelihood of corporate treasurers finding such a riskless profit

opportunity is tiny.
• Arbitrage by traders in the wholesale market eliminates this possibility almost as
quickly as it arises.
• In addition, most firms deal in the retail market, where spreads are relatively wide.

2. Least cost dealing consists of finding the best route for a particular transaction.

• In contrast to arbitrage, least cost dealing may work – not in the sense of creating
large profits, but in the sense of saving on commissions.
• It is generally worth calling a few banks for the best rate when you need to make a
large transaction.
• It may be pay to compute a triangular cross rate, especially through routes that
involve heavily traded currencies like the USD or the EUR. Doing such a
computation could enable corporate treasurers to find cheaper routes for undertaking
transactions as compared to direct routes.

37
3 Topic 3 – Understanding Forward Exchange Contracts

In this topic, we study forward contracts in perfect financial markets. That is, we assume:

• No transaction costs.
• No taxes.
• No default risk.

3.1 Introduction to Forward Contracts

A forward contract stipulates how many units of foreign currency are to be bought or sold
and at what exchange rate.

Like spot markets, forward markets are not organized exchanges, but over-the-counter (OTC)
markets, where banks act as market makers or brokers look for counterparts.

The rate that is used for all contracts initiated at time t and maturing at some future moment T
is called the time-t forward rate for delivery date T.

We denote it as Ft ,T .

3.1.1 Market Conventions for Quoting Forward Rates

Traditionally, forward exchange rates can be quoted in two ways.

• Outright rate: the actual rate.

• Swap rate: the difference between the outright forward rate and the spot rate.

38
Example 3.1

Look at the Financial Times (20 May 2013) excerpt above.

USD/EUR EUR/USD Swap Rates

Spot 1.2857 0.777786 – –

1 month 1.2859 0.777665 +0.0002 -0.000121
3 months 1.2864 0.777363 +0.0007 -0.000423
12 months 1.2898 0.775314 +0.0041 -0.002472

Traders traditionally quoted swap rates. But newspapers have stopped the practice.

3.1.2 Forward Premiums and Discounts

Now that you understand how forward contracts are quoted, it is time to introduce some
important terminology regarding the relationship between forward and spot exchange rates.

It is common to express the premium or discount of a forward rate as an annualized

percentage deviation from the spot rate. The forward premium or discount is useful for
comparing against the interest rate differential between two countries. The forward premium
or discount can be calculated using FC terms or HC terms.

Assume the following spot rate for our discussion:

FC/HC HC/FC
Spot JPY/USD 118.27 USD/JPY 0.0084552
3-month Forward JPY/USD 116.84 USD/JPY 0.0085587

3.1.2.1 Foreign Currency (FC) Terms

When the foreign currency is used as the price of the home currency, and substituting
JPY/USD spot and forward rates, as well as the number of days forward (n = 90), the forward
premium on the yen is calculated as follows:

St  Ft ,T 360
 100
Ft ,T n
118.27  116.84 360
   100
116.84 90
 4.90%

We can say the JPY is selling forward at a premium of 4.9% against the USD.

39
3.1.2.2 Home Currency (HC) Terms

When the home currency is used as the price for the foreign currency, the reciprocals of the
spot and forward rates used in the previous calculation, the calculation of the forward
premium on the yen is:

Ft ,T  St 360
 100
St n
0.0084552  0.0085587 360
   100
0.0085587 90
 4.9%

Again, the result is identical to the previous premium calculation: a positive 4.9% premium of
the JPY against the USD.

3.2 The Relationships between Exchange and Money Markets

3.2.1 Spot and Forward Markets

A spot transaction has two “sides”:

• Your position before the transaction: an “input” (the money you give to the bank).
• Your position after the transaction: an “output” (the money you get from the bank).

Example 3.2

Suppose you sell EUR 1 million for USD 1.25 million.

• The input: EURt  EUR 1 million .

• The output: USDt  USD 1.25 million .

The proportionality factor that allows us to compute the amount of output from the amount of
input is an exchange rate (HC/FC).

In general:

“output” = “input” × “factor”

• HCt  FCt  St
1
• FCt  HCt 
St

40
Graphically, any possible entry is shown as an arrow:

• A move HCt  FCt refers to buying FC spot.

• A move FCt  HCt refers to selling FC spot.

Similarly, for the forward market:

• A move HCT  FCT refers to buying FC forward.

• A move FCT  HCT refers to selling FC forward.

3.3 Money Markets as Links between Spot and Forward Markets

3.3.1 Our Definition of Returns on Investments

The effective risk-free return is the simple percentage difference between the initial time-t
value and the final, time-T value of a nominally risk-free asset over a certain holding period.

Example 3.3

You deposit EUR 100,000 for six months and that the deposit will be worth EUR 105,000 at
maturity. The six-month effective return is:

41
If you invest for nine months, the maturity value of this deposit is EUR 107,200. Then the
nine-month effective return is:

Notes:

1. An effective return is not annualized. It is ready for use.

2. An interest rate is a return that has been annualized in some way. You first have to de-
annualize the rate – using the same convention as the one your banker had in mind when
annualizing.

3. As there are many (de-) annualization methods, in the formulas we assume you have
already computed the effective return.

Example 3.4

Suppose that the p.a. simple interest rate for a three-month investment is 6%. It means:

Convention Formula rt ,T

 3 
Simple interest 1   0.06   1  0.01500
 12 
3
Compound (annual) 1  0.06 12  1  0.01467

3
 0.06 
Compound (monthly) 1   1  0.01507
 12 
90
 0.06 
Compound (daily) 1   1  0.01511
 360 
3
0.06
Compound (continuous) e 12
1  0.01523

42
3.3.2 Money Market Operations

Investments and loans – the money market – are important because they form the link
between the spot and forward exchanges.

A domestic deposit (or an investment in T-bills) is a transaction in which you invest money
(input) today and receive money in the future (output).

Likewise, a loan (or a sale of T-bills) means that you receive the money (output) today and
pay back the money in the future (input).

Thus, the proportionality factor by which the input amount is multiplied in order to find the
1
output amount is 1  rt ,T for investments and for loans.
1  rt ,T

Recall that:

“output” = “input” × “factor”

• Investments: HCT  HCt  1  rt ,T 

1
• Loans: HCt  HCT 
1  rt ,T

Similarly, for the foreign money market, the same set of relationships holds, where the
*
foreign return is denoted by rt ,T . Thus:

• Investments: FCT  FCt  1  rt*,T 

1
• Loans: FCt  FCT 
1  rt*,T

43
Graphically:

• A move HCt  HCT refers to investing or lending HC.

• A move FCT  FCt refers to borrowing against an FC income.

3.3.3 Money Market and Exchange Operations

How to use the diagram?

44
Example 3.5

Consider a U.S. investor who converts an amount of USDt into an amount of EURt , deposit it
for 6 months, and immediately sells forward the proceeds EURT so as to obtain a known
amount of USD at time T. Given:

USDt  1 million ; St  USD EUR 1.25 ; rt ,T  0.01 over six months; and Ft ,T  1.2480
*

1. Buy spot EUR:

2. Invest the EUR at 1%:

3. The future EUR inflow is sold forward at:

Alternatively, we identify the route: USDt  EURt  EURT  USDT , and multiply initial
input by all proportionality factors next to the arrows:

45
Example 3.6

Your customer will pay EUR 20,100 (A/R) at time T, six months from now. You decide to
sell forward and to borrow USD against the proceeds of the forward sale. How much can you
borrow on the basis of this invoice without taking any exchange risk?

Assume St  1.25 , Ft ,T  1.2450 , and rt ,T  0.005 for six months.

46
3.4 Arbitrage and Interest Rate Parity

Two types of sequences of transactions can be analyzed:

1. Round-trip sequences: arbitrage

• A round-trip means that you start in a particular box, and then make four transactions
that bring you back to the starting point.
• For example, ( USDT  USDt  EURt  EURT  USDT ). In words, borrow USD,
convert the proceeds of the USD loan into EUR, and invest these EUR; the proceeds
of the EUR investment are then immediately sold forward for USD.
• If the USD proceeds of the forward sale are more than sufficient to pay off the
original USD loan, you have found an arbitrage opportunity.

2. Non-round-trip sequences: least cost dealing

• You end up in a box that is not the same as the box from which you start.
• For example, the covered EUR investment ( USDt  EURt  EURT  USDT ) versus
the direct USD investment ( USDt  USDT ).

3.4.1 Two-way Arbitrage and Interest Rate Parity

Suppose that you find a round-trip sequence of transactions generates a sure profit without
requiring any capital. You will make as large a transaction as possible.

Let the maturity equal to six months. Consider the following two round-trip transactions:

1. USDT  USDt  EURt  EURT  USDT clockwise.

• That is, borrow USD for six months. Convert all of it into EUR. Invest this amount
for six months, and immediately sell forward the amount of EUR you will receive six
months from now.
• If that forward sale yields more USD than what is needed to pay back the loan, you
have a money machine.

This trip starts with a loan ( USDT  USDt ) and goes full circle back to USDT . Suppose
you start with USDT  1 .

47
Thus,

1
USDt 
1  rt ,T

Converting this into EURt :

1 1
EURt  
1  rt ,T St

Investing this yield:

  1  rt*,T 
1 1
EURT 
1  rt ,T St

Finally, selling this EURT amount forward one gets:

  1  rt*,T   Ft ,T
1 1
USDT 
1  rt ,T St

The no-arbitrage condition says that, when starting with USDT  1 , the forward sale
cannot yield more than USDT  1 :

  1  rt*,T   Ft ,T  1
1 1
1  rt ,T St

This implies that, in equilibrium, the forward rate must satisfy:

1  rt ,T
Ft ,T  St  (1)
1  rt*,T

48
2. USDT  EURT  EURt  USDt  USDT counter-clockwise.

This trip also starts with a loan, USDT  1 .

Buying EURT amount forward one gets:

1
EURT 
Ft ,T

If we get the foreign currency for today:

1 1
EURt  
Ft ,T 1  rt*,T

And sell it in the spot market:

1 1
USDt    St
Ft ,T 1  rt*,T

Finally, if we invest the proceeds, they cannot yield more than USDT  1 :

 St  1  rt ,T   1
1 1

Ft ,T 1  rt*,T

This implies that, in equilibrium, the forward rate must satisfy:

1  rt ,T
Ft ,T  St  (2)
1  rt*,T

49
By analyzing these two round-trips, we have derived a lower and an upper bound on the
forward rate. Equation (1) and (2) imply:

1  rt ,T
Ft ,T  St 
1  rt*,T

This is the interest rate parity. It says that, in equilibrium, the forward rate must be the spot
rate adjusted for a factor that depends on the ratio of the domestic and foreign returns.

Example 3.7

A Japanese firm wants to calculate the one-year forward JPY/USD rate. With spot yen
selling at St  JPY USD 150 and the JPY annual interest rate is 7% and the USD annual
interest rate is 9%.

The one-year forward rate:

Example 3.8

Now suppose that HSBC is quoting the forward rate for delivery in one-year at
JPY USD 140 . What will happen?

If the interest rate parity is violated, arbitrage will use covered interest arbitrage to take
advantage of this situation.

3.4.2 Synthetic Forward

Before we discuss how the covered interest arbitrage strategy works, let us introduce the
concept of synthetic forward.

A synthetic forward is an investment strategy that mimics a regular forward contract.

50
Suppose we long a forward, we buy FC (sell HC).

We have to pay the HC (outflow) and get the FC (inflow) at time-T. The cash flow:

Instead of buying a direct forward, we can create a “synthetic” forward by borrowing and
investing:

Cash flow at t = 0 Cash flow at t = T

1. Borrow HC
+ FC – HC
Convert it into FC
2. Invest FC – FC + FC
+ FC
Total 0
– HC

Suppose we short a forward, we sell FC (buy HC).

We have to pay the FC (outflow) and get the HC (inflow) at time-T. The cash flow:

Instead of selling a direct forward, we can also create a “synthetic” forward by borrowing
and investing.

Cash flow at t = 0 Cash flow at t = T

1. Borrow FC
+ HC – FC
Convert it into HC
2. Invest HC – HC + HC
+ HC
Total 0
– FC

51
Example 3.9

A Japanese firm wants to calculate the one-year forward JPY/USD rate. With spot yen
selling at St  JPY USD 150 and the JPY annual interest rate is 7% and the USD annual
interest rate is 9%.

Now suppose that HSBC is quoting the forward rate for delivery in one-year at
JPY USD 140 . How to formulate the covered interest arbitrage?

Recall that the one-year forward rate:

Ft ,T  147.25

The direct forward is less than what the arbitrage-free valuation should be. To carry the
covered interest arbitrage, we can (1) long direct forward and (2) short synthetic forward at
the same time.

Cash flow at t = 0 Cash flow at t = T

1. Borrow USD 1
Convert USD 1 into JPY

2. Invest JPY

3. Long forward
(Sell JPY at
JPY/USD 140)
Total

At time-T, the arbitrageur will realize a risk-free profit of USD 0.0564 per USD borrowed.
HSBC will soon realize its forward quote is not correct, because it will receive an unusually
large number of “Sell JPY forward” orders.

3.4.3 One-way Arbitrage

Any non-round-trip sequence of transactions can be made via two routes. For instance, we
can go directly from USDt  USDT , or we can go via USDt  EURt  EURT  USDT .

In perfect market, where interest rate parity holds, any two routes must produce the same
output.

52
Example 3.10

Let us check the irrelevance of the route chosen for USDt  USDT (domestic lending versus
covered foreign lending).

• Domestic lending. If we start with USDt  1 , we obtain a time-T amount worth:

• Covered foreign lending. Alternatively, we can buy spot EUR, invest it, and sell
forward the proceeds of the investment:

3.4.4 Convergence

As the interval T – t decreases, the spot and forward rates tend to become closer to each other.

1  rt ,T
Ft ,T  St 
1  rt*,T

• as rT ,T  rT ,T  0 .
*
FT ,T  ST

• rt ,T and rt*,T tend to decrease as t  T (but not perfectly smoothly).

3.4.5 Interest Rate Parity and Causality

Interest rate parity says that the four variables – spot and forward rates, and the two interest
rates – are determined jointly, and that the equilibrium outcome should satisfy:

1  rt ,T
Ft ,T  St 
1  rt*,T

But it does not imply that the forward rate is a “dependent” variable, determined by the spot
rate and the two interest rates.

53
3.5 Swap Rates

The swap rate is the difference between the outright forward rate and the spot rate. The
origin of the term swap rate is the swap contract. In the context of the forward market, a
swap contract is a spot contract immediately combined with a forward contract in the
opposition direction.

For example, to invest in the U.S. stock market for a few months, a British investor buys
USD 100,000 at EUR/USD 1.10. In order to reduce the exchange risk, he immediately sells
forward USD 100,000 for 90 days at EUR/USD 1.101. The combined spot and forward
contract – in opposite directions – is a swap contract.

When the forward rate exceeds the spot rate, the foreign currency is said to be at a premium.
Otherwise, the currency is at a discount. The premium or discount uniquely depends on the
sign of the return differential, rt ,T  rt ,T :
*

 1  rt ,T 
Ft ,T  St  St   1
 1 r * 
 t ,T 
 1  rt ,T 1  rt*,T 
 St   
 1  r* 1  r*
 t ,T t ,T 
r r *

 St t ,T *t ,T
1  rt ,T

Thus, a higher domestic return means that the forward rate is at a premium, and vice versa.

The swap rate is a convenient way of quoting because it is fairly constant over short intervals:

  Ft ,T  St  rt ,T  rt*,T

St 1  rt*,T
 rt ,T  rt*,T

54
Example 3.11

Let the p.a. simple interest rate be 4% for JPY and 3% for USD. If St changes from 100.0 to
100.5 in a month, then:

Spot Forward Swap Rate

1.003333
100.0 100.0   100.0831
1.002500
1.003333
100.5 100.5   100.5835
1.002500
Change 0.5 0.5004

Notes:

• Whenever the spot rate changes, all forward rates must change in lockstep.
• In the past, time-pressed traders noticed that the swap rate is relatively insensitive to
changes in the spot rate.
• However, the rule of thumb work reasonably well only when interest rates are low
and rather similar across currencies.

3.5.1 Market Practice

In practice, outright rates are quoted in swap rates. By adding (premium) or subtracting
(discount) these swap points from the spot rate, you get the full outright rate. Two examples
of Reuters pages are shown below:

55
3.5.1.1 Analysis of the Quotation

Swap rates are quoted with bid and ask rates, just like spot rates. The market user sells at the
bid rate and buys at the ask rate. Usually, traders do not state the algebraic sign when quoting
swap rates.

This table shows the spot rates and swap rates for several terms:

GBP/USD EUR/USD
Spot 1.5930 – 1.5935 1.1005 – 1.1010
1-month 40 – 39 20 – 21
3-month 120 – 118 35 – 37
12-month 280 – 275 65 – 70

What are the outright rates of GBP/USD and EUR/USD?

For GBP/USD, the bid rate is higher than the ask rate. This means:

• GBP/USD is at a discount.
• The swap points have to be subtracted.

GBP/USD 1-month 3-month 12-month

Swap Rates
40 – 39 120 – 118 280 – 275
(discount)
Outright Rate 1.5890 – 1.5896 1.5810 – 1.5817 1.5650 – 1.5660

For EUR/USD, the bid rate is lower than the ask rate. This means:

• EUR/USD is at a premium.
• The swap points have to be added.

EUR/USD 1-month 3-month 12-month

Swap Rates
20 – 21 35 – 37 65 – 70
(premium)
Outright Rate 1.1025 – 1.1031 1.1040 – 1.1047 1.1070 – 1.1080

56
There are some reasons why outrights are quoted in terms of swap rates:

1. Swap rates are mainly influenced by interest rates. Interest rates are not that volatile than
spot rates. If outright rates would be quoted, they would have to be updated for every
move in the spot rate.

2. Customers compare the quotes of different market makers and look at the spot rate only
when they are ready to deal.

3. In practical dealing the FX-forward trading book is separated from the FX-spot trading
book. Thus forward points are not quoted at the spot desk. Usually the FX-forward desk
belongs to the money market department.

4. Forward deals are most frequently used as a part of FX-swap transactions in the interbank
market. FX-swaps are dominated by the interest rate differential rather than the spot rate.

3.6 The Market Value of an Outstanding Forward Contract

The market value of a forward contract is the price at which the contract can be bought or
sold in the market.

Why do we need this market value?

• To negotiate early settlement of the contract.

• The injured party wants to file a claim when default.
• To mark-to-market the book value of the firm’s forward positions.
• To generate insights for corporate management and asset pricing.

There are two approaches to derive the current market value of the forward contract: (1) by
replication and (2) by hedging.

57
3.6.1 The Replication Approach

A forward contract has two sides – the foreign currency inflow, and the home currency
outflow – can be replicated as follows:

1 1
• Buying and investing units of foreign currency, at a cost of St  , in
1  rt ,T
*
1  rt*,T
terms of the home currency.
Ft0 ,T
• Borrow .
1  rt ,T

Replication
Cash outlay at t,
Strategy at time t Cash flow at T
in HC terms
Side 1: Buy and invest:
Inflow FC 1 1 1 Inflow FC 1
FC St 
1  rt*,T 1  rt*,T

Side 2: Borrow:
Outflow HC Ft0 ,T Ft0 ,T Ft0 ,T Outflow HC Ft0 ,T
HC 
1  rt ,T 1  rt ,T
St Ft ,T
 0
1  rt ,T 1  rt ,T
*

The combined net outlays, at time t, from the replication strategy are:

St Ft ,T
 0
1  rt ,T 1  rt ,T
*

The market value of the outstanding forward contract must equal the value of its replicating
portfolio. This implies that the value at t of the forward contract initiated at t0 must be equal
to:

St Ft ,T
 0
1  rt ,T 1  rt ,T
*

58
By the Law of One Price, value of a forward contract at time t that was initiated at t0 :

St Ft ,T Ft ,T  Ft0 ,T
 0 
1  rt ,T 1  rt ,T
*
1  rt ,T

Thus, an outstanding forward contract can have a negative value, notably when the historic
forward rate exceeds the current forward rate for the same maturity. A negative value means
that you are willing to pay in order to get rid of the contract.

3.6.2 The Hedging Approach

Suppose you close out the outstanding contract. That is, to the existing forward purchase
contract you add a forward sales contract for the same expiration day and at the current
forward rate, Ft ,T .

Cash flows at T from a Cash flow at time T from Cash flow at time T from the
forward purchase contract hedging, that is adding at original and the new forward
initiated at t0 at the historic time t, a forward sale at Ft ,T
rate Ft0 ,T
Side 1:
Inflow FC 1 Outflow FC 1 0

Side 2:
Outflow HC Ft0 ,T Inflow HC Ft ,T Ft ,T  Ft0 ,T

Therefore, the net remaining cash flow at time T becomes the risk-free amount Ft ,T  Ft0 ,T .
The value of a forward contract is the present value:

Ft ,T  Ft0 ,T
1  rt ,T

59
Example 3.12

A trader buys forward USD 10m from HSBC at JPY/USD 108.0, and five minutes later sees
the rate move up to 108.5. He can lock in his gain by selling forward at 108.5. If rt ,T  1%
p.a., what is the contract value?

Forward purchase contract: Hedging: Combined cash flow

USD 10m at JPY/USD 108.0 USD 10m at JPY/USD 108.5 at time T
Side 1:
In: USD 10m Out: USD 10m USD 0

Side 2:
Out: JPY 1,080m In: JPY 1,085m JPY 5m

The present value:

3.6.3 Implications

1. Implication 1: The value of an expiring contract.

• as rT ,T  rT ,T  0 .
*
By convergence, for t = T, FT ,T  ST

• Thus, expiration value  ST  Ft0 ,T .

Example 3.13

You bought forward USD 1 at EUR/USD 0.8. At expiration, the USD trades at EUR/USD
0.85. So you receive a dollar worth EUR 0.85 and you pay EUR 0.8. The net value is:

ST  Ft0 ,T  EUR 0.05

The equation ST  Ft0 ,T also formally explains how hedging works. Suppose you buy
forward to hedge a debt:

Value of the debt at expiration:  ST

Value of the forward contract at expiration: ST  Ft0 ,T
Combined value at time T:  Ft0 ,T

60
2. Implication 2: The value of a new forward contract is zero.

• For t0  t , Ft0 ,T  Ft ,T .
Ft0 ,T  Ft0 ,T
• Obviously, the value of a forward contract at rate Ft0 ,T is: 0.
1  rt0 ,T
• The reason is that a “new” contract can be replicated at zero cost.

Example 3.14

Suppose St  10, rt ,T  21%, rt ,T  10%. Then by interest rate parity, Ft ,T  11 .

*

If Citibank asks you to pay an up-front price for a forward purchase at F = 11, what would
you do?

You would refuse since you could synthetically replicate the forward.

At time-t:

• Borrow.
• Convert this spot into.
• Invest

At time-T:

• Pay of the HC loan,.

• Cash in the FC deposit,.

Thus, you have replicated a forward contract, and it did not cost you anything up-front.

61
3. Implication 3: The forward rate is the home currency risk-adjusted expected future spot
rate.

The zero-value property of forward contracts discussed above has another extremely
important interpretation. Suppose that the AUD/GBP six-month forward rate equals 2,
implying that you can exchange one future GBP for two futures AUD and vice versa without
any up-front cash flow. This must mean that the market perceives these amounts as being
equivalent (that is, having the same value). If this were not so, there would have been an up-
front compensation to make up for the difference in value.

Since any forward contract has a zero value, the present value of GBPT 1 and AUDT 2 must
be equal anywhere; that is, the equivalence of GBP 1 and AUD 2 holds for any investor.
However, the equivalence property takes on a special meaning if we pick the AUD as the
home currency. In terms of AUD, we can write the equal-value property as:

 
PVt ST  PVt  Ft ,T 

We can interpret this equation in at least two ways. First, it can be read as a simple reflection
of the zero-value property: PVt  ST  Ft ,T   0 . Second, the forward price on the right-hand
side of equation is a risk-free, known number whereas the future spot rate on the left is
uncertain. That is, the forward rate Ft ,T is not just perceived at time t as being equivalent to
one unit of foreign currency; this amount of future home currency is also a certain, risk-free
amount. For this reason, we shall say that in home currency, the forward rate is the time-t
certainty equivalent of the future spot rate, ST .

The notion of the certainty equivalent deserves some elaboration.

Example 3.15

To you, a lottery ticket that pays out (with equal probabilities) either USD 1,000 or nothing is
as good as USD 450.

When valuing the lottery ticket, you have marked down its expected value, USD 500, by
USD 50, because the lottery is risky. Thus, your personal certainty equivalent, USD 450, is
the expected value of the lottery ticket corrected for risk.

62
Market certainty equivalent is defined as the single known amount that the market considers
to be as valuable as the entire risky distribution. Market certainty equivalents are what
matters if we want to:

• Price assets.
• Make managerial decisions that maximize the market value of the firm.

Formally:

 
CEQt ST  Ft ,T

Example 3.16

To make the market’s risk adjustment a bit less abstract, for example, there are two ways to
value a unit FC T-bill.

1. General asset pricing:

 
Et ST
 
PVt ST 
1 E r  t S ,t ,T

2. Value the hedged asset:

CEQt ST  
 
Ft ,T
PVt ST  
1  rt ,T 1  rt ,T

We can re-interpret CEQ as risk-adjusted expectation:

Ft ,T

 
Et ST
1  rt ,T 1 E r 
t S ,t ,T

1  rt ,T
 Ft ,T  Et ST  1 E
t r 
S ,t ,T

  1  E 1r
 Et ST
  t S ,t ,T

63
4. Implication 4: Valuation of foreign currency assets or liabilities.

The certainty equivalent interpretation of the forward rate implies that, for the purpose of
corporate decision making, we can use the forward rate to translate foreign currency
denominated claims or liabilities into one’s domestic currency without having to worry about
how to adjust for risk.

Example 3.17

What is the value at time-t, in HKD, of GBP 500,000 180 days from now? Suppose
rt ,T  2% p.a. and Ft ,T  HKD GBP 14.2 .

For NPV approach:

• We need to assess expected value, choose a model, assess the risk, and discount at
risk-adjusted discount rate.

For CEQ approach:

5. Implication 5: The (ir)relevance of hedging.

Does the zero initial value mean that hedging adds no value?

Criterion of firm’s market value as the yardstick of relevance:

• Takes into account effects of hedging on expected cash flow and risk.
• MM propositions.

At time-t, adding a hedge does not add/destroy any value provided the firm’s other cash flows
are unaffected.

In many cases, the firm’s other cash flows are likely to be affected:

• Avoiding direct/indirect costs of financial distress.

• Taxes.
• Better information to managers, to analysts.

64
3.7 Summary

1. Forward quotes can be outright or in swap rate format.

2. The matrix:

• Spot, forward and money markets are so closely related that we have to study them
together.
• In a perfect market one could eliminate one of them and not lose anything.

3. The perfect replicability implies a no-arbitrage result, Covered Interest Parity:

1  rt ,T
• Ft ,T  St 
1  rt*,T

4. Viewing an outstanding contract as a portfolio of two promissory notes, one long and one
short, we can easily value an outstanding contract as:

  St Ft0 ,T
PV ST  Ft0 ,T  
1  rt*,T 1  rt ,T
•
Ft ,T  Ft0 ,T

1  rt ,T

5. Zero initial value does not necessarily mean that hedging adds no value: other cash flows
may be affected.

6. The forward rate is also a risk-adjusted expectation or certainty equivalent:

1  rt ,T
•  1 E
Ft ,T  Et ST
t r 
S ,t ,T

65
3.8 The Forward-Forward and the Forward Rate Agreement

The forward-forward and the forward rate agreement is a contract between two parties to fix
a future interest rate. This contract defines the interest rate for a future period based on an
agreed principal.

3.8.1 Forward-Forward

A forward-forward (FF) contract:

• It fixes an interest rate today (time t) for a deposit or loan starting at a future time T1
(  t ) and expiring at T2 (  T1 ).
• It is called a forward-forward because the interest rate is for a time period that begins
and ends in the future.
• A forward-forward contract protects against market changes in the interest rates.

Example 3.18

Consider a 6-to-9-month FF on a USD 10m deposit at 12% p.a. (simple interest).

• At time T1 :
• At time T2 :

3.8.1.1 The Pricing of FF

Define:

• t0 = the date on which the contract was initiated.

• t   t0  = the moment the contract is valued.
• T1 = the expiration date of the forward contract.

• T2   T1  = the expiration date of the notional deposit.

• rt0forward
,T1 ,T2 = the effective return between T1 and T2 , without annualization, promised on

the notional deposit at the date the FRA was signed, t0 .

66
 Initiation date Valuation date Starting date Expiration date
of forward deposit of forward deposit
t0 t T1 T2

First consider the valuation of a T1 to T2 forward-forward deposit for USD 1 that has been
forward
outstanding since t0 and promises a return of rt0 ,T1 ,T2 .

Like a currency forward, this contract has two sides, each of which can be replicated in the
money markets – the outflow by a loan, and the inflow by a deposit.

Replication Strategy
Cash flows from
Cash flows in
outstanding FF Action today Cash outlays today
future
deposit
Time T1 : Borrow: Time T1 :

-1 1 -1 1

1  rt ,T1 1  rt ,T1

Maturing at T1
Time T2 : Deposit: Time T2 :


 1  rt0forward
,T1 ,T2  1  rt0forward
,T1 ,T2

 1  rt0forward
,T1 ,T2  1  rt0forward
,T1 ,T2

1+rt ,T2 1+rt ,T2

Maturing at T2
Combined T1 to T2 FF 1  rt0forward 1

,T1 ,T2

1  rt ,T1
forward
at r t0 ,T1 ,T2 1+rt ,T2

To rule out arbitrage, the market value of the FF must be equal to the cost of the replicating
portfolio.

Market Value of FF  PV  Deposit   PV  Debt 

1  rt0forward 1
 
,T1 ,T2

1+rt ,T2 1  rt ,T1

67
3.8.2 Forward Rate Agreement

Forward Rate Agreement (FRA):

• Under an FRA, the deposit or loan is notional. That is, the contract is about a
hypothetical deposit rather than an actual deposit.
• If on the agreed date (fixing date) the FRA rate differs from the current market rate
(reference rate), a settlement payment depending on the difference must be paid by
one of the contractors. The principal is not exchanged and there is no obligation by
either party to borrow or lend capital.

The notion for FRA is unique. There are two numbers associated with an FRA: (1) the
number of months until the contract expires and (2) the number of months until the
underlying loan is settled. The difference between these two is the maturity of the underlying
loan.

For example, a 2 × 3 FRA is a contract that expires in two months (60 days), and the
underlying loan is settled in three months (90 days). The underlying rate is 1-month (30 days)
LIBOR on a 30-day loan in 60 days.

68
3.8.2.1 Why FRAs Exist?

1. Speculation.

• Market participants who want to make profits based on their expectations on the
future development of interest rates.

2. Hedging.

• To facilitate budget projections, to reduce risk (e.g. maturity mismatch in banks) and
costs of financial distress.

3.8.2.2 Forward Interest Rate

Using the zero-value property of a forward contract at inception, the value of FF at time
t  t0 :

1  rt ,forward 1
 0
T1 ,T2

1+rt ,T2 1  rt ,T1

1+rt ,T2
 1  rt ,forward 
1  rt ,T1
T1 ,T2

It implies that:

1+r   1  r 1  r
t ,T2 t ,T1
forward
t ,T1 ,T2 
It says that the proceeds of a direct time deposit expiring at time T2 , 1+rt ,T2 , are the same as
the proceeds of a (synthetic) time deposit consisting of a shorter-lived deposit prolonged by a
FF.

The rate in an FRA is actually a forward interest rate. We will illustrate this with an example.

69
Example 3.19

Calculate the rate of a 1 × 4 FRA (i.e., a 90-day loan, 30 days from now). The current 30-day
LIBOR is 4% and the 120-day LIBOR is 5%.

The effective rate on the 30-day loan is:

The effective rate on the 120-day loan is:

We wish to calculate the effective rate on a 90-day loan from day 30 to day 120:

We can annualize this rate as:

70
The time line is shown in the following figure.

3.8.2.3 Valuing an FRA at Maturity

To understand the calculation of the value of the FRA after the initiation of the contract,
recall that the long in the FRA has the right to borrow money 30 days from inception for a
period of 90 days at the forward rate.

If interest rates increase, the long will profit as the contract has fixed a borrowing rate below
the now-current market rate. These “savings” will come at the end of the loan term, so to
value the FRA we need to take the present value of these savings.

Example 3.20

Continuing the prior example for a 1 × 4 FRA, assume a notional principal of $1 million and
that, at contract expiration, the 90-day rate has increased to 6%, which is above the contract
rate of 5.32%. Calculate the value of the FRA at maturity.

The interest savings at the end of the loan term (compared to the market rate of 6%) will be:

71
The present value of this amount at the FRA settlement date (90 days prior to the end of the
loan term) discounted at the current rate of 6% is:

This will be the cash settlement payment from the short to the long at the expiration of the
contract. Note that we have discounted the savings in interest at the end of the loan term by
the market rate of 6% that prevails at the contract settlement date for a 90-day term, as shown
in the following graph.

3.8.2.4 Valuing an FRA Prior to Maturity

To value an FRA prior to the settlement date we need to know the number of days that have
passed since the initiation of the contract. For example, let us suppose we want to value the
same 1 × 4 FRA 10 days after initiation.

Originally it was a 1 × 4 FRA, which means the FRA now expires in 20 days. The
calculation of the savings on the loan will be the same as in our previous example, except that
we need to use the new FRA price that would be quoted on a contract covering the same
period as the original loan. In this case the new FRA price is the now-current market forward
rate for a 90-day loan made at the settlement date (20 days in the future). Also, we need to
discount the interest savings implicit in the FRA back an extra 20 days, or 110 days, instead
of 90 days as we did for the value at the settlement date.

72
Example 3.21

Value a 5.32% 1 × 4 FRA with a principal amount of $1 million 10 days after initiation if
110-day LIBOR is 5.9% and 20-day LIBOR is 5.7%.

Step 1: Find the new FRA rate on a 90-day loan 20 days from today. This is the current 90-
day forward rate at the settlement date, 20 days from now.

Step 2: Calculate the interest difference on a $1 million, 90-day loan made 20 days from now
at the forward rate calculated previously compared to the FRA rate of 5.32%.

Step 3: Discount this amount at the current 110-day rate.

You can value an FRA at any date from initiation to settlement following these steps.
Remember the value of an FRA comes from the interest savings on a loan to be made at the
settlement date and this value is to be received at the end of the loan. Once you understand
this, you can calculate the present value of these savings even under somewhat stressful
conditions.

73
74
4 Topic 4 – Currency Swaps

We have learnt that a firm can hedge a single cash flow, denominated in foreign currency, by
a forward sale or purchase. To hedge a series of cash flows with many different maturities,
one could use a portfolio of different forward contracts, one for each cash flow. Alternatively,
one could use a currency swap.

Swaps are agreements between two counterparties to exchange a sequence of cash flows. In
a currency swap, it is an agreement between two counterparts to exchange currencies on a
future date at a fixed rate. It allows a firm to take out a coupon loan in one currency, and
then essentially change the effective currency of denomination of the entire loan – principal
and interest payments – using just one contract.

4.1 Earlier Swap-like Contracts

To initiate our study of the swap, we shall first discuss the traditional short-term swap, that is,
a contract associated with a single future cash flow. Studying this contract is useful in itself,
and it also helps us to understand the long-term swap where many future cash flows are
exchanged.

4.1.1 The Short-term Currency Swap

Our explanation of the short-term currency swap starts with an illustration:

• The Bank of England wants to borrow USD from the Bundesbank.

• Bundesbank asks, as security, an equivalent amount of GBP (to be deposited by the
Bank of England with the Bundesbank).
• Assume away default, on the expiration day the USD and the GBP would each be
returned, with interest, to the respective owners.

Example 4.1

Assume St  USD GBP 2.5 , rUSD  3% and rGBP  5% .

Time t:

• Bank of England receives USD 100m from the Bundesbank for six months, and
deposits GBP 40m into an escrow account with the Bundesbank.

Time T:

• Bundesbank returns GBP 42m, and the Bank of England returns USD 103m.

75
We have described the deal as a loan plus a deposit that serves as collateral. There are at
least two ways in which such a contract can be interpreted.

4.1.1.1 Two Ways to View the Traditional Short-term Swap Contract

View 1:

• Two mutual loan contracts, one for USD 100m to the Bank of England, and the other
for GBP 40m to the Bundesbank, with a right-of-offset clause linking the two loans.
• If one party fails to fulfill its obligations, then the other party is exonerated (free from
charge) from its normal obligations too, and can sue the defaulting party if any losses
occur.

View 2:

• A spot sale by the Bundesbank of USD 100m for GBP, combined with a six month
103
forward purchase of USD 103m at  2.4524 .
42
1.03
• Ft ,T  2.5  .
1.05

USD Loan GBP Loan

At time-t: Bundesbank transfers Bank of England Spot sale of USD 100m
USD 100m to Bank of transfers GBP 40m to to Bank of England at:
England Bundesbank St  USD GBP 2.5

At time-T: Bank of England Bundesbank transfers Forward purchase of

transfers USD 103m to GBP 42m to Bank of USD 103m from Bank
Bundesbank England of England at:
1.03
Ft ,T  2.5 
1.05
 2.4524

Total = Swap contract

Advantages of the spot/forward version of the contract:

• Right of offset is automatic in a forward contract; thus, the same security is obtained.
• Forward contracts are reported off-balance-sheet. No need for explicit warnings
about the right-of-offset clause.
• No need to register the right of offset with a court or an official registration agency.
• No complications with bond contracts, negative pledges, seniority rules.

76
4.1.1.2 Why Short-term Swap Contract Exists?

1. Safety (collateral). One reason why two firms may set up a swap contract is to secure a
loan.

Example 4.2

The central bank of former Soviet Union used gold as security for hard-currency loans
obtained from western banks. For the Western counterpart, the risk was limited to the book
value of the loan minus the market value of the gold.

The Soviet Union repeatedly failed to pay back the loans, but the banks never suffered losses
due to valuable gold collateral.

Example 4.3

An investor in need of short-term financing sells low-risk assets (like T-bills) to a lender, and
buys them back under a short-term forward contract.

This is a repurchase order.

2. Reduction of transaction costs (if an investor intends to reverse the transaction).

Example 4.4

A French investor is optimistic about dollar returns on U.S. stocks, but not about the dollar
itself. She buys spot USD to invest in U.S. stocks, and sells USD forward to hedge the dollar
risk.

3. Tax avoidance (when capital gains are taxed at a lower rate).

Example 4.5

Buy 10 kilos of gold from a Luxemburg bank at the spot price St  EUR 5m and sell it back
(forward) at Ft ,T  St 1  rt ,T   5.25m .

This is a disguised deposit of EUR 5m at 5%, but the return is a capital gain.

4. Religious objections against interest (Islam).

77
5. Fictitious transactions.

• Hide losses by selling assets at inflated prices (and buy them back at similarly inflated
forward prices).
• Hide the ownership of assets by transactions around the reporting date.

4.1.2 Back-to-Back and Parallel Loans

The right-of-offset was already used in back-to-back and parallel loans.

Back-to-back loans:

• Before mid-1970s, there were two-tier FX rates: commercial (for trade) and financial
(for investment) U.S. dollars. While commercial USD is freely available, financial
USD was rationed and hence had a premium.
• U.K. institutional investor (UKII) wants to invest in U.S. capital market. But
“investment dollar premium” made foreign investments expensive to U.K. investors.
Thus, UKII wants to avoid the spot market at t and T, by setting up a deal with a
foreign business firm (USCo) that wants to invest in the UK:
o USCo lends USD to UKII.
o UKII lends GBP to USCo (or its UK subsidiary).
o Right of offset between these two loan contracts: if (say) UKII cannot pay
back, USCo can withhold its payments and sue for the net loss (if any).

78
Parallel loan:

• There are FX controls in China: capital account transactions are regulated.

• A HK company, HKCo1, set up a subsidiary in Shenzhen years ago, and now this SZ
subsidiary has made profits. HKCol wants this mature subsidiary to send profits back
to Hong Kong, but cannot do so directly due to capital control.
• Another HK company, HKCo2, wants to expand a subsidiary that is still in growth
period in Shanghai and intends to inject millions of HKD into the SH subsidiary.
• Both can avoid the spot market by granting loans to each other, with a right of offset
in the two loan contracts.

4.2 The Fixed-for-Fixed Currency Swap

We first review the example of the short-term swap between the Bundesbank and the Bank of
England. Recall that, in Example 4.1, the Bundesbank lent USD 100m at 3% effective return
for six months, while the Bank of England lent GBP 50m at a 4% effective return for six
months.

There are two crucial characteristics to be remembered:

1. The contract has zero initial value.

• The swap consists of a forward contract and a spot-exchange transaction.

• The spot and forward contracts each have zero value because the amounts are
exchanged at the going spot and forward rate.

79
The spot contract has zero value because the amounts are exchanged at the current spot rate.
The forward contract has zero value because the amounts to be exchanged at T are equivalent
in the sense that their discounted values, after conversion at the spot rate, are the same.

Example 4.6

In the Bundesbank / Bank of England case, St  USD GBP 2.5 , rUSD  3% and rGBP  5% .
The present value of the amounts exchanged by the Bundesbank and the Bank of England are:

2. The rates used for setting the forward rate or, equivalently, for discounting the promised
payments are the (near-riskless) short-term interbank rates.

• Default risk is limited by the forward contract’s right-of-offset.

• Remaining risks are largely eliminated by screening of the customers, and by margins
or other pledges.

4.2.1 Characteristics of the Modern Currency Swap

Two parties agree to:

• Exchange, at time t, two initially equivalent principals denominated in different

currencies.
• Return these principals to each other at time T.
• Pay the normal interest, periodically, to each other on the amounts borrowed.

The deal is structured as one single contract, with a right-of-offset.

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Example 4.7

Suppose you want to swap a GBP 18m loan for seven years into USD. The spot rate is
GBP/USD 1.8, and the seven-year swap rates are 8% on GBP and 7% on USD, payable
annually.

GBP USD
18m at 8% 10m at 7%
(“lent”) (“borrowed”)
Initial exchange of principals
Annual interest payments
Payment of principal

Swap rates:

• The interest payments for each currency are based on the currency’s “swap (interest)
rate” – yields at par for near-riskless bonds with the same maturity as the swap.

Why risk-free rates?

• Right-of-offset clause; sometimes margin is posted.

• Probability of default is small.
• The uncertainty about the bank’s inflows is the same as the uncertainty about the
bank’s outflow side. Thus, the corrections for (minute) risk virtually cancel out.

Zero initial value:

• The initial exchange of principals is zero-value transaction because the amounts are
initially equivalent. The future interest payments and amortization have equal present
values too.

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Example 4.8

Following the previous example, we can check that the present value of the inflows and
outflows match:

This implies that:

Costs:

• A commission of, say, USD 500 on a USD 1m swap, for each payment to be made.
Most often this fee is built into the interest rates, which would raise or lower the
quoted rate by a few basis points.
• Sometimes an equivalent up-front fee is asked.

Example 4.9

Suppose that 7-year yields at par are 7.17% on USD and 9.90% on GBP. The swap dealer
quotes:

USD 7.13% - 7.21%

GBP 9.58% - 9.95%

If your swap contract is one where you “borrow” GBP and “lend” USD, you pay 9.95% on
the GBP, and you receive 7.13% on the USD.

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4.2.2 Motivations for Fixed-for-Fixed Currency Swap

1. A comparative information advantage in the home market.

Example 4.10

Let the 5-year swap rates are 13% for ARS and 7% for USD, St  ARS USD 5 . The
Argentine company can borrow ARS at 14% and USD at 9%. It prefers a USD loan.

How to avoid the 2% spread (9% – 7%) on the USD loan?

• Borrow ARS, lowest spread: 14% – 13% = 1%.

• Swap risk-free component of ARS loan for risk-free component of USD loan.

Swap Contract
Loan ARS USD Total
ARS 100m at 100m at 13% 20m at 7%
14% (“lent”) (“borrowed”) (Loan + Swap)
Time t:
Principal
Annual
Interest
Time T:
Principal

Otherwise, a direct USD loan requires interest USD 1.8m.

• Compare: (ARS 1m) versus (USD 0.4m).

2. Subsidized loan.

• Subsidized loans (to stimulate investments or exports) are often available in domestic
currency and to domestic companies only.
• Even if the domestic company intends to take a FC loan instead of the subsidized HC
loan, the company can still benefit from the subsidy by using a swap.

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Example 4.11

The Argentine company can get a five-year subsidized ARS loan at 8%, 5% below the ARS
swap rate of 13%.

Use this loan and swap: ARS 8% against USD 13%, and St  ARS USD 5 :

Swap Contract
Loan ARS USD Total
ARS 100m at 100m at 13% 20m at 7%
8% (“lent”) (“borrowed”) (Loan + Swap)
Time t:
Principal
Annual
Interest
Time T:
Principal

Otherwise, a direct USD loan requires interest USD 1.8m.

• Compare: ARS 5m versus (USD 0.4m).

• The Argentine company effectively borrows at the USD swap rate (7% on USD 20m),
without having to give up the interest subsidy of 5% p.a. on ARS 100m.

3. No access or limited access to “national” capital markets.

• Sometimes the company cannot obtain a loan in its preferred currency because the
market is closed to foreign borrowers.
• For example, the yen capital market was closed to foreign borrowers until early
eighties.
• Renault, for instance, swapped a USD loan with Yamaichi Securities for JPY in the
early 1980s when Japan’s capital market was still closed.

4. Avoiding transaction costs.

• IBM / World Bank in 1981: avoid costs of withdrawing (IBM) / reissuing (World
Bank) CHF & DEM debt.
• Synthetic alterative involves three transactions: borrow currency 1, convert and
reinvest currency 2.

5. Possible advantages of off-balance-sheet reporting.

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4.2.3 Valuing an Outstanding Fixed-for-Fixed Currency Swap

Why?

• When the contract is terminated prematurely by negotiation, or by default, or by the

credit trigger clause.

Rule:

• Value it as a portfolio where one loan is held short, one loan is held long.
• Zero initial value, but non-zero value as soon as the interest rates or spot rate change,
or as the spot rate changes.

Let’s consider a 3-year fixed-to-fixed rate USD-AUD currency swap with a principal value of
USD 50 million. At the initiation, the exchange rate is USD/AUD 0.625. Currency swaps
are constructed so that at initiation the principal amounts exchanged are equal at the currency
exchange rate. This implies that the AUD principal of this swap will be AUD 80 million
today. This is an even-up exchange today at the current exchange rate. The firm then makes
semiannual payments to the counterparty in AUD (the borrowed currency) at the fixed rate of
5.0% p.a. and receives semiannual payments from the counterparty in USD (the lent currency)
at a fixed rate of 4% p.a. At maturity, the firms re-exchange the initial principals.

The cash flows on the swap from the perspective of the firm look as follows:

Note the fixed currency swap is like a spot exchange rate transaction, USD 50 million for
AUD 80 million, and a series of forward transactions, USD 1 million for AUD 2 million,
over the next six semi-annual periods, and a final forward transaction. Thus, a fixed interest
rate currency swap can be thought of as a bunch of forward contracts.

85
Suppose that one year into this swap, the interest rate remained the same but the exchange
had chanced relative to expectations. In particular, the spot exchange rate at time 1 is at
USD/AUD 0.75. The impact of this exchange rate change on the value of the swap can be
examined using either the close out method or the discounting method.

4.2.3.1 Method 1: Close Out Method

If we are interested in the USD value of the original swap to the firm under the new exchange
rates, we need to consider a new 2-year swap for AUD 80 million notional principal to
eliminate the AUD side of the existing swap.

1 1.5 2 2.5 3
Original Swap
CFs to be received
CFs to be paid

New Swap
CFs to be received
CFs to be paid

Net Flows

Taking the present value of the net cash flows on the two swaps combined at 4% p.a.:

The exchange rate change – USD depreciation – has resulted in a loss on the swap to the firm
of USD 10 million. The reasoning behind this is that in the original swap the firm was
receiving USD and paying AUD. When the value of AUD went up, the value of paying
AUD and receiving USD became less valuable. The market value of this loss at time 1 is
USD 10 million.

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4.2.3.2 Method 2: Discounting Method

Another way is to discount the remaining cash flows on the original swap in each currency at
the current interest rate for that currency. The PV of the AUD cash flows is converted into
USD using the current exchange rate and this value is compared to the PV of the USD cash
flows to determine the gain or the loss. The difference between the value USD value of the
cash flows to be received and the value of the USD cash flows to be paid out is the gain or
loss on the swap.

With the current spot rate at USD/AUD 0.75, the USD value of the PV AUD side of the swap
at time 1 = PV(AUD) = 80 × 0.75 = USD 60 million.

The net difference in PV of cash flows in USD = 50 – 60 = -USD 10 million.

87
5 Topic 5 – Currency Options

5.1 An Introduction to Currency Options

5.1.1 Call Options

A call gives the holder the right to buy a stated number of “underlying” assets at a given price
(exercise price or strike price) from the counterparty (the writer of the option):

• At time T, in the case of a “European” -style option.

• At any time until time T, in the case of an “American” -style option.

Example 5.1

You buy a call on one EUR at USD/EUR 1.20 expiring on June 30. You are the holder of the
option.

The counterparty is the writer of the call. He has a potential obligation to deliver one EUR to
you at USD 1.20 if you want him to (that is if you exercise the option).

If ST  USD EUR 1.30 , you will exercise your right and buy EUR at USD EUR 1.20 , and
save USD 0.10.

If ST  USD EUR 1.15 , you will not exercise the option.

5.1.2 Put Options

A put gives the holder the right to sell a stated number of “underlying” assets at a given price
(exercise price or strike price) from the counterparty (the writer of the option):

Call Option Put Option

Right to buy at X Right to sell at X
Useful to hedge a FC debt: Useful to hedge a FC asset:
You pay no more than X You get no less than X
CT  max  ST  X , 0  PT  max  X  ST , 0 

88
5.1.3 Forward versus Options

A European call option will be exercised at T, if and only if, ST  X  0 .

This option allows you to obtain just the “nice” part of the forward purchase: rather than
paying X for sure (as in a forward purchase), you pay no more than X for the foreign currency
and possibly less than X.


CT  max ST  X , 0 
 

 ST  X

5.1.4 Option Premiums and Option Writing

A call can be used to “insure” a FC debt against a high ST .

A put can be used to “insure” a FC debt against a low ST .

You pay an insurance premium (up front) to buy the option.

An option writer:

• Charges a fee equal to expected costs adjusted for risk.

• Diversifies by buying assets that are negatively correlated with the option.

5.2 Graphical Analysis of European Options

5.2.1 Payoffs of Forward Contracts

Value of forward purchase ST  Ft ,T

Value of FC debt  ST
Value of FC debt covered forward  Ft ,T

Value of forward sale Ft ,T  ST

Value of FC asset ST
Value of FC asset covered forward Ft ,T

89
5.2.2 Payoffs of a Call

Call on USD with strike price X  JPY USD 110 .

Value to holder:

ST 108 109 110 111 112 113

CT 0 0 0 1 2 3

Value to writer:

ST 108 109 110 111 112 113

CT 0 0 0 -1 -2 -3

It is just the negative of the value to the holder.

• The payoff from a short (or written) call is minus the payoff from a long position in a
call.
• The up-front cash flows also differ by their sign only (the buyer pays the premium,
the writer receives it).

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5.2.3 Payoffs of a Put

Put on USD with strike price X  JPY USD 110 .

Value to holder:

ST 108 109 110 111 112 113

PT 2 1 0 0 0 0

Value to writer:

ST 108 109 110 111 112 113

PT -2 -1 0 0 0 0

91
Summary:

Call Option Put Option

Nice part of a Nice part of a
Long (holder)
forward purchase forward sale
Bad part of a Bad part of a
Short (writer)
forward sale forward purchase

You can replicate a forward contract from options.

5.2.4 Buy a Put and Sell a Call: A Synthetic Forward Sale

Put “minus” Call at X  JPY USD 110 , same T.

ST 107 108 109 110 111 112 113

PT 3 2 1 0 0 0 0
CT 0 0 0 0 -1 -2 -3
PT  CT 3 2 1 0 -1 -2 -3

Forward 3 2 1 0 -1 -2 -3
Sale

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5.2.5 Synthetic Contracts, Arbitrage and Put-Call Parity

Put – Call = Domestic deposit (risk-free) – Foreign T-bill (risky)

•    
max X  ST , 0  max ST  X , 0  X  ST
 Forward Sale

Implication 1: You can replicate any of put, call, FC T-bill, HC T-bill using the other three
instruments.

For example,

Put  Call  FC T-bill  Synthetic HC T-bill

  
max X  ST ,0  max ST  X ,0  ST  X 
ST 107 108 109 110 111 112 113
PT 3 2 1 0 0 0 0
CT 0 0 0 0 -1 -2 -3
ST  PT  CT 110 110 110 110 110 110 110

Similarly,

Synthetic Put  HC T-bill  FC T-bill  Call

 
max X  ST ,0  X  ST  max ST  X ,0  
Synthetic Call  FC T-bill  HC T-bill  Put
 
max ST  X ,0  ST  X  max X  ST ,0  
Synthetic FC T-bill  HC T-bill  Put  Call
  
ST  X  max X  ST ,0  max ST  X ,0 

93
Implication 2: Law of One Price – a portfolio of a put minus a call must be priced the same as
a forward sale at X (Put Call Parity for European options).

X  Ft ,T
Pt  Ct 
1  rt ,T
X St
 
1  rt ,T 1  rt*,T

Implications of Put Call Parity:

• At-the-forward puts and calls have equal prices.

• At-the-money puts and calls usually have different values.

At the money, X  St :

St St
Pt  Ct  
1  rt ,T 1  rt*,T
rt*,T  rt ,T
 St
1  r  1  r 
t ,T
*
t ,T

 
Thus, Pt  Ct 0 if rt*,T rt ,T
 

more 
Put is valuable if Ft ,T St .
less 

A quick approximate test of Parity for at the money options: express option prices as
percentages of spot, and compare to interest rate differential:

Ct  Pt
 rt ,T  rt*,T
St

As soon as we have a Call option price model, Put Call Parity implies the Put option pricing
model.

94
5.3 Institutional Aspects of Options Markets

5.3.1 Traded Options

There is an organized secondary market, with a clearing house as a guarantor party. A sale
closes out an earlier purchase and vice versa.

5.3.2 Over the Counter (OTC) Markets

More liquid than forward contracts: Writer quotes two-way prices (bid and ask).

Tailor made: Customized expiration date, contract size, and strike price.

Bid-ask spread in the OTC market is higher than in the traded options market.

“At the money options” prices sometimes quoted as a % of the spot rate.

Convenient: Option prices rise proportionally when to St and X both rise by the same factor
(ceteris paribus).

5.4 Bounds on Option Values

5.4.1 Intrinsic Value and Time Value

Call Put
In the money St  X  0 X  St  0
At the money St  X  0 X  St  0
Out of the money St  X  0 X  St  0
Intrinsic value max  St  X , 0  max  X  St , 0 
Time value Ct  Intrinsic value Pt  Intrinsic value

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Example 5.2

For a call on EUR with strike price X = USD/EUR 1.20:

• The intrinsic value is 5 cents if the spot rate is 1.25.

• Time value is 1 cent if the market price is 6 cents.
• The intrinsic value is 0 if the spot rate is 1.15 (or any other prices equal to or below
1.20).
• Time value is 2 if market price is 2.

For a put on EUR at X = 1.20:

• If the spot rate is 1.25, the intrinsic value is 0; and time value is 2 cents if the market
price is 2 cents.
• If the spot rate is 1.17, the intrinsic value is 3 cents; and time value is 2 cents if
market price is 5.

5.4.2 Early Exercise Rules of American Options

Out of money American options:

• All value is time value.

In the money American options:

• Positive time value signals a consensus that the (uncertain) prospects of later exercise
are worth more than immediate exercise.
• Zero time value signals a consensus that “this is the moment”.

Exercise rules:

• For early exercise of an American option to be rational, two conditions must be met:
o St  X  0 , that is, a positive value dead (the option killed).
o The option’s market value (value “alive”) is no higher than the value dead.

96
Example 5.3

Suppose you have an American option to buy 1 unit of EUR, X = USD/EUR 1.20.

• If St  1.15 ,
• If St  1.23 but Ct  0.04 ,

Of course, if the option is still alive at T, CT   ST  X  .



5.4.3 Lower Bounds on Option Prices

 St X 
CtAmerican  Ct  max   , 0 
 1  r* 1  r
 t ,T t ,T 
 X St 
Pt American  Pt  max   ,0
 1 r 1  rt ,T 
*
 t ,T

Because:

• American option gives the holder all the rights of the European put or call plus the
right of early exercise.
• Option prices have non-negative exercise values (limited liability).
• Limited liability: European option is a right, not an obligation, so it’s worth at least as
much as the comparable forward purchase or sale.
• American option can be exercised at any moment.

97
5.5 Options as Hedging or Speculating Devices

5.5.1 Hedging the Downside Risk Only

98
5.5.2 Hedging Positions with “Reverse” Risk

If foreign currency cash flows is not certain – that is, foreign currency cash flows that are
conditional on other events:

1. International tenders:

• Inflow of FC if you win.

• No inflow of FC if you lose.

2. Foreign exchange A/R with substantial default risk:

• Inflow of FC if customer pays.

• No inflow of FC if there is default.

3. International “deductible” reinsurance:

• Outflow of FC if damage > “deductible”.

• No outflow of FC if damage ≤ “deductible”.

4. Risky portfolio investment:

• Large inflow of FC if foreign stocks rally.

• Small inflow of FC if foreign stocks crash.

Risk of a forward hedge:

• You may have bad news on the “other event” and losses on the forward contract.

Advantage of an option:

• Avoids both bad tidings in one shot.

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Example 5.4

Hutchison Whampoa submits a GBP 1m bid in a 3G tender in the U.K. Ft ,T and X are

HKD/GBP 12. If Hutchison wins the contract, it earns GBP 1m, which is worth HKD ST ,
while its cash flow from the tender is zero if the contract is awarded to a competitor.

ST Win the contract Fail to win the contract

Hedge with ST  12
Forward
ST  12
Hedge with ST  12
Put
ST  12

For perfect hedge, we need a contract that is conditional on the “other event”, like “tender to
contract” forward or option.

5.5.3 Speculating on Changes in Exchange Rates

For someone to be called a speculator,

• She must disagree with the market’s perceived probability distribution function for an
asset’s future value.
• She must be willing to back up the dissident opinion with money (that is, buying the
“underpriced” asset and selling (or short selling) the “overpriced” asset).

Advantages of options relative to forwards:

• Limited funds (no need for large margin).

• In the worst case, the loss of the pre-paid premium if your expectations do not
materialize.

Notes:

• The probability of losing the premium is quite high – about 50% for an at-the-money
option.
• A bull can also write puts, and a bear can write calls (hoping that they will end out of
the money). This is (misleadingly) called “generating income”. In reality it is quite
risky.

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5.5.4 Speculating on Changes in Volatility

Suppose you disagree:

• Not about the expected exchange rate change (bull, bear).

• But about the likely absolute size (volatility) of the time-T exchange rate change.

Example 5.5

You think that the market underestimates by how much the exchange rate may move –
whether up or down.

The ideal strategy must pay off when the exchange rate moves by a large amount – whether
the movement is up or down.

• Straddle (a call + a put with the same X): always pays off.
• Vertical combination ( X call  X put ): pays off for large S .

Use a straddle to bet on your view about volatility:

(a) Market View Your View

ST CT PT CT  PT Prob. (a)×Prob. Prob. (a)×Prob.
9 0 1 1 0.2 0.2 0.3 0.3
10 0 0 0 0.6 0.0 0.4 0.0
11 1 0 1 0.2 0.2 0.3 0.3
E(Mkt) = 0.4 E(You) = 0.6

5.6 Currency Option Valuation

In the preceding, we described options and their possible applications. We know that the
buyer of an option has to pay a premium, but we have not yet explained how this premium is
set. In this section, we address this issue. We adopt a relatively simple approach – the
binomial option pricing model.

In the binomial option pricing model, it assumes that, given the current level of the exchange
rate, there are only two possible values for the exchange rate next period: “up” and “down”.

101
The binominal assumption may appear rather restrictive. But:

• The distribution of the total return, after many of these binomial price changes,
becomes bell-shaped.
• The binomial option price converges to the Black-Merton-Scholes price.
• The binomial math is much more accessible than the Black-Merton-Scholes math.
• Binomial method can be used to value more complex derivative that have no closed-
form Black-Scholes type solution.

Binomial option pricing can be explained from two points of view, using either (1)
replication approach or (2) hedging approach.

Consider a call on 1 USD against JPY, the home currency, with strike price X = JPY/USD
105. The current spot rate is S0  JPY / USD 100 . Assume the domestic (JPY) risk-free
return is 5% per period and the USD risk-free return is 3.9604%.

By IRP, the one-period forward rate is:

We assume that S1 is ether S1,u  110 or S1,d  95 . Given a 1-period European-style call
with X = JPY/USD 105, the payoff of the call:

S1 C1
110 5
100
95 0

102
The slope of the exposure line:

5.6.1 The Replication Approach

The payoff of an option can be replicated in the forward market. We then invoke the law of
one price – two assets or portfolios with the same payoff must have the same price – to infer
the price of the option from the value of the replicating portfolio.

Step 1: Replicate the payoff from the call

(a) (b) (a) + (b)

Forward Purchase Deposit
Buy USD 1/3 at 101
S1,d  95
S1,u  110

Step 2: Time-0 cost of the replicating portfolio

• Forward contract is free.

• Deposit will cost

Step 3: By law of one price, option price = portfolio value

The replication approach suggests that:

Call = Forward Position + Risk-free Deposit

103
5.6.2 The Hedging Approach

The hedged version of the binomial model tells the story slightly different:

Call – Forward Position = Risk-free Deposit

Step 1: Hedge the call

(a) (b) (a) + (b)

Forward Hedge Call
Sell USD 1/3 at 101
S1,d  95
S1,u  110

Step 2: Time-0 value of the risk-free portfolio

Value =

Step 3: By law of one price, option price = portfolio value

5.6.3 The Risk-adjusted Probabilities

Implicitly, the replication/hedging story:

• Extracts a risk-adjusted probability “up” from the forward market.

•  
Uses this probability to compute the call’s risk-adjusted expected payoff, CEQ0 C1 .
• Discounts this risk-adjusted expectation at the risk-free rate.

104
Step 1: Extract risk-adjusted probability from F0,1

Ordinary expectation:

The only parameter in a binomial model is p, the probability of “up”. Thus, the only way we
can correct for risk is by correcting p.

Risk-adjusted expectation:

We do not know how the market selects q, but q is revealed by F0,1  101.

Step 2: CEQ of the call’s payoff

Step 3: Discount the risk-adjusted expected value at the risk-free rate

105
In general,

q  Ct 1,u  1  q   Ct 1,d
Ct 
1  rt ,t 1
where :
Ft ,t 1  St 1,d
q
St 1,u  St 1,d
1  rt ,t 1
St  St d
1  rt*,t 1

St u  St d
1  rt ,t 1
d
1  rt*,t 1

ud

St 1,u
u
St
St 1,d
d
St

5.6.4 Notation and Assumptions for the Multiperiod Binominal Model

We use S n , j where:

• n = how many jumps have been made since t = 0.

• j = how many of these jumps were up.

106
Assumptions:

1. The risk-free one-period rates of return on both currencies are constant.

2. The multiplicative factors, u and d, are constant over time.

1 r
d  u .
3. The interest rates and the u and d factors satisfy: 1  r*

• Assumption 3 is made to rule out risk-free arbitrage profits. To understand this,

multiply all terms by S0 , so that the relation becomes:
1 r
• S d  S0  F0,1  Su  0  q  1
1  r*

Convergence to a bell-shaped (normal) distribution:

S0  u  d  S0  d  u : There are two ways to get in node (2,1). But there is just one way to
get in (2,0) or (2,2).

• The probability of the outcome S1,2  S 2,1 is higher than the probability of the extreme
outcomes.

S0  u  d  d  S0  d  u  d  S0  d  d  u : There are three ways to arrive in node (3,1).

Likewise, there are three ways to get to node (3,2). In contrast, there is just one way to arrive
in node (3,3) or (3,0).

• The probability of (3,1) and (3,2) is much higher than the probability of an extreme
outcome.

107
5.6.5 The One-Period European Currency Call

The purpose here is to explicitly solve the replication problem and formally link it to the
notion of CEQ.

We want a portfolio of (1) domestic risk-free deposit (D) and (2) b number of forward
purchase contracts that replicates the call.

If:

S1  S0u  D 1  r   b  S0u  F0,T   C1,1 (1a)

S1  S0 d  D 1  r   b  S0 d  F0,T   C1,0 (1b)

To find b, subtract (1b) from (1a), and solve:

b  S0u  S0 d   C1,1  C1,0

C1,1  C1,0 (2)
b  exposure
S0u  S 0 d

To find the domestic deposit D, substitute (2) into (1b):

C1,1  C1,0
D 1  r  
S 0u  S 0 d
S d  F   C
0 0,T 1,0

 F  S0 d 
D 1  r    C1,1  C1,0   0,T   C1,0
 S0u  S0 d 
D 1  r    C1,1  C1,0  q  C1,0 (3)
D 1  r    C1,1  C1,0  q  C1,0
D 1  r   qC1,1  1  q  C1,0
qC1,1  1  q  C1,0
D
1 r

Finally, by Law of One Price, C0  D . Therefore,

qC1,1  1  q  C1,0
C0 
1 r
(4)

CEQ C1 
1 r

108
Example 5.6

S0 S1 C1
110 10
100
90 0

Given u = 1.1; d = 0.9; 1  r  1.05 ; 1  r *  1.0294118 .

The forward factor:

Consider a one-period call with X = 100 expiring at time 1, then:

109
5.6.6 The N-Period European Call

Call  X  95 
S 2,2  121 26
S1,1  110
S0  100 S 2,1  99 4
S1,0  90
S 2,0  81 0

1 r
Given u = 1.1; d = 0.9; 1  r  1.05 ; 1  r *  1.0294118 ;  1.02 ; q  0.6
1  r*

In this two-period model, two price changes before the option expire. u, d, r, r* are constant
parameters per period. At any discrete moment in the model, investors can trade and adjust
their portfolios of home currency and foreign currency loans.

We price backward, step by step.

If at time 1, S1,1  110 , we can easily replicate price:

26  4
b1,1  1
121  99
0.6  26  0.4  4
C1,1   16.38
1.05

If at time 1 the rate moves down to S1,0  90 :

40
b1,0   0.222
99  81
0.6  4  0.4  0
C1,0   2.29
1.05

16.38 if S1  110
At time 0, we do have a two-point problem, C1   :
 2.29 if S1  90

16.38  2.29
b0   0.704
110  90
0.6 16.38  0.4  2.29
C0   10.23
1.05

110
In summary, we hedged dynamically.

• Start the hedge at time 0 with 0.704 units sold forward.

• The time 1 hedge will be to sell forward 1 or 0.222 units of foreign currency,
depending on whether the rate moves up or down.

5.6.7 A Shortcut for European Options

S2,2  121 C2,2  26

S1,1  110 C1,1  16.38
S0  100 S2,1  99 C0  10.23 C2,1  4
S1,0  90 C1,0  2.29
S2,0  81 C2,0  0

If we price backward, step by step:

qC2,2  1  q  C2,1
C1,1 
1 r
qC2,1  1  q  C2,0
C1,0 
1 r
qC1,1  1  q  C1,0
C0 
1 r

Or we can do one-step valuation:

qC1,1  1  q  C1,0
C0 
1 r
 qC  1  q  C2,1   qC2,1  1  q  C2,0 
q  2,2   1  q   
 1 r   1 r 

1 r
q 2C2,2  2q 1  q  C2,1  1  q  C2,0
2


1  r 
2

111
5.6.8 Black-Merton Scholes Equation

In the three-period problem, the probability is the risk-adjusted chance of having “j” ups in “n”
jumps:

n! n
 q j 1  q     q j 1  q 
n j n j

j ! n  j  !  j
prob of such a path
# of paths with j ups

Example 8.7

The probability when n = 3 and j = 2:

3!
q 2 1  q 
3 2
Pr3,2 
2! 3  2  !
3  2 1 2
 q 1  q 
 2 11
 3q 2 1  q 

112
In general,

 Pr
j 0
n, j Cn , j
C0 
1  r 
n

 Pr  S X
n

n, j n, j
j 0

1  r 
n

Let a:  j  a  Sn, j  X  ,

 Pr  S X
n

n, j n, j
j a
C0 
1  r 
n

 Pr n, j Sn, j
X n
 j a
  Pr
1  r  1  r 
n n n, j
j a

j n j
n j 1 1  1  r*   1  r* 
Recall that S n , j  S0u d j
and  n     .
1  r  1  r *   1  r   1  r 
n

 Pr n, j Sn, j
S0 n
 n   1  r*  
j
1  r* 
n j
j a
    q   1  q  
1  r  1  r  1 r   1 r 
n * n
j  a  j 

n j
S0 n
n j
     1   
1  r  * n
j a  j 

where :
1  r*
 q
1 r

Thus,

j  a probability-like expression
probability of j  a
n j
S0 n
n j X n
C0      1      Pr
1  r  1  r 
n, j
* n n
j a  j  j a

price of the underlying FC PN discounted strike

113
In the limit for n   :

S0 X
C0  N  d1   N  d2 
1  r  * n
1  r 
n

ln  Ft ,T X   12  t2,T T
• The first probability typically denoted N  d1  , d1  .
T  t ,T
ln  Ft ,T X   12  t2,T T
• The second probability typically denoted N  d 2  , d 2  .
T  t ,T

5.6.9 Conclusion

One way to value options is to build a portfolio of domestic bonds and forward contracts that
exactly replicates the short-run price evolution of the option; thus, the option must have the
same value as the replicating portfolio.

A closely related approach to option valuation is to hedge the option against short-term
exchange rate changes. Since the resulting portfolio is risk-free, it is easily valued by
discounting the known next-period value at the risk-free rate.

Option prices can be thought of as risk-adjusted expected future values discounted at risk-free
rate, where the information required to compute the risk-adjustment is implicit in the forward
premium:

q  Ct 1, j 1  1  q   Ct 1, j
Ct , j 
1  r 
n j

where :
1 r
d
q  1 r
*

ud

The exposure of the option is changing depending on how far in the money or out of the
money of the option is and what the option’s remaining life is. To track the option in the
longer run, we need to adjust the forward positions dynamically.

114
 Part II

Exchange Rate Determination and Forecasting

115
6 Topic 6 – Purchasing Power Parity

In this topic, we discuss one of the early theories of exchange rate determination, the
Purchasing Power Parity (PPP) theory. This theory is based on the concept that the demand
for a country’s currency is derived from the demand for the goods that that country produces.

If changes in the spot rate were exactly offset by changes in prices at home and abroad, then
there would be no effect of changes in the spot rate on the real value of variables.

However, if changes in the spot rate are not offset by changes in the price level at home
relative to that abroad, then there is real exchange rate risk.

6.1 Commodity Price Parity (CPP)

In this section, we assume that commodity markets are perfect: no transactions costs for
exporting goods from one country to another.

6.1.1 The Concept of CPP

In perfect markets, arbitrage ensures that:

Pjt  St Pjt*

Note that no causality is implied in an arbitrage condition.

6.1.2 Implications of CPP

A consumer’s nationality or place of residence does not affect her consumption opportunities.
Consumption in the home county is the same as consumption abroad.

From a firm’s point of view, it makes no difference whether Apple exports iPhone for sale in
a foreign currency or sells them domestically.

If CPP holds for all goods that one uses as inputs and competes against, then it does not even
matter whether one produces at home or abroad.

Thus, under CPP, exchange rates are irrelevant.

116
6.1.3 Empirical Tests of CPP

The Big Mac index was invented by The Economist in 1986 as a lighthearted guide to
whether currencies are at their “correct” level. It is based on the theory of Purchasing Power
Parity (PPP), the notion that in the long run exchange rates should move towards the rate that
would equalize the prices of an identical basket of goods and services (in this case, a burger)
in any two countries. For example, the average price of a Big Mac in America at the start of
2013 was $4.37; in China it was only $2.57 at market exchange rates. So the “raw” Big Mac
index says that the Yuan was undervalued by 41% at that time.

We can see that the difference can be enormous. For example, compared to the price in the
U.S., the 2013 price of the Big Mac was 74.54% higher in Sweden and 49.83% lower in
Hong Kong.

117
In general, CPP does not hold very well. CPP holds only for easily traded, homogenous
commodities such as oil, gold and silver.

118
6.1.4 Why CPP May Not Hold?

1. Transaction costs.

• Tariffs, transportation costs, insurance fees, and other such costs, mean that even in
the presence of price differences across countries it may not be possible to make
arbitrage profits.

Example 6.1

Let the price of this book in China be Pjt  RMB 63 and the spot exchange rate is
St  RMB HKD 1.06 . If the shipping costs for exporting the book are RMB 3.18, the price
of the book in Hong Kong could be as low as HKD 57 or as high as HKD 63 before you
consider an arbitrage transaction.

2. Non-traded goods.

• Many goods are essentially non-tradable. For example, the price of goods such as
housing or services can differ enormously across countries.

3. Quantitative restrictions.

• In the presence of quotas and other barriers to trade, it is impossible to import more
units once the import ceiling has been reached.
• If demand at home increases, the domestic price can be substantially higher than the
world price.

4. Imperfect competition.

• Exclusive dealerships lead to segmented markets across which one cannot arbitrage.
• Manufacturers discourage parallel imports to profit from price discrimination.

119
6.2 Absolute Purchasing Power Parity (APPP)

Absolute Purchasing Power Parity holds if, at a particular time t, the cost of a foreign
country’s representative bundle translated into domestic terms equals the cost of the domestic
representative bundle:

Pt
St 
Pt *

Pt  the domestic (home) aggregate price level at time t.

Pt*  the foreign aggregate price level at time t.

As a theory of exchange rate determination, APPP states that the exchange rate must adjust so
that the foreign price level translated at the spot rate is the same as domestic price level.

6.2.1 The Real Exchange Rate and the Effective Real Exchange Rate

The real exchange rate is the nominal spot rate deflated by the ratio of domestic to foreign
prices:

St
Rt 
Pt
Pt *
St Pt *

Pt

Example 6.2

Suppose that Canada’s nominal exchange rate is CAD/USD 1.265, and the ratio of the
Canadian price level to the U.S. price level is 1.15. What is the Canada’s real exchange rate
with the U.S.?

St
Rt 
Pt
Pt *
1.265

1.15
 1.1

120
Insights from the real exchange rate:

• Rt  1 : PPP holds.
• Rt  1 : Strong FC relative to PPP. The foreign country is more expensive.
• Rt  1 : Strong HC relative to PPP. The home country is more expensive.

Thus, we can say that U.S. is less competitive than Canada since its prices are higher than the
Canadian prices, after taking into account the nominal exchange rate between the two
countries.

To compare the competitiveness of a country with respect to all its trading partners, we need
to compute the average real exchange rate, which is called the effective real exchange rate:

Rteff  wt ,1Rt ,1  wt ,2 Rt ,2  wt , N Rt , N

wt ,i  share of trade volume (imports and exports) between the home country and its trading
partner i of the total at time t.

N = N trading partners.

Example 6.3

Suppose that Canada’s real exchange rates, at time t, with the U.S., U.K., and Europe are 1.1,
0.8 and 0.7 respectively. Canada’s trade with the U.S. is 50% of its total trade, with the U.K.
30% and with Europe 20%. What is Canada’s real effective exchange rate?

Given the current nominal exchange rate, Canada is less competitive than its average trading
partner.

6.2.2 Link between APPP and CPP

APPP holds if:

• CPP holds for every commodity in the representative consumption basket.

• Consumers in both countries choose the same consumption bundle, then APPP holds.

121
Example 6.4

Consider a world with only two goods – milk and tea. Let both Hong Kong and New
Zealand residents consume two liters of milk and a liter of tea per unit of time. The spot rate
is HKD/NZD 5. Verify that CPP holds for each good separately and show that APPP also
holds.

Country Pmilk / liter Ptea / liter Price of the Consumption Bundle

Hong Kong HKD 5 HKD 15
New Zealand NZD 1 NZD 3

Note that the ratio of the price of milk and tea in Hong Kong and New Zealand is equal to the
exchange rate. The same is true for the relative price of the consumption bundle.

However, if residents of different countries do not consume the same bundle of goods, it is
not clear how one should compare purchasing powers across countries.

Rather than comparing purchasing powers, one can still:

• See if there are systematic deviations from CPP, or conversely, whether good-by-good
deviations from CPP tend to cancel out if we average across “some” wide bundle of
goods.
• We could consider a different concept of PPP, one that compares relative price
changes across countries.

6.2.3 The Implications of APPP

The real exchange rate gives information about the competitive position of the average firm a
country.

At the level of the economy, large deviations (violation) from APPP will cause an imbalance
between exports and imports of goods and services which will eventually affect relative
prices in the two countries and the exchange rate.

122
For example, if prices in the U.S. are too high relative to those of its trading partners, U.S.
exports will drop, and imports will surge. The low domestic and foreign demand for
American goods will eventually:

• Exert downward pressure on prices in the U.S.

• Depress USD as demand for USD to pay for American goods drops.

6.2.4 Empirical Tests of APPP

When we plot the price levels against GDP per capita of various countries, we find that there
is a strong positive correlation between price levels and per capita GDP.

The pattern suggests that highly developed countries with high GDP per capita tend to be
more expensive than other economies.

A formal test of the APPP hypothesis runs the following regression:

P 
St  b0  b1  t*   et
 Pt 

The joint null hypothesis is that the slope coefficient b1  1 and the intercept b0  0 .

123
6.2.5 Why APPP May Not Hold?

1. Systematic violations of CPP.

• Individual deviations from CPP may cancel out across goods in such a way that APPP
holds even when CPP does not.
• This requires that deviations are not predominantly in the same direction. There are
no common factors at work that cause most price differences to have the same sign.

2. International differences in consumption bundles.

• Chinese and Western consumption bundles are different.

Example 6.5

Suppose the typical consumption of a New Zealand resident be two liters of milk and a liter
of tea, while that a Hong Kong consumer is two liters of tea and one liter of milk. According
to the information in the previous example above, we can show that the ratio of the price
level in HKD to the price level in NZD is not equal to the spot rate.

Country Pmilk / liter Ptea / liter Price of the Consumption Bundle

Hong Kong HKD 5 HKD 15
New Zealand NZD 1 NZD 3

6.3 Relative Purchasing Power Parity (RPPP)

If APPP holds at t and T, that is, if:

Pt P
St  *
and ST  T*
Pt PT

Then:

PT
ST PT*

St Pt
Pt*

124
To express the change in the sport rate in simple percentage terms, we subtract 1 from both
sides:

PT
ST PT*
1  1
St Pt
Pt*

P
Define st ,T as the percentage change in the exchange rate between time t and T, I t ,T = T 1
Pt
as the domestic inflation rate between time t and T, and denote foreign inflation by
P*
I t*,T = T *  1 , we have:
Pt

1  I t ,T
st ,T  1
1  I t*,T
I t ,T  I t*,T

1  I t*,T
 I t ,T  I t*,T

Alternatively, we can define the changes in the variables in terms of logs, that is:

PT
ST PT*
ln  ln
St Pt
Pt *
ST P P*
ln  ln T  ln T*
St Pt Pt

RPPP tells us about the relation between the exchange rate and the percentage changes in the
prices at home and abroad, rather than absolute price levels.

RPPP as a theory of exchange rates:

• It takes the inflation rates as determined by some outside factors (like the money
supply and the level of economic activity).
• It says that the exchange rate between two countries must change to reflect
differences in inflation rates between these countries.

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6.3.1 The Links between RPPP, APPP and CPP

If APPP holds, so will RPPP.

RPPP may hold even if there are persistent deviations in the average absolute price levels
across countries.

Example 6.6

If prices in Japan are persistently 80% higher than in China, RPPP can still hold. If:

St PJapan ,t  PChina ,t 1.8

ST PJapan ,T  PChina ,T 1.8

Then:

The deviation from RPPP can always be computed – even in cases where the consumption
bundles differ across countries. Even if one cannot compare different consumption bundles
directly, it is still possible to compare changes in the prices of these baskets of goods.

Even when CPP holds for every single good, RPPP may not generally hold if the
consumption bundles differ across countries.

6.3.2 The Implications of RPPP

Deviations from RPPP tell us whether a domestic consumer’s purchasing power has
increased, or decreased, relative to a foreign consumer’s purchasing power – without telling
us who has the higher purchasing power.

For firms, deviations from RPPP give indications about changes in relative competitiveness –
without telling us who has the better position.

126
6.3.3 Empirical Tests of RPPP

To test the RPPP, the typical regression equation is:

St 1  P P* 
ln  b0  b1 ln t 1  ln t *1   et
St  Pt Pt 

The null hypothesis is that, if RPPP holds, the slope coefficient b1  1 and the intercept b0  0 .

Cumby and Obstfeld (1984), Huang (1987), and many others reject RPPP: b1  1 . Apte, Kane
and Sercu (1994) show that, correcting for lead-lags of about one year, RPPP may hold.

6.3.4 Conclusion

Some support for the hypothesis that exchange rates tend to revert back to their PPP values
over the long run – although the relationship remains very weak.

RPPP may also hold rather well in the short run when inflation is high. But even in these
studies, there are substantial period-by-period deviations from RPPP.

At least in the short run, there is real exchange risk definitely. Moreover, the conventional
claim that “PPP holds in the long run” merely means that the variance of PPP deviations
increases less than proportionally with time.

6.4 Evaluation of PPP as a Theory of Exchange Rate Determination

There is little empirical support for the PPP theory: deviations from PPP are frequent, large
and persistent.

The PPP approach, with its exclusive focus on trade as a determinant of the demand and
supply of foreign exchange, ignores financial transactions.

Given the large variation in the nominal spot rate relative to the variation in inflation rates, it
is unlikely that in the short run exchange rates are explained by international inflation
differentials. It is more likely that the short term variation in exchange rates is caused by
interest rate changes, or news about the relative state of the domestic and foreign economies,
or even changes in the prices of other assets.

127
 St Pt *
Changes in the real exchange rate, Rt  , are mostly a result of changes in the nominal
Pt
exchange rate. That is, deviations from RPPP are almost the same as nominal exchange rate
changes. This implies that the assumption that inflation is non-random is a good
approximation to reality.

6.5 Implications of the Evidence on PPP for Financial Managers

CPP and APPP rarely hold. Violations of RPPP are also quite frequent and persistent. There
is substantial real exchange risk in the short run.

St Pt *
Changes in the real exchange rate, Rt  , are mostly a result of changes in the nominal
Pt
exchange rate. This implies that one can use contracts whose payoff depends on the nominal
spot rate, such as futures and options, to hedge exposure to the real exchange risk.

128
7 Topic 7 – The Balance of Payments

The PPP approach to determining the exchange rate is based on the traditional view that the
demand for currencies is derived from the demand for goods. However, it is not a good
theory. In this topic, we introduce the Balance of Payments (BOP).

According to the BOP theory, the exchange rate is not just determined by the demand for
goods and services, but also the international capital transactions.

7.1 What is the Balance of Payments?

BOP is an accounting statement that summarizes the economic transactions between residents
of a home country and residents of all other countries.

BOP is based on double-entry bookkeeping. Every transaction is recorded twice, once as a

debit and once as a credit.

According to accounting convention, a source of funds (either a decrease in assets or an

increase in liabilities) is a credit (+) and a use of funds (either an increase in assets or a
decrease in liabilities) is a debit (–).

Inflows are reported with a positive sign and are listed as a credit. Outflows are reported with
a negative sign and are reported as a debit.

There are three major BOP categories:

• Current Account (CA): Records flows of goods, services, and transfers.

• Capital Account (KA): Shows public and private investment and lending activities.
• Official Reserves Account ( RFX ): Measures changes in holdings of gold and
foreign currencies by official monetary institutions.

By definition, the overall BOP must balance.

BOP is related to the foreign exchange market. All transactions that affect the inflows and
outflows of foreign currency are recorded in the BOP.

129
7.2 Balance of Payments: Overview

Balance Account
Sources (+) Uses (–)
(Sources – Uses)
1. Current Transactions

Exports of goods Imports of goods Trade balance

Exports of services Imports of services “Invisibles” balance
Inward unilateral transfers Outward unilateral transfers Net inward transfers
CA = Current Account Balance

2. Capital Transactions

Inward portfolio investment Outward portfolio investment Net portfolio investment

Inward direct investment Outward direct investment Net direct investment
KA = Capital Account Balance

3. Central Bank Transactions

Decrease in foreign reserves Increases in foreign reserves Net decreases in

foreign reserves
RFX

4. Errors and Omissions

Unrecorded inflows Unrecorded outflows Net Errors & Omissions

E&O

7.2.1 Current Account (CA) Balance

The current account (CA) of the BOP is a record of the trade in goods, in services, and of
unilateral transfers between a country and the rest of the world.

1. “Merchandise”: Goods sold (+) or bought (–) internationally.

• Merchandise trade represents exports and imports of tangible goods, such as oil,
wheat, clothes, automobiles, computers, and so on.
• The trade balance measures whether a country is a net importer or exporter of goods.
• A trade surplus (deficit) indicates residents of a country are exporting more (less) than
they are importing.

130
2. “Services”: Services (+) or bought (–) internationally.

• Consulting and insurance.

• Income from labor: Wages earned or paid internationally.
• Income from capital: Dividends and interest earned or paid internationally.

3. “Unilateral” income transfers: Inward (+) or outward (–).

• Payments made abroad or received from abroad for which there is no corresponding
international flow of goods or services.
• Examples: Development aid, gifts and wages repatriated by foreign workers.

7.2.2 Capital Account (KA) Balance

The capital account is a record of the inward and outward investment and amortization flows
between a country and the rest of the world. The capital transactions recorded include those
that result from the purchase or sale of real or financial assets.

The sale of assets to foreigners and the borrowing of funds from abroad are transactions that
are recorded with a positive sign because these transactions result in capital inflow.

The purchase of foreign assets is recorded with a negative sign, as they lead to capital
outflow.

A surplus in the capital account implies a decrease in the net holding of foreign assets by
domestic residents.

Unlike trades in goods and services, trades in financial assets affect future payments and
receipts of factor income.

The categories:

1. Direct investment:

• Occurs when investors acquire a measure of control of foreign business.

2. Portfolio investment:

• Represents sales and purchases of foreign financial assets such as stocks and bonds
that do not involve a transfer of control.

131
7.2.3 Changes in Official Reserves (ΔRFX)

Official reserves include gold, government holdings of foreign currencies (mostly in the form
of commercial paper, T-bills, and bonds), money deposited at the IMF, and Special Drawing
Rights (SDRs) with the IMF.

An increase in foreign assets held by the central bank is recorded with a negative sign
because an increase in assets held by the central bank is a use of foreign currency.

A decrease in the central bank’s stock of foreign assets is a source of foreign currency for the
country.

The change in official reserves measures a nation’s surplus or deficit on its current and
capital account transactions by netting reserve liabilities from reserve assets.

Example 7.1

Suppose the U.S. computer maker Dell sells $20 million of computers to Komatsu, a
Japanese manufacturer of construction and mining equipment. Komatsu pays Dell by
transferring dollars from its dollar-denominated bank account at Citibank in New York to
Dell’s bank account. What are the credit and debit items on the U.S. BOP?

U.S. BOP Credit (+) Debit (–)

Computer purchase by Komatsu
from Dell.

Citibank foreign deposit decrease.

Example 7.2

Suppose LVMH, a French luxury goods company, buys EUR 1.5 million of consulting
services from the British subsidiary of the Boston Consulting Group (BCG). LVMH pays by
writing a check on its euro-denominated bank account at its Paris bank, Societe Generale, and
BCG deposits the check in its euro-denominated bank account at a different Paris bank, BNP
Paribas. What are the credit and debit items on the French BOP?

French BOP Credit (+) Debit (–)

LVMH purchase of consulting
service from BCG.

BNP Paribas foreign deposit

increase.

132
Example 7.3

Consider an Indonesian resident who in previous years invested in Japanese government

bonds. Each year, the Indonesian receives JPY 500,000 of coupon payments from her
Japanese bonds. Suppose that these payments are paid to her Tokyo bank, where she keeps a
yen-denominated bank account. What are the credit and debit items on the Indonesian BOP
if the rupiah-yen exchange rate is IDR/JPY 89?

Indonesian BOP Credit (+) Debit (–)

Coupon receipts from Japanese
treasury.

Tokyo bank foreign deposit

increase.

Example 7.4

Consider the effect on the Japanese BOP of a gift of $2 million by a Japanese firm to a U.S.
university to create an endowed chair. Suppose, also, that the Japanese firm finances the gift
by selling U.S. Treasury bonds in which it had previously invested. The yen-dollar exchange
rate is JPY/USD 100.

Japanese BOP Credit (+) Debit (–)

Gift by Japanese firm to U.S.
university.

Sale of U.S. treasury bonds.

7.2.4 Errors and Omissions

It is the differences in the timing between the date on which a transaction takes place and the
date on which it is recorded.

• Estimating items: such as expenditure on travel.

• Illegal or unreported transactions.

133
7.3 The BOP Approach to Exchange Rate Determination

The objective of the BOP theory of exchange rates is to explain:

1. Why exchange rates and prices do not conform to the PPP theory?

• Prices of goods are sticky and are adjusted slowly.

Pt
• Exchange rate can move fast, and is not tied to because of market imperfections.
Pt *

2. Why do we see continuous capital flows between countries?

• Given that prices adjust slowly, economies are in a state of persistent disequilibrium
leading to the flow of capital between countries.

The BOP theory of exchange rate is a Keynesian flow approach to the determination of the
exchange rate. This approach treats a currency like any other commodity and determines its
price from its supply and demand.

Under flexible exchange rate:

• If the demand for foreign exchange exceeds its supply, then either the price of the spot
rate will increase and / or there will be an increase in the inflow of foreign exchange.

Under fixed exchange rate:

• The imbalance is offset by a change in the quantity of official reserves.

The supply and demand for a currency arises from the elements of the BOP:

• Trade in goods and services.

• Portfolio investment.
• Direct investment.

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Factors affecting exchange rates according to the BOP:

 (  )* (  ) (  ) 
 SP *
1. CA  CA  P , Y , Y 
 
 

• The CA which reflects the demand for goods and services is determined by the real
exchange rate and the national income.
SP*
• An increase in R  leads to an increase in the CA.
P
o .
• The effect of national income on the CA is assumed to be through imports.
o .
o .

 (  ) ( *) (  ) 
KA  KA  r , r , S 
2.
 

• The KA is assumed to depend on the relative interest rates at home and abroad and
the current exchange rate.
• An increase in r attracts foreign investment and leads to an inflow of international
funds  KA  .
• An increase in r leads to an outflow of investment funds  KA  .
*

• The value of S will determine the value of the foreign return in terms of domestic
units.

135
7.3.1 Adjustment under Fixed Exchange Rates

Under a fixed-rate regime, the private sector can buy or sell any amount of goods or assets at
a constant exchange rate.

If, at this fixed rate, the plans of the private sector lead to a net demand for foreign exchange,
then the central bank makes up for the shortfall – otherwise, the excess demand for foreign
exchange would lead to an appreciation of the foreign currency, which is not allowed under a
fixed-rate regime.

 (  )* (  ) (  ) 
 SP *  (  ) ( *) (  ) 
RFX  CA , Y , Y  KA  r , r , S 
 P   
 

In this expression, S is fixed; and P, P* are sticky.

If there is a disequilibrium at P, P* and S , it will be reflected in RFX (quantity

adjustment).

Persistent drops in RFX can be prevented,

1. In the short-run:

• By boosting KA through an increase in r .

2. In the long-run:

• By decreasing Y and hence imports.

• By devaluation. S  improves CA (exports up and imports down) and KA (foreign
assets are too expensive and domestic assets are cheaper).

136
7.3.2 Adjustment under Flexible Exchange Rates

In contrast to the case where exchange rates are fixed, when exchange rates are flexible there
is no intervention by the central bank and no change in the holdings of official reserve.

 (  )* (  ) (  ) 
 SP *  (  ) ( *) (  ) 
0  RFX  CA , Y , Y  KA  r , r , S 
 P   
 

Now RFX is fixed at 0. Thus, there is a price adjustment rather than a quantity adjustment.

If, at S0 , CA + KA < 0, then the private sector cannot implement its plans: there is too little
forex around. Competition for forex drives up S , which improves the trade balance and
discourages capital export.

All else being equal,

• An increase in domestic prices, P  , leads to a decrease in exports and, thus, to a

decrease in the demand for the domestic currency, implying a depreciation of home
currency, S  .
• An increase in domestic income, Y  , leads to a depreciation of the home currency
through an increase in demand for foreign currency driven by the increase in demand
for imports.
• An increase in the domestic interest rate, r  , leads to an increase in the demand for
domestic assets, a decrease in the demand for foreign assets, and therefore an
appreciation of the home currency.

7.4 Evaluation of the BOP Theory of Exchange Rate Determination

It is an improvement over the PPP theory, because it allows the exchange rate to be
influenced by a change in the demand for foreign assets.

 () () () 

But based on fairly restrictive assumptions, the view that KA  KA  r , r * , S  :
 

• Ignores the role of expected future exchange rate, Et  ST  , in the total return on forex.
• Ignores risks.
• Ignores other assets: Demand for forex depends on expected returns and risks of other
assets such as described by the portfolio theory.

137
7.5 Relationship between the BOP and Fiscal Policy

The relationship between the BOP accounts and a government’s fiscal policy is quite simple
once we recall the National Income Accounting Identities. We use the following notation:

Y  GNP
C  Consumption expenditure
I  Investment expenditure
G  Government expenditure
A  Absorption by domestic residents  A  C  I  G
S P  Private savings
T  Taxes
NS P  Net private savings  S P  I
NS G  Net government savings  T  G
CA  Current Account balance (Export  Import)  X  M

7.5.1 Relationship between Current Account and Domestic Absorption

In a closed economy, the value of total output has to be equal to the value of spending on that
output (total absorption). That is,

YA

In an open economy, some domestic expenditure may be on imported goods, and some of the
domestic production may be consumed abroad as exports. Therefore,

Y  A  CA

Of course, the difference between exports and imports is the current account balance, which
allows us to rewrite the above equation as:

CA  Y  A

This equation has a number of interesting implications.

CA surplus is equal to the excess of domestic income over domestic expenditure. Thus, an
improvement in the CA balance can be achieved either through an increase in Y (production)
or a decrease in A (domestic absorption).

138
Any policy that attempts to improve the CA balance by means of a reduction in expenditures,
A, is called an expenditure-reducing policy.

• Examples of such a policy include cutting government spending or implementing a

general deflationary policy.

An alternative policy to increase the CA is the use of an expenditure-switching policy. This

is a policy that stimulates exports and selectively discourages imports.

• One frequently used policy instrument is the exchange rate. A devaluation of the
exchange rate by the central bank makes imports expensive and exports cheaper
relative to foreign goods and leads to an improvement in the CA balance.
• Other examples are import tariffs or export subsidies.

7.5.2 Relationship between Current Account and Budget Deficit

A country’s current account surplus is equal to that part of its income that is not absorbed by
its residents – the country’s overall savings.

Overall savings in a country can be divided into private saving and public saving:

CA  Y  A  NS P  NS G

By definition, the CA balance equals the sum of net private saving and net government
saving. We can rewrite the equation as follows:

CA  NS P  NS G
  S P  I     NS G 
  S P  I    Budget Deficit 

This equation is useful for understanding the source of current account deficits. The origins
of a current account deficit can be traced to one of the following factors:

• Too little private savings.

• Too much investment relative to savings.
• A large government budget deficit.

Empirically, S P is relatively stable in the short-run. This means that changes in the CA
deficit usually reflect changes in aggregate investment and in the government deficit. Note
that a CA deficit that reflects an investment boom is not necessarily bad.

139
We can also isolate the budget deficit on the left-hand side.

Budget Deficit   S P  I   CA
 NS P  KA  RFX

We establish the link between budget deficits and the capital account balance, KA. Thus, a
budget deficit must be financed either:

• Through private savings.

• Through the sale of private assets to foreigners.
• Through the sale of official reverse assets.

Under flexible rates and without any intervention in the exchange market by the central bank,
there is no change in the official reverses and therefore “through the sale of official reverse
assets” is not a feasible way of financing a budget deficit.

140
8 Topic 8 – Asset Approach of Exchange Rate Determination

In this topic, we extend the BOP analysis of the exchange rate to a more general asset
demand framework. The viewpoint of this topic is that the exchange rate is determined by
portfolio decisions of all investors. Thus, the demand for foreign exchange arises from the
demand for all financial assets simultaneously.

Under this view, exchange rates are asset prices that adjust to equilibrate international trade
in financial assets. Exchange rates are relative prices between two currencies and these
relative prices are determined by the desire of residents to hold domestic and foreign financial
assets.

We will examine two asset approach models:

1. Monetary Theory.

• Money (including deposits) is held for consumption purposes, and the equilibrium
exchange rate equates the demand and supply in the domestic and foreign money
markets.
• It is a useful way of summarizing the long-term determinants of exchange rates, or as
a way to formulate long-run expected future spot rates (similar to the PPP view).
• This theory is limited in the way that it attempts to price a single asset – foreign
currency – in isolation from all other assets.

2. Mean-Variance Portfolio Model.

• Analyses optimal portfolio weights and the equilibrium exchange rate in a simple
portfolio choice model where investors can hold risky assets (stocks), home T-bills,
and foreign T-bills.

8.1 Monetary Theory of Exchange Rate Determination

The monetary approach predicts that the spot rate behaves just like any other risky asset price:
the value of the spot rate changes whenever relevant information is released.

Because the arrival of new information is much more frequent than changes in relative goods
prices, the monetary approach can explain the frequent changes in the exchange rate.

The monetary approach is also different from the BOP approach because it does not assume
that prices are sticky.

141
8.1.1 The Monetary Model

The monetary model is based on the Quantity Theory of Money (QTM). From QTM, the
money demand depends on the nominal transactions volume and the velocity of money.

Let:

Ld  money demand
Ls  money supply
P  price level
Y  real output
v  velocity

Thus,

PY
Ld 
v

In equilibrium, money demand is equal to the money supply, Ld  Ls . We can turn the result
into a price theory:

vLs
P
Y

We can also derive a similar equation for a foreign country:

v* L*s
P* 
Y*

From PPP,

P
S
P*

We finally derive the monetary model of exchange rate:

vLs Y *
S 
Y v* L*s
v Y * Ls
  
v* Y L*s

142
8.1.2 Relationship between the Exchange Rate and the Money Supply

Ceteris paribus, an increase in domestic money supply, Ls , leads to an increase in S , while

an increase in foreign money supply, L*s , leads to an drop in S .

v Y * Ls
S  
v* Y L*s

The mechanism works as follows:

1. In the Monetary view:

• Direct effect:.
• Indirect effect: In the long-run,.

2. In the Keynesians view:

• It assumes that commodity prices are sticky in the short-run, P  0 .

• An increase in the money supply stimulates real economic activity through its effect
on overall spending and a decrease in the domestic interest rate.
o .
o .

They have the same predictions but through different channels.

8.1.3 Relationship between the Exchange Rate and Real Activity

1. In the Monetary view:

• Ceteris paribus, an increase in real activity, Y , leads to an decrease in S , that is, an

appreciation of the home currency.
• .

143
2. In the Keynesians view:

• .
• Monetarists argue that:
o This prediction focuses on the current account and on interest rates and
ignores the role of long-run expectations.
o It assumes that the prices of goods are constant (which, at best, is true only in
the short-run).

8.1.4 Relationship between the Exchange Rate and Budget Deficits

1. In the Monetary view:

• The real activity is largely independent of monetary policy, especially in the long-run.
• A budget deficit will not affect the long-run output, Y. Rather, it leads to either an
increase in the interest rate or to money creation.
o .
o .

2. In the Keynesians view:

• Deficit spending is an economic stimulant.

o

8.1.5 Evaluation of the Monetary Theory of Exchange Rates

The model holds, at best, only in the long-run:

• Changes in Ls are not incorporated into commodity prices instantly.

• PPP holds only in the long-run, if at all.

The monetary model can still be viewed as a theory that relates the long-term views of
relative money supplies, economic activity, and the exchange rate.

In determining the exchange rate, the market takes into account all information about long-
run expected economic activity, the velocity of money, and inflation. Any new information
becomes quickly incorporated in expected exchange rates and changes their current level.

144
Major weakness:

• Single-asset model.
• The demand for an asset depends on risks and on the expected returns on other assets.

8.2 The Portfolio Theory of Exchange Rate

We will first introduce the assumptions of the mean-variance portfolio model and derive
some basic results on the expected return and variance of a portfolio.

Assumptions of the mean-variance portfolio model:

• In choosing their portfolio, investors care only about their wealth at the end of the
period (time T).
• Investors only care about two characteristics: (1) expected return and (2) the variance
of the return, of their portfolio.
• There is no inflation.
• Markets are perfect: no information costs or transaction costs; and taxes do not
discriminate between capital gains and dividend or interest income.

8.2.1 The Expected Return on a Portfolio

Suppose:

• A domestic T-bill (asset 0, risk-free) with return r0 .

• A stock (risky asset 1) with return r1 .
• A foreign T-bill (risky asset 2) with return r2 , issued at a present price FC 1.

Return on the portfolio:

rp  x0 r0  x1r1  x2 r2

Expected return:

E  rp   E  x0 r0  x1r1  x2 r2 
 x0 r0  x1 E  r1   x2 E  r2 

145
Expected excess return (with wealth constraint: x0  x1  x2  1 ):

E  rp   1  x1  x2  r0  x1 E  r1   x2 E  r2 
 r0  x1 E  r1  r0   x2 E  r2  r0 

E  rp   r0  x1E  r1  r0   x2 E  r2  r0   x0 E  r0  r0 
 x1 E  r1  r0   x2 E  r2  r0 

The expected excess return on a portfolio is a weighted average of all component assets’
expected excess returns. In that sense, the contribution of a risky asset to the portfolio’s
expected excess return is the asset’s own expected excess return.

8.2.2 The Variance of the Return on a Portfolio

Var  rp   Cov  rp , rp 
 Cov  x0 r0  x1r1  x2 r2 , rp 
 x1Cov  r1 , rp   x2Cov  r2 , rp 

The portfolio variance is the weighted average of the component assets’ covariance with the
portfolio return. In this sense, the contribution of an asset to the portfolio’s risk is reflected in
the asset’s covariance with the portfolio return.

Note the computation of portfolio covariance risks:

Cov  r1 , rp   Cov  r1 , x0 r0  x1r1  x2 r2 

 Cov  r1 , x1r1   Cov  r1 , x2 r2 
 x1Var  r1   x2Cov  r1 , r2 

Cov  r2 , rp   x2Var  r2   x1Cov  r1 , r2 

8.3 Mean-Variance Portfolio Choice

The investor trades off the return from an asset against its risk. Using graphs, we are going to
explain the choice of the optimal portfolio.

146
8.3.1 Descriptive Explanation of Equilibrium in World Capital Markets

8.3.1.1 Risk and Return of a Portfolio of Two Risky Assets

x1 E(r˜p )
E1
1 E(r˜1 )=0.25
0.5
E
0 E(r˜2 )=0.145 E2
r0 =.10

sd(r˜2)=0.10 sd(r˜1)=0.20 sd(r˜p )

By changing the selected portfolio expected return, the investor also
changes the portfolio's standard deviation. The relationship is non-
linear.The weight of the risky component E, xE , can be read off from
the x-axis drawn parallel to the E(~r p )-axis. For instance, to obtain the
combination [sd(~rp1 ), E(~
rp1 )], x E has to be set at x E = 0.50.

8.3.1.2 Portfolio of Two Risky Assets and Risk-free Asset

x1 E(r˜p )

1 E(r˜1 )=0.25
E2
0.5
E
T
0 E(r˜2 )=0.145 E1
r0 =.10

sd(r˜2)=0.10 sd(r˜1)=0.20 sd(r˜p )

If the investor combines the risky portfolio E with risk-free assets, all
attainable risk-return combinations are on the line r 0 E. In fact, The 'best'
risky porfolio is T: it offers the risk-return combinations on the line r0 T.
The weight of the first asset, x 1 , in T can be read off from the x 1 -axis
drawn parallel to the E(r˜p ) axis. In this figure, T consists of x1 = 0.40
invested in the first risky asset, and 1-x1 = 0.60 invested in the second
risky asset.

147
8.3.2 Analytical Derivation of Optimal Portfolio Weights

Each asset contributes:

• Its own expected excess return to the portfolio’s expected excess return (we consider
the return a “good”).
• Its own portfolio covariance risk to the total variance of the portfolio (we consider the
covariance a “bad”).

Thus, in an optimal portfolio the ratio of marginal “good” and marginal “bad” must be equal
across all assets:

E  r1  r0  E  r2  r0 
 
Cov  r1 , rp  Cov  r2 , rp 

The common return/risk ratio,  reflects the investor’s attitude towards risk, and is called the
investor's measure of relative risk aversion.

Then, if portfolio p is efficient (optimal), then:

E  r1  r0    Cov  r1 , rp 
E  r2  r0    Cov  r2 , rp 

E  r1  r0     x1Var  r1   x2Cov  r1 , r2  
E  r2  r0     x2Var  r2   x1Cov  r1 , r2  

Solving the equations, the analytical solution for the optimal portfolio weights, x1 and x2 :

 E  r1   r0  Var  r2    E  r2   r0  Cov  r1 , r2 
x1  
 Var  r1 Var  r2   Cov  r1 , r2   
2

 
 E  r2   r0  Var  r1    E  r1   r0  Cov  r1 , r2 
x2  
 Var  r1 Var  r2   Cov  r1 , r2   
2

 

148
8.3.3 Equilibrium in the World Capital Markets

To obtain the amount of each asset demanded by the investor we multiply the portfolio
weight by the investor’s wealth.

We then sum the individual demands for that particular asset across all investors.

The equilibrium price of each asset is the one that makes the aggregate demand for the asset
equal to its total supply.

Let us assume that all investors are homogenous and hence that all investors would like to
hold the same portfolio. Also assume that the total wealth worldwide is W. Then, the amount
invested in asset 0 is  x0  W  , in asset 1 is  x1  W  , and in asset 2 is  x2  W  .

Recall that the second risky asset, asset 2 is a foreign T-bill. Suppose that the number of
foreign unit T-bill is N * . Then the equilibrium exchange rate is one that makes the demand
equal to its supply.

x2 W  S  N *

This implies that the exchange rate is:

x2  W
S
N*

Example 8.1

Assume that all investors are identical and that the total portfolio wealth across all investors,
W, is USD 100 billion. We calculated the optimal portfolio: 10% of wealth is invested in
asset 0, 70% in asset 1, and 20% in asset 2. The supply (N) of the domestic T-bill is 2 billion
units, while the supply of stock is 1 billion shares and the number of foreign unit bonds
outstanding is 4 billion.

Value of all domestic bonds:

• 0.10  USD 100b  USD 10b

10b
• Unit price of asset 0: USD  USD 5 .
2b

149
Value of all equity:

• 0.70  USD 100b  USD 70b

70b
• Unit price asset 1: USD  USD 70 .
1b

Value of all foreign bonds:

• 0.20  USD 100b  USD 20b

20b
• Exchange rate is USD  USD 5 .
4b

8.3.4 Applying the Portfolio Theory of Exchange Rates

If the supply of one of the assets j changes, the old equilibrium is upset (not optimal
anymore):

x j W
price j 
Nj

For instance, if more stock in the domestic firm is issued, the portfolio weights (and the
expected returns and risks that determine these weights) have to change.

A change in the portfolio weights will lead to a change in the demand for the foreign bond,
and will, therefore, affect the exchange rate.

Example 8.2

Assume that there is an expansion of the number of domestic T-bills (asset 0).

At the old prices, the amount of T-bills in the typical investor’s portfolio is too large, while
the quantity of other assets held, the foreign T-bills and the risky equity is too low.

In the process of rebalancing their portfolios, investors will wish to get rid of the excess
domestic bonds, and increase their holdings of the risky equity and foreign T-bills.

Rebalancing will cause:

• A fall in domestic T-bill prices ( r goes up)

•
*
A rise in the price of foreign T-bills ( S up, and / or r down)

150
Example 8.3

Assume that to finance the German reunification, there is an increase in the supply of foreign
(German) bonds – from the US point of view. Now investors hold too many foreign assets.
In an attempt to rebalance their portfolios by selling foreign bonds, investors depress the
value of the DEM and possibly also bond prices in DEM.

8.3.5 Comparing the Portfolio Theory with Other Approaches

The differences between the portfolio theory of exchange rates and the other approaches to
exchange rate determination:

• In contrast to the more primitive monetary model, money demand now depends not
only on r and r but also on the expected change in the exchange rate, Et  ST  St .
*

• Again in contrast to the monetary model, the current account (CA) plays a direct role
in this model. The link is as follows. A CA surplus means that the investors in the
country with the surplus accumulate foreign assets. This implies that the wealth, W,
of these investors has increased, and that these investors own a larger share of foreign
assets. As a result, these changes are likely to lead to portfolio adjustments, that is, it
will affect the money supply, the interest rates, and the spot rate.
• In contrast to the PPP model, which emphasizes the role of the CA items in the BOP,
the focus of the portfolio model is on transactions in the capital account – adjustments
in holdings of the relative amounts of domestic and foreign assets.
• In contrast to the BOP approach, which considers the impact of interest rates on S and
capital flows, the portfolio theory considers expected returns of all risky assets.
Foreign exchange is merely one of the risky assets (in terms of domestic investors)
along with common stocks.

151
9 Topic 9 – Risk and Return in Forward Markets

The central questions in this topic:

1. Is the forward rate, Ft ,T , a biased forecaster of the future spot rate, ST ?

• Is there a risk premium?

   
?
• Et ST  Ft ,T  CEQt ST

2. How accurate is the forward rate as a predictor of ST ?

These questions are important because:

1. From the academic point of view, portfolio theory suggests a risk premium – unless
people are risk neutral or exchange risk is totally diversifiable.

2. From the managerial point of view, we know that changes in S are to a large extent
“real”. If changes in S were easily predictable, using the forward rate as the predictor,
we would be able to predict in a real sense as well.

9.1 The Unbiased Expectations Hypothesis (UEH)

We study the relationship between the current forward rate and the future spot rate. We
begin by discussing the relationship when the future rate is certain. We then examine what
this relationship should be when the future spot rate is uncertain.

9.1.1 The Certainty Case

In the absence of risk there are arbitrage opportunities unless:

Ft ,t 1  St 1

For example, if it is certain that the EUR will be worth EUR/USD 0.8 six months from now,
nobody will sell EUR forward for less than that, and nobody will buy forward for more than
this amount.

152
 1  rt ,t 1
Corollary 1. From interest rate parity (IRP), Ft ,t 1  St , we obtain:
1  rt*,t 1

1  rt ,t 1
St  St 1
1  rt*,t 1

1  rt ,t 1  1  rt*,t 1 
St 1
St
1  rt ,t 1  1  rt*,t 1  1  st ,t 1 

St 1  St
st ,t 1  is the capital gain expressed as percentage.
St

Thus, under certainty, the total return on the foreign T-bill is equal to the domestic risk-free
return.

St 1  St
Corollary 2. If st ,t 1   0 , then rt ,T 1  rt ,t 1 :
*

St

Strong currencies can afford low interest rates because the anticipated (certain) appreciation
makes up for the relatively low interest rate.

9.1.2 Under Uncertainty

The unbiased expected hypothesis assumes that, to deal with uncertainty, it suffices to add an
expectation operator:

 
?
Et St 1  Ft ,t 1

Conceptual problems:

• It assumes that investors are risk-neutral.

• It defines risk-neutrality in nominal terms, not in real terms.
• It ignores inflation risk and risk aversion.
• Siegel paradox. It holds in one currency, it cannot hold in the other unless there is no
 1 
uncertainty. If Et  St 1   Ft ,t 1 , then Et 
1
 .
 St 1  Ft ,t 1

153
Example 9.1

If ST  CAD USD , takes on a value of either 1.1 or 0.9 with equal probability. The

 
expectation is Et St 1  1 .

CAD/USD USD/CAD
Up (prob. = 0.5)
Down (1 – prob. = 0.5)
Mean

The Canadian point of view and American point of view are incompatible.

• Canada wants.
• U.S. wants.

9.1.3 Implications for Exchange Rate Determination

IRP plus UEH suggests:

1  rt ,t 1
 
?
Et St 1  St
1  rt*,t 1
1  rt*,t 1
 1 r
?
 St  Et St 1
t ,t 1

Implications:

• For given interest rates, changes in expectations are reflected in the current price, St .
•
*
For given expectations, an increase in r lowers St , and an increase in r strengthens
St .
• The effect of changes in expectations, Et  St 1  , can be temporarily offset by a change
in interest rates.

154
Example 9.2

Initially, r  r *  0.05 . Let Et  St 1  increase from SKK/USD 20.5 to 21. The central bank
of Slovakia can stabilize the spot rate at 20.5 by increasing r to 0.0756:

Thus, the higher Slovakia interest rate does strengthen the current SKK spot rate, all else
being equal.

However, this partial analysis may be incomplete, because a change in interest rates may also
affect expectations. An increase in r may also have a positive feedback effect on Et  St 1  :
by signaling a more rigorous monetary policy.

9.2 Regression Tests of the UEH

Issues in testing UEH:

•  
Et St 1 is unobservable. All we can do is to assume market efficiency. That is,

 
Et   t 1   0 in St 1  Et St 1   t 1 .

o St 1  Ft ,t 1   t 1

If we observe anomalies (violations), what is the explanation?

• Inefficiency – that is, Et   t 1   0 .

• Risk premium.

Statistical issue: Nonstationarity of F and S. This is easy to solve:

• Convert St 1  Ft ,t 1   t 1 into a relative change form.

St 1  St Ft ,t 1  St
o   et ,t +1
St St

155
Regression test:

 St 1  St   Ft ,t 1  St 
        et ,t +1
 St   St 
st ,t 1     FPt ,t 1  et ,t +1

The null hypothesis is that   0 and   1 .

Results:

•   1 and even less than 0 (Froot and Thaler, 1990). The average  obtained from 75
empirical studies is -0.88. Not a single study finds a slope that is equal to or greater
than unity.
•
2
But R is very low, the predictive power is quasi nil.

Possible explanations:

• Just a freak result due to an unusual sample period? No, in view of the significance
tests.
• Investors are not risk neutral, and the bias in the forward rate’s prediction of the spot
rate reflects a risk premium? (See 7.3).
• Inefficiency? Investors make errors in forming expectations. (See 7.4).

9.3 Can Risk Premiums Explain Violations of UEH?

The risk premium of a given security or portfolio is defined as the return on this security or
portfolio, over and above the risk-free return.

Suppose that one invests St units of the home currency in the domestic risk-free bond and
also buys a forward contract. The domestic bond yields St 1  rt ,t 1  . The expected payoff on

the forward contract is given by Et St 1  Ft ,t 1 . 

The total expected return on this portfolio of the domestic bond and the forward contract is:

 
Et St 1  Ft ,t 1  St 1  rt ,t 1 
1
St

156
And the expected excess return is:

 
Et St 1  Ft ,t 1  St 1  rt ,t 1 
 1  rt ,t 1
St

Simplifying this expression, the expected excess return (risk premium) on this risky portfolio
is:

 
Et St 1  Ft ,t 1
St

We define this quantity, which is the expected relative profit on a forward contract, as the risk
premium at time t, RPt ,t 1 :

 
Et St 1  Ft ,t 1
 RPt ,t 1
St

Subtracting and adding St in the numerator on the left:


 
 Et St 1  St   F S 
   t ,t 1 t   RPt ,t 1
 St   St 
 
Et  st ,t 1   FPt ,t 1  RPt ,t 1

Rewriting this equation in terms of observable variables leads to the following test equation:

st ,t 1  FPt ,t1  RPt ,t 1  et ,t 1

et ,t 1 is the percentage forecast error, should be totally unpredictable given the available
information.

157
9.3.1 Regression Tests of Risk Premium

In the regression Et  st ,t 1      FPt ,t 1 , we have the slope estimate:

Cov  s , FP 

Var  FP 

Given st ,t 1  FPt ,t 1  RPt ,t 1  et ,t 1 , we have:

Cov  FP  RP  e , FP 

Var  FP 
Cov  FP, FP   Cov  RP, FP   Cov  e , FP 

Var  FP 
Cov  RP, FP  Cov  e , FP 
 1 
Var  FP  Var  FP 

Thus,   1 is evidence of either a risk premium, or inefficiency if Cov  e, FP   0 .

Cov  RP, FP 
Assuming efficiency,   0 means that  1 . To explain the data, the risk
Var  FP 
premium needs to be large in magnitude and strongly negatively correlated with the forward
premium.

This is a puzzle if we believe the risk story.

158
9.3.2 Other Tests of the Risk Premium

Besides regression, there are several other tests that study the properties of the risk premium.

We can study the time series of:

st ,t 1  FPt ,t1  RPt ,t 1  et ,t 1

“Prediction error or forward bias”, st ,t 1  FPt ,t1 measures the risk premium – up to zero-mean
noises (in an efficient market).

The key questions typically asked are:

1. What is the mean of the forecast error over long periods and over sub-periods? Is this
mean significantly different from zero?

2. How often is the sign of FPt ,t 1 the same as the sign of st ,t 1 ; that is, how often does the
forward premium correctly predict the direction of change in the spot rate?

3. Is the forecast error predictable on the basis of past realized forecast errors, using either
linear regression analysis, sophisticated time-series methods, or trading rules?

4. Is the forecast error predictable on the basis of other available information, like interest
differentials or forward premiums?

We briefly describe some of these tests and their findings.

9.3.2.1 Tests of Average Prediction Errors

The average of prediction errors is significantly different from zero when tested over sub-
periods, but the sign of the average error is unstable.

9.3.2.2 Autocorrelation Tests

A positive error is often followed by another positive error (although it becomes typically
smaller), and vice versa. In an efficient market this must mean that there is a risk premium
that changes over time.

159
9.3.2.3 Sign Tests

The forward premium is “no better than a toss of a coin” as a predictor of the subsequent
exchange rate change.

Thus:

• Either the risk premium fluctuates over time, or the market is inefficient.
• The forward premium is not an impressive predictor of the future spot rate.

9.3.3 Trading Rules Based on the Forward Bias

UEH:

1  rt ,t 1
Ft ,t 1  St
1  rt*,t 1
 
 Et St 1

  1 r
Et St 1
1  r  
t ,t 1
S
  *
t ,t 1
t

 1 
 
 Et St 1  St 
 1  rt*,t 1 
 St 
 

Thus, under UEH it should be impossible to obtain total returns on foreign T-bills that
systematically exceed the home risk-free rate.

Alternative investment strategies are tested at the beginning of every month.

For example:

• Invest in the currency with the highest nominal rate.

• Buy forward whenever there is a discount.

Results confirm regression tests:

• Strategies tend to do better than buy-and-hold home currency; that is, high-interest
currencies typically provide the highest total returns, or discounts tend to be followed
by appreciations.
• Interest rates differentials (≈FP) tend to overcompensate for expected depreciations.

160
9.4 Other Explanations for Violations of the UEH

In the previous section, we raised questions about the hypothesis that the presence of a risk
premium explains the forward rate bias.

In this section, we examine other hypotheses.

9.4.1 Errors in Forming Expectations

One explanation for the forward bias is that it is the result of investors making errors in
forming expectations.

“It takes time for investors to learn about market conditions.” For example, the effect of
changes in monetary policy or in the exchange rate policy may not be immediately
understood.

But why don’t investors do not eventually learn about how such events affect exchange rates?

9.4.2 Peso Problem

A peso problem is a very specific form of a small sample problem that affects statistical
inference. According to this view, for long periods of time investors assign a small but
positive probability to an extreme change in the asset price (such as a devaluation or a stock
market crash), which may never materialize in a limited sample period. The frequency of the
extreme events in the sample studied does not equal the ex-ante anticipated probability. The
forward rate, however, will reflect the ex-ante probability distribution. Since the event may
never materialize, markets will observe a persistent forward bias.

The small sample problem is called peso problem, in reference to the discrete changes in the
Mexican peso in 1976. Before 1976, the Mexican peso had been successfully pegged to the
USD for 23 years. Mexican interest rates were substantially higher the U.S. interest rates,
creating a MXP/USD forward rate higher from the MXP/USD spot rate. Therefore, the
MXP/USD showed a persistent premium.

In short:

• “Investors take into account possible huge events that can occur only with tiny
probabilities. The event may never actually occur in a finite sample.”

161
But what exactly is this huge event? For freely traded floating currencies there have been
large exchange rate changes, but never of the order of magnitude that could explain, say, a
2% bias if the probability of the event is less than 1%.

9.5 Real and Nominal Returns: International Relationships

So far, we have derived the following parity conditions:

1. Interest Rate Parity (IRP):

• It relates the forward premium to the interest rate differential.

Ft ,T  St rt ,T  rt*,T
• 
St 1  rt*,T

2. Purchasing Power Parity (PPP):

• It links the expected exchange rate change to the inflation differential.

S  St I t ,T  I t ,T
*

• st ,T  T 
St 1  I t*,T

3. Unbiased Expectations Hypothesis (UEH):

• It links the forward premium to the expected change in the spot rate.
ST  St Ft ,T  St
• 
St St

There must be a forth relationship that links the interest differential to the inflation
differential. This link is called the Fisher Open Relationship.

162
The four international parity relations under certainty:

9.5.1 The Fisher Relationship

Define:

•  = the real return to a domestic investor on the domestic risk-free asset.

• P = the domestic commodity price level.
P
• I t ,T  T  1 = inflation rate.
Pt

Thus,

VT PT
1  t ,T 
Vt Pt
VT Vt

PT Pt
1  rt ,T

1  I t ,T

163
 1  rt ,T
t ,T  1
1  I t ,T
rt ,T  I t ,T

1  I t ,T
 rt ,T  I t ,T

9.5.1.1 Fisher Closed

For a single economy, the nominal interest rate equals the real interest rate plus the expected
rate of inflation.

rt ,T  t ,T  I t ,T  t ,T I t ,T
 t ,T  I t ,T

Fisher turned this definition into a theory by adding an assumption. It is postulated that
investors care only about the expected real return. That is,

1  r   1  E    1  E  I 

t ,T t t ,T t t ,T

For example, at the end of one period, a $1 commodity holding can be liquidated for
 
$1 1  Et I t ,T  .

To be indifferent, an interest-bearing asset will need an end-of-period value of

 
$1 1  Et  t ,T   1  Et I t ,T  .

164
9.5.1.2 Fisher Open

Let us derive the International Fisher Effect.

In an open economy, an investor has two options:

1. Invest HC 1 in home country.

• Terminal wealth  1  rt ,T 

2. Invest abroad and convert at future spot.

• Terminal wealth 
1
St
1  rt*,T   ST

International Fisher Effect states:

 
1  r   E 1  r  SS
t ,T t
*
t ,T
T

 t 
Et ST   1 r t ,T

St 1 r *
t ,T

 
Et ST  St

rt ,T  rt*,T
St 1  rt*,T

It tells us about the market’s implied future spot rate.

1  rt ,T
 
Et ST 
1  rt*,T
St

The market expects the HC to depreciate when domestic interest rates are higher than foreign
interest rates, and vice versa.

For two economies, the home interest rate minus the foreign interest rate equals the expected
change in the exchange rate.

rt ,T  rt*,T
E  st ,T  
1  rt*,T
 rt ,T  rt*,T

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9.5.1.3 International Fisher and PPP

Based on PPP, the expected change in the exchange rate is:

I t ,T  I t*,T
E  st ,T  
1  I t*,T

Combining with the International Fisher Effect gives:

I t ,T  I t*,T rt ,T  rt*,T

1  I t*,T 1  rt*,T
I t ,T  I t*,T  rt ,T  rt*,T

Thus, the nominal interest differential is equal to the expected inflation differential.

9.5.2 A General Evaluation

IRP holds very well:

• Arbitrage is unaffected by any uncertainty or risk premiums.

• IRP purely links current financial prices / variables.

PPP usually does not hold in short-run:

• Trading is, at best, costly and takes time (trading is affected by uncertainty).

UEH should be violated:

• Uncertainty makes it impossible to observe expectations and creates (time-varying)

risk premiums.

Fisher Open cannot be right:

• Real rates differ (ex-ante and ex-post) because UEH fails and PPP fails.

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9.6 Implications for Financial Decision Making

Regarding UEH:

1. The forward premium is a biased predictor of the change in the spot rate. A forward
premium is (weakly) associated with later depreciations and vice versa.

2. There is evidence of a risk-premium which is small (on average), but non-stable, auto-
correlated, and negatively related to the forward premium. It also seems to be related to
the real interest rate differential, as it should be.

3. The bias in the forward rate does not necessarily imply that it does not contain any useful
information: the forward rate is still the certainty equivalent future spot rate (the risk-
adjusted expectation).

4. Deviations from UEH have nothing to do with the (ir)relevance of hedging or the value of
a forward contract:

• Example of a nonsense statement: “if the unbiased expectations theory holds, hedging
does not matter in the long run. Hedging does matter, though, if UEH fails.”
• Relevance has to do not with expectations but with present values. And present
values change only when hedging affects the operational cash flows.

Regarding other relationships:

5. Never consider exchange rates in isolation: We should also consider the inflation
differential.

• Example of a nonsense statement: “if not for its technological strength and its
reputation for quality and excellent service, Germany would be pricing itself out of
Europe’s markets by its revaluations.”

6. Never compare interest rates in isolation: We should also be aware of the expected
evolution of the spot rate and of the associated risk. In reasonably well-functioning
markets, you should be very suspicious of so-called “bargain” interest rates.

• Example of a nonsense statement: “the South African Rand is a good investment

because it offers a 10% interest rate.”

167
 Part III

International Risk Management

168
10 Topic 10 – Contractual Exposure to Exchange Rate

In today’s world of globalization, all multinational corporations are exposed to complex

foreign exchange regulations, which affect their operations and impact their financial
positions. It is therefore critical for every multinational corporation to identify and measure
its foreign exchange exposures in order to eliminate or reduce the impact caused by them.

One of the important responsibilities of a financial manager is to understand the nature of

foreign exchange risks, what can be done to minimize the adverse effects, and what the cost
of such action may be.

So far, we have established some important facts about exchange rate:

1. Nominal exchange rates are volatile.

2. Movements in the nominal exchange rate are not offset by changes in prices across
countries – PPP does not hold for the short- and medium-run.

3. Forward rate is not successful in forecasting the exchange rate. It is difficult to forecast
nominal exchange rates, especially over horizons exceeding a few days.

4. Given a variety of imperfections in financial markets, a firm can increase its value by
hedging against changes in the exchange rate.

10.1 Motivating Problem

Husky Energy, a Canadian company, had a bid of USD 425 million for the installation of a
cross-border natural gas pipeline for a power plant in the United States.

The bid was accepted. In accordance with the contract, the U.S. firm transferred USD 42.5
million as deposit on the contract, with the balance of USD 382.5 million due in 180 days.

On the day the bid is accepted, the value of the USD was CAD/USD 1.3310. However, there
was concern that the USD might depreciate during the next 180 days.

1. To which currencies is Husky Energy exposed?

2. What will be the effect on Husky Energy if there is a drop of 25% in the real value of the
USD against the CAD?

3. Should Husky Energy attempt to hedge its USD exposure?

4. What methods are available for hedging this exposure?

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10.2 The Concepts of Risk and Exposure

We need to distinguish between the terms exchange risk and exchange exposure.

10.2.1 Definition of Risk and Exposure

Exchange risk refers to uncertainty about the future spot rate.

• One measure of exchange risk is the standard deviation or the variance of the future
spot rate change.
•  
Risk   t ST or  t2 ST  
Exchange rate exposure measures how sensitive the HC value of a firm is affected by
changes in the exchange rate.

• It is a quantity that tells us how relevant the exchange risk is for a particular firm.
Total unexpected change in firm value, measured in HC at time T
Exposure 
Unexpected change in ST

• 
 
VT  Et VT
ST  E S 
t T

VT

ST

Note that:

1. Exposure is an amount expressed in FC terms because:

• The numerator is in HC terms.

• The denominator is expressed as HC/FC.
• Implying that after the HC units cancel out in the numerator and denominator, we
are left with just the FC component.

2. Exposure depends on the maturity date of the cash flow.

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Example 10.1

A portfolio contains (1) a GBP (FC) T-bill maturing at time T, with face value of GBP
100,000; and (2) a USD (HC) T-bill with face value at time T of USD 50,000.

The HC value of the portfolio at time T is:

And, the time-t expected value of your portfolio is:

The unexpected effect of the exchange rate on the portfolio value is:

The exposure is the unexpected change in value divided by the unexpected change in the
exchange rate:

In the definition of exposure above, we did not specify how one would measure the value of a
firm. There are two types of exposure, depending on how one measures the value of the firm.

1. Economic exposure: the effect on the economic value of the firm from an unexpected
change in the exchange rate. Economic exposure can further subdivide into:

• Contractual exposure: it reflects the exposure from past contractual undertakings

(whose value is fixed in FC terms) that have future cash flow implications because
the asset or liability is still outstanding.
• Operating exposure: it measures the effect of changes in the exchange rate on the
future cash flows of the firm through the effect on the firm’s competitive position.

2. Accounting exposure: the effect on the accounting value of the firm from an unexpected
change in the exchange rate.

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10.3 Managing Contractual Exposure

Managing contractual exposure involves two key steps:

• Identify and measure exposure.

• Hedge exposure.

10.3.1 Measuring Contractual Exposure

The exposure from a single contract in a particular foreign currency is simply the value of the
contract at maturity.

Example 10.2

A firm (located in the U.K.) has an A/R next month of AUD 100,000. If the future exchange
rate changes from GBP/AUD 0.5 to 0.6, then the GBP value of the A/R changes from GBP
50,000 to 60,000.

Thus, the exposure of the firm is:

An ongoing firm is likely to have many contracts outstanding, with varying maturity dates
and denominated in different foreign currencies.

Inflows: FC accounts receivable

(for a particular date and currency) FC long-term sales contracts
FC deposits, bonds, notes
Forward purchase of foreign currency

Outflows: FC accounts payable

(for a particular date and currency) FC long-term purchase contracts
FC loan, bonds, notes due
Forward sales of foreign currency

Net Exposure by currency and date = Total Inflows – Total Outflows

One can measure the exposure for each given future day by summing the outstanding
contractual foreign currency cash flows for a particular currency and date as shown in the
above table.

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The net sum of all the contractual inflows and outflows gives us the firm’s net exposure – an
amount of net foreign currency inflows or outflows for a particular date and currency, arising
from contracts outstanding today.

Example 10.3

Suppose that a U.K. firm has the following AUD commitments:

1. A/R: AUD 100,000 next month and AUD 2,200,000 two months from now.
2. Expiring deposits: AUD 3,000,000 next month.
3. A/P: AUD 2,300,000 next month, and AUD 1,000,000 two months from now.
4. Loan due: AUD 2,300,000 two months from now.

Transaction One month Two months

from now from now
Inflows A/R 100,000 2,200,000
Deposit 3,000,000

Outflows A/P (2,300,000) (1,000,000)

Loan (2,300,000)

Net Exposure 800,000 -1,100,000

10.3.2 Managing Contractual Exposure

We will briefly go over the standard financial methods available for hedging this exposure.
Among the standard methods for hedging contractual exposure are:

10.3.2.1 Forward Market Hedge

It is an OTC agreement to exchange currencies at certain exchange rate in the future.

In Example 10.3, one could hedge the one-month exposure with a 30-day forward sale of
AUD 800,000 and the two-month exposure by a 60-day forward purchase of AUD 1,100,000.

Note the default risk in forward contracts arises because such a contract is a commitment for
future performance, and one or other party may be unwilling or unable to honor that
commitment.

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10.3.2.2 Option Market Hedge

It gives the owner the right, but not the obligation to trade foreign currency in a specified
quantity at a specified price over a specified period.

In Example 10.3, one could buy a 30-day put option on AUD 800,000 and a 60-day call
option on AUD 1,100,000. Buying these options provides a lower bound on the firm’s inflow
of AUD 800,000, and an upper bound on its outflows of AUD 1,100,000.

The key difference between an option and the forward hedge is that an option has a nonlinear
payoff profile. They allow the removal of downside risk without cutting off the benefit from
upside risk.

10.3.2.3 Money Market Hedge

This method utilizes the fact from covered interest parity, that the forward price must be
exactly equal to the current spot exchange rate times the ratio of the two currencies’ riskless
returns. The basic idea is to avoid future exchange rate uncertainty by making the exchange
at today’s spot rate instead.

If we are hedging a future payment:

• Buy the present value of the foreign currency amount today at the spot rate.
• The foreign currency purchased is placed on deposit and accrues interest until the
transaction date.
• The deposit is then used to make the foreign currency payment.

If we are hedging a receipt:

• Borrow the present value of the foreign currency amount today.

• The foreign loan accrues interest until the transaction date.
• The loan is then repaid with the foreign currency receipt.

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Example 10.4

Suppose the current spot rate is GBP/AUD 0.6, the one-month and two-month effective GBP
rates are 0.4% and 0.8%, and the effective AUD rates are 0.8% and 1%.

The one-month and two-month forward rate are:

1.004
F0,1  0.6 
1.008
 0.5976

1.008
F0,2  0.6 
1.01
 0.5988

Following Example 10.3, one could hedge the one-month exposure by:

• Borrow AUD 793,650.79.

• Convert AUD 793,650.79 into GBP 476,190.48 at the current spot exchange rate of
GBP/AUD 0.6.
• Deposit GBP 476,190.48 in U.K.
• In future, settle the AUD loan with the net receipt.

Transaction Current Cash Flow Cash Flow at Maturity

Borrow AUD
Buy GBP spot
with AUD
Deposit in U.K.
Collect the net receipt
Net cash flow

To hedge the two-month exposure:

• Borrow GBP 653,465.35.

• Convert GBP into AUD 1,089,108.91 at the current spot exchange rate of
GBP/AUD 0.6.
• Deposit AUD 1,089,108.91 in Australia.
• In the future, use the AUD deposit to settle the net payment.

Transaction Current Cash Flow Cash Flow at Maturity

Borrow GBP
Buy AUD spot
with GBP
Deposit in Australia
Settle the net payment
Net cash flow

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10.4 Aggregate Contractual Exposure

Typically, firms need to hedge more than a single FC cashflow. With several cash flows,
each of different maturity, it is no longer practical to hedge each cash flow individually.

Ideally, one would like a method to aggregate the exposure arising from multiple FC cash
flows, and then hedge this aggregate exposure using a limited number of transactions.

We will see how one can add up the contractual exposures for different maturities into one
aggregate quantity, and how one can hedge this pooled exposure.

10.4.1 When Interest Rates are Zero

Example 10.5

If the contractual exposure of the firm is AUD 800,000 in one month and –AUD 1,100,000 in
two months, the aggregate exposure of this firm is –AUD 300,000.

Thus, one could hedge this with a two-month forward purchase of AUD 300,000.

10.4.2 When Interest Rates are Positive but Certain

One can aggregate the net exposures across different maturities by computing their present
value, or by computing their future value on a particular date. The aggregate contractual
exposure can then be hedged with a single forward contract.

Example 10.6

Suppose that it is known today that the one-month effective AUD return, one month from
now is 1%.

Then, deposit the AUD 800,000 one month from now. In two months, AUD 808,000 will be
available.

Given the contractual outflow is AUD 1,100,000 at T2 , the net exposure will be –AUD
292,000. One single forward purchase will do.

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10.4.3 When Interest Rates are Uncertain

In the real world, we do not know what the future interest rates are going to be. When we
pool the cash flows over various maturities, we have interest rate risk in addition to exchange
rate risk. The hedging strategy that we design must account for both interest rate risk and
exchange rate risk.

10.4.3.1 Combining Forward Rate Agreements with Currency Hedges

Example 10.7

Suppose that the effective forward interest rate for deposits (the 1-to-2-month forward rate) is
r0,1,2  1.5% .

We deposit AUD 800,000 one month from now, and AUD 812,000 will be available in two
months.

Given the contractual outflow is AUD 1,100,000 at T2 , the net exposure will be –AUD
288,000.

Note:

• The firm still uses two contracts to hedge its contractual exposure – an FRA and a
two-month forward purchase.
• Forward sale of AUD 800,000 is replaced by FRA. FRAs tend to be cheaper than
forward contracts as no foreign currency transaction is involved.
• Reduction of second forward purchase from AUD 1,100,000 to only AUD 288,000.

10.4.3.2 Matching Duration of Pooled Exposure with that of the Hedge

If forward money market contracts are not available or are too expensive, and if hedging the
exposure for each maturity date with individual forward contracts is too expensive, then we
need to devise a hedging strategy that uses only a few financial contracts and hedges against
both interest rate risk and exchange risk.

Note that by definition a firm is perfectly hedged if, at every point in time, the hedge position
has the same offsetting value as that of the contracts being hedged. Thus, the hedge position
that we design must match the changes in the value of the exposures from both the changes in
the exchange rate and the interest rate.

1. To account for the different maturity dates of the FC cash flows, we discount the cash
flows to a common date and only then aggregate them. That is, we compute the total
present value of the cash flows, and match it to the present value of the hedge.

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2. To account for changes in interest rates, in addition to matching the size of the hedging
contract to the size of the aggregate exposure, we also match the duration of the cash
flows with that of the hedging contract.

If the hedge meets the above two conditions simultaneously, changes in the value of the
hedge will offset changes in value from contractual exposure.

Example 10.8

Consider a Canadian firm, CanWood, that exports timber and imports oil to operate its plants.
The price of timber and of oil is set in USD million. Assume that the US spot interest rates
and the cash flows of the firm for the following four maturities are the following:

Date Interest Rate at t = 0 USD inflow USD outflow Net USD Flow
1 5.0% 10 8 +2
2 5.6% 6 7 –1
3 6.1% 7 9 –2
4 6.5% 12 7 +5

One way to hedge would be to buy a contract for each inflow and outflow.

A more efficient way would be to buy one contract for the aggregated value of the inflows
and another contract for the outflows. This is preferred when the maturities of the cash flows
are different – duration-matching provides a better hedge when done in this way.

To hedge the net inflows, aggregate the net inflows by finding their present value:

Compute the duration of the net inflows:

PV
Maturity PV Weight  Weight  t
Total PV
2
1  1.91
1.0501
5
4  3.89
1.0654
Total PV = 5.80

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To hedge the net inflows, sell forward a contract with USD as the underlying foreign
currency of maturity 3.01 years and the size of the forward contract =

To hedge the net outflows, find the present value:

The duration of the net outflows:

Thus, we need to buy a forward contract with a maturity equal to the duration of the net
outflows 2.65 year and with size =

Summary:

1. Identify all the transactions exposed to a particular exchange rate for each maturity.
You can net out inflows and outflows which are for the same date.

2. Aggregate across maturities by finding the present value of all the inflows and all the
outflows for a particular currency.

3. To hedge, take two forward contracts, one for inflows and one for outflows. The
contractual amount whose present value equals the opposite of the present value of cash
inflows / outflows, and whose maturity is equal to their duration.

4. For cash flows with very long duration, one may not be able to obtain forward contracts.
In this case, one may use the longest available contract to hedge the capitalized value of
all the cash flows which are to occur past its maturity date.

5. Duration is an imperfect measure of interest rate risk. It works well only for small
changes in interest rates. Over time, the change in the duration of the forward contract
may not match exactly the change in the duration of the cash flows; thus, one may have
to adjust the size of the forward hedge to correct for this.

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10.5 Comprehensive Example

A Dutch company, Dutch Lady, has the following JPY commitments:

(a) A/R of JPY 1,000,000 for 30 days.

(b) A/R of JPY 500,000 for 90 days.
(c) A sales contract (twelve months) of JPY 30,000,000.
(d) A forward sales contract of JPY 500,000 for 90 days.
(e) A deposit that at maturity, in one month, pays JPY 500,000.
(f) A loan for which Dutch Lady will owe JPY 8,000,000 in six months.
(g) A/P of JPY 1,000,000 for 30 days.
(h) A forward sales contract for JPY 10,000,000 for twelve months.
(i) A/P of JPY 3,000,000 for six months.

1. What is Dutch Lady’s net exposure for each maturity?

Maturity 30 days 90 days 180 days 360 days

(a)
(b)
(c)
(d)
(e)
(f)
(g)
(h)
(i)
Total

2. How would Dutch Lady hedge the exposure for each maturity on the forward market?

For 30 days,
For 90 days,
For 180 days,
For 360 days,

3. Assume that the interest rate is 5% per annum for all maturities and that this rate will
remain 5% with certainty for the next twelve months. Also, ignore bid-ask spreads in
the money market. How would the company hedge its exposure on the spot market and
the JPY money market? Describe all money-market transactions in detail.

The total time-t value of Dutch Lady’s exposure equals:

Thus, Dutch Lady can sell the time-t value of its exposure on the spot market.

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 That is, it borrows JPY 8,810,689. After 30 days, the company makes a partial
repayment of JPY 500,000 on its JPY loan. After 180 days, it borrows another JPY
11,000,000 (at 5% compound, for 5 months). And after 360 days it pays off all its debts,
including interest, with the JPY 20,000,000 inflow.

Thus, no spot transaction is needed at all after the initial hedge – that is, the exposure is
eliminated.

0 day 30 days 90 days 180 days 360 days

Bal b/f
CF
Bal c/f

4. If the interest rate is 5% (compound, per annum) for all maturities and will remain 5%
with certainty for the next twelve months, how would the company hedge its exposure
on the forward market if only one forward contract is used?

Dutch Lady could hedge its exposure with one forward contract in many different ways,
depending on the maturity of the forward contract it chooses.

(a) Hedge with a 30-day forward contract.

First, discount its 180 and 360 days exposure to 30 days:

Dutch Lady then sells this exposure forward at the forward rate for 30 days. After 30
days, it borrows JPY 8,346,585 and delivers these, together with the JPY 500,000. After
180 days, it borrows another JPY 11,000,000 (at 5% compound, for 5 months). After
360 days, it receives an inflow of JPY 20,000,000 which is exactly enough to pay off the
first debt plus interest at JPY 8,728,354 and the second debt plus interest at JPY
11,271,646.

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 (b) Hedge with a 180-day forward contract.

First, compute the exposure:

Dutch Lady then sells this exposure forward at the forward rate for 180 days. After 30
days, the company invests its JPY 500,000 inflow for five months. After 180 days, the
proceeds of his investment are delivered to the bank; the company also borrows another
JPY 9,028,270 – 510,269 = 8,518,001 to fulfill its remaining forward obligation. In
addition, it borrows JPY 11,000,000. After 360 days, all outstanding loans, including
interest, are paid back using the JPY 20,000,000.

(c) Hedge with a 360-day forward contract.

First, compute the exposure:

Dutch Lady sells its exposure of JPY 9,251,224 forward at the forward rate for 360 days.
After 30 days, it invests its JPY 500,000 at 5% for eleven months. After 180 days, it
borrows JPY 11,000,000. After 360 days, its net debt (including interest) and its
forward obligation are all settled using the JPY 20,000,000 inflow.

5. Assume that Dutch Lady prefers to use traded options rather than forward contracts.
The option contracts are not divisible, have a life of either 90, 180, 270, or 360 days, and
for each maturity the face value of a contract is JPY 1,000,000. How could Dutch Lady
hedge its exposure? Do the options offer a perfect hedge for each maturity?

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6. The term structure is flat right now (at 5% p.a., compound), but is uncertain in the future.
Consider the spot hedge of part (c). If, instead of FRAs, duration is used to eliminate the
interest rate risk, how should Dutch Lady proceed?

As Dutch Lady has both positive and negative exposures, these should be hedged
separately. It could deposit the present value of its negative exposure for 180 days, that
is:

This deposit perfectly matches this single outflow, so no interest risk remains on the
short side.

Dutch Lady also computes the present value and the duration of its positive exposures:

Dutch Lady should then take out a loan in JPY with, initially, the above PV and time to
maturity.

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11 Topic 11 – Operating Exposure to Exchange Rate

In Topic 10, we explained that the economic exposure of a firm includes:

• Contractual exposure.
• Operating exposure.

Contractual exposure focuses on the effect of the exchange rate on future cash flows whose
value in foreign currency terms is contractually fixed in the past.

Operating exposure analyzes the impact of future exchange rates on non-contractual future
cash flows.

The difference between the two is that transaction exposure is concerned with future cash
flows already contracted for, while operating exposure focuses on expected (no yet
contracted for) future cash flows that might change because a change in exchange rates has
altered international competitiveness.

11.1 Introduction to Operating Exposure

We define what is operating exposure and explain why the operations of firms that have
neither export nor import transactions may still be exposed to the exchange rate.

11.1.1 Definition of Operating Exposure

Operating Exposure
Total unexpected change in the time-T operational cash flows, measured in HC

Unexpected change in ST

Example 11.1

In the 1970s, Volkswagen’s profits from exports to the U.S. were severely affected by the fall
of the USD from DEM/USD 4 to about DEM 2.

In the short-run Volkswagen had to decide to what extent it should change the USD price of
its cars, trading off sales volume against profit margin.

Volkswagen’s long-run problem was to decide whether to continue competing in the U.S.
market and, if so, whether or not it should move production from Germany to the U.S., or to
Latin-America.

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11.1.2 The Sources of Operating Exposure

Two misconceptions:

1. Only firms that have foreign operations are exposed to the exchange rate.

2. If a firm denominates all its sales and purchases in terms of its own currency, there is no
exposure.

Conclusion:

• Even a monopolist / exporter cannot simultaneously have both stable FC prices and
stable HC revenues.
• If there are competitors located in different countries, then a change in the exchange
rate affects their relative competitive position, and therefore, the cash flows of the
firms.
• The magnitude of the effect depends on magnitude of PPP deviations; demand and
supply elasticity; degree of competition; operating leverage; sourcing of inputs; and
taxes.

11.2 The Importance of the Economic Environment

Dansk AS, a subsidiary of AS Canada, has the following cash flows projection:

Sales (2m units at DKK 20) DKK 40,000,000

Direct costs (2m units at DKK 12) DKK -24,000,000
Cash overhead expenses DKK -5,100,000
Depreciation DKK -900,000
Profit before taxes DKK 10,000,000
Taxes (50%) DKK -5,000,000
Profit after taxes DKK 5,000,000

Cash flow in DKK DKK 5,900,000

Cash flow in CAD (at CAD/DKK 0.2) CAD 1,180,000

Now suppose that there is an unexpected 25% devaluation to CAD/DKK 0.15 (or 33%
revaluation of DKK/CAD).

185
We will evaluate the effects of this devaluation in:

• Two polar cases: Perfectly closed or perfectly open.

• Various intermediate cases: The economy is neither perfectly closed nor perfectly
open.
o Half of the current output of Dansk AS is exported while the other half is sold
in Denmark.

11.2.1 Scenario 1: Perfectly Closed Economy

Internal costs and prices are unaffected by exchange rate changes. No exports or imports.
Then:

• DKK cash flows are clearly unaffected.

• DKK value of Dansk AS does not change: Exposure, in DKK, to DKK/CAD
exchange rate is zero.
• CAD value of cash flows decreases by 25%: Exposure, in DKK, to DKK/CAD
exchange rate is the current value of Dansk AS.

11.2.2 Scenario 2: Perfectly Open Economy

Denmark is assumed to be a small and open economy, and an international price taker. DKK
prices for all goods and factors increase by 33.33%. Then, except for contractual exposure
effects (including depreciation tax shields):

• DKK sales and costs increase by 33.33%; thus, all future DKK cash flows increase by
33.33%.
• The CAD value of the cash flows is unaffected.
• The CAD value of Dansk AS is essentially unaltered: Exposure is zero.

11.2.3 Scenario 3: Sticky Prices and Price Discrimination

Assume that:

• Dansk AS faces little competition either in Denmark or internationally.

• The Danish Government freezes prices: Costs are constant, home sales price remains
at DKK 20.
• Markets are segmented internationally, so that Dansk AS can maintain its export price
at CAD 4.

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 Before Devaluation After Devaluation
Initial Situation Scenario 3:
(in 1,000) Sticky Prices &
Price Discrimination
Sales
In Denmark 1m × 20 = 20,000 1m × 20 = 20,000
Exports 1m × 20 = 20,000 1m × 26.67 = 26,667
Total sales 40,000 46,667

Costs
Direct 2m × 12 = 24,000 2m × 12 = 24,000
Overhead 5,100 5,100
Depreciation 900 900
Total cost 30,000 30,000

Income
Before tax (Sales – Costs) 10,000 16,667
After tax (50%) 5,000 8,334

Cash Flow
Change in WC 0 -667
(10% of change in sales)
Net cash flow in DKK 5,900 8,567

Net cash flow in CAD 5,900 × 0.2 = 1,180 8,567 × 0.15 = 1,285

Change in CF (DKK) 8,567 – 5,900 = 2,667

Change in CF (CAD) 1,285 – 1,180 = 105

The (one-year) cash flow of Dansk AS rises dramatically both in terms of DKK as well as
CAD when compared to the initial situation. Dansk AS has a positive exposure to the
exchange rate in both CAD and DKK terms.

11.2.4 Scenario 4: Pass-through Pricing

Assume:

• Many producers inside Denmark, but little competition from producers located
outside Denmark.
• Price freeze in Denmark.
• Intense competition leads to a drop of 25% in FC export prices (CAD 3 or DKK 20),
and exports rise by 100%.
• Requires overtime, unit variable cost jumps to DKK 13.

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 Before Devaluation After Devaluation
Initial Situation Scenario 4:
(in 1,000) Pass-through
Pricing
Sales
In Denmark 1m × 20 = 20,000 1m × 20 = 20,000
Exports 1m × 20 = 20,000 2m × 20 = 40,000
Total sales 40,000 60,000

Costs
Direct 2m × 12 = 24,000 3m × 13 = 39,000
Overhead 5,100 5,100
Depreciation 900 900
Total cost 30,000 45,000

Income
Before tax (Sales – Costs) 10,000 15,000
After tax (50%) 5,000 7,500

Cash Flow
Change in WC 0 -2,000
(10% of change in sales)
Net cash flow in DKK 5,900 6,400

Net cash flow in CAD 5,900 × 0.2 = 1,180 6,400 × 0.15 = 960

Change in CF (DKK) 6,400 – 5,900 = 500

Change in CF (CAD) 960 – 1,180 = -220

There is an increase in the cash flows of Dansk AS, when measured in terms of DKK, but
less than in previous case. In terms of CAD, there is a decrease in the cash flows of Dansk
AS compared to the CAD cash flows in the initial situation.

11.2.5 Scenario 5: International Price-takership

Assume:

• Only foreign firms compete with Dansk AS in the Danish market.

• Foreign competitors continue to sell at the CAD prices of CAD 4 (DKK 26.67).
• Low demand elasticity.

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 Before Devaluation After Devaluation
Initial Situation Scenario 5:
(in 1,000) International
Price-takership
Sales
In Denmark 1m × 20 = 20,000 1m × 26.67 = 26,667
Exports 1m × 20 = 20,000 1m × 26.67 = 26,667
Total sales 40,000 53,334

Costs
Direct 2m × 12 = 24,000 2m × 12 = 24,000
Overhead 5,100 5,100
Depreciation 900 900
Total cost 30,000 30,000

Income
Before tax (Sales – Costs) 10,000 23,334
After tax (50%) 5,000 11,667

Cash Flow
Change in WC 0 -1,333
(10% of change in sales)
Net cash flow in DKK 5,900 11,234

Net cash flow in CAD 5,900 × 0.2 = 1,180 11,234 × 0.15 = 1,685

Change in CF (DKK) 11,234 – 5,900 = 5,334

Change in CF (CAD) 1,685 – 1,180 = 505

General conclusions:

1. The effect of the devaluation on the firm’s value depends on:

• The openness of the economy.

• The openness of the firm’s domestic market sector.
• The competitive position of the firm abroad and at home.
• The firm’s strategy.

2. Forecasting the effect of changes in the exchange rate on future cash flows requires
assumptions about competitors’ reactions, and other variables such as inflation.

3. From the Danish point of view, the devaluation is a boom; that is, the DKK value of
Dansk AS is positively related to the DKK value of the CAD under all three scenarios, or
in DKK, the economic exposure of Dansk AS is positive.

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4. Depending on the environment, the CAD value of Dansk AS may be either positively
related to the value of the DKK (as in Scenario 3 and 5), or negatively (as in Scenario 4).

11.3 Measuring and Hedging Operating Exposure

11.3.1 The Approach to Measuring and Hedging Linear Operating Exposure

Simulations:

• Pick a number of possible future values for the spot exchange rate ST  i  , and
compute the HC value of the cash flows for each possible future exchange rate value.

Run a cross-sectional (as opposed to time-series) regression:

VT  i   at ,T  bt ,T ST  i   eT  i 

• bt ,T has dimension (FC) and measures the exposure.

• at ,T  eT  i  has dimension (HC) and is the unexposed amount. at ,T is a cross-
sectional constant, eT  i  is uncorrelated with ST .

To hedge this exposure in the forward market, sell forward at the amount bt ,T .

VT ,hedged  i   Vt  i   bt ,T  ST  i   Ft ,T 
  at ,T  bt ,T ST  i   eT  i    bt ,T  ST  i   Ft ,T 
 at ,T  bt ,T Ft ,T  eT  i 

11.3.2 Exposure Measurement with Two Possible Future Exchange Rates

Example 11.2

In 1990, a Belgian company has a marketing affiliate located in the U.K. The U.K. has
experienced a sudden surge in inflation. There are two possible implications:

• Outcome #1: A strong deflationary policy and S remains at BEF/GBP 60. The value
of the marketing affiliate is GBP 1.55m.
• Outcome #2: The pound devalues to BEF/GBP 55. The value of the firm would be
GBP 1.8m.

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 93m  99m
bt ,T 
60  55
 GBP 1.2m

at ,T  BEF 93m  bt ,T 60
 BEF 93m   1.2  60 
 BEF 165

Value at time T
ST Unhedged Forward Contract Hedged Firm
BEF/GBP Firm 
 b ST  Ft ,T  = Unhedged + Forward
60

55

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11.3.3 Problem with Residual Risk

Consider a European firm that has set up a subsidiary in the U.S. Assume that the
subsidiary’s cash flow can take on either USD 150 (boom) or USD 100 (recession) with
equal probability. ST can either be EUR/USD 1.2 or 0.8. Recession is more likely when S is
high, as follows:

State of the Economy

Boom Recession Expected Cash Flow
Exchange Rate Cash flow USD 150 Cash flow USD 100 Conditional on ST
Prob. = 0.5 Prob. = 0.5
ST high:
Cash flow: EUR 180 Cash flow: EUR 120
EUR/USD 1.2 138
Joint Prob. = 0.15 Joint Prob. = 0.35
Prob. = 0.5

ST low:
Cash flow: EUR 120 Cash flow: EUR 80
EUR/USD 0.8 108
Joint Prob. = 0.35 Joint Prob. = 0.15
Prob. = 0.5

180  0.15  120  0.35

Et VT | ST  1.2  
0.5
 EUR 138
120  0.35  80  0.15
Et VT | ST  0.8  
0.5
 EUR 108

138  108
bt ,T 
1.2  0.8
 USD 75

Suppose the forward rate is EUR/USD 0.96.


The hedge will be the forward sales  b ST  Ft ,T : 
• When S is low: Forward profit is.
• When S is high: Forward profit is.

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The hedged cash flows of the subsidiary:

State of the Economy

Boom Recession Expected Cash Flow
Exchange Rate Cash flow USD 150 Cash flow USD 100 Conditional on ST
Prob. = 0.5 Prob. = 0.5
ST high:
Cash flow: EUR 162 Cash flow: EUR 102
EUR/USD 1.2 120
Joint Prob. = 0.15 Joint Prob. = 0.35
Prob. = 0.5

ST low:
Cash flow: EUR 132 Cash flow: EUR 92
EUR/USD 0.8 120
Joint Prob. = 0.35 Joint Prob. = 0.15
Prob. = 0.5

The effect of hedging:

• The conditional expectations of the hedged EUR cash flows no longer depend on the
spot rate.
• The value of the subsidiary still depends on “boom” or “recession”, but the remaining
uncertainty is uncorrelated with the exchange rate uncertainty and cannot be further
reduced by forex contracts.

11.4 Implications for Treasury Management

General points:

• Contractual exposure is very visible, and easy to measure. Still, for many firms
operating exposure is more important in the long run than contractual exposure.
• Operating exposure is very pervasive, and is not eliminated by hedging the
outstanding FC contracts.

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Caveats:

• Linear hedging is a double-edged sword. You lose on the forward hedge if the
exchange rate change improves the value of your operations. So you might consider
hedging with options rather than forwards.
• When using short-term forward contracts to hedge long-term exposure, there is the
possibility of liquidity problems: mismatch between the maturity of the underlying
position and the hedging instrument.
• The estimate of exposure that one obtains changes over time, and may not be very
precise at any given moment. Still estimating the exposure forces we to think about
the way exchange rates affect the firm’s operations.
• Hedging does not reduce the operating losses. We also need an operational response
– like revising the marketing mix, reallocating production, choosing sourcing policies
to reduce exposure.
• When making scenario projections about the possible future exchange rates, we
should therefore also make contingency plans for various possible future exchange
rates.

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12 Topic 12 – Accounting Exposure to Exchange Rate

Accounting exposure, also called translation exposure, results from the need to restate foreign
subsidiaries’ financial statement usually stated in foreign currency, into the parent’s reporting
currency when preparing the consolidated financial statements.

Restating financial statements may lead to changes in the parent’s net worth or net income.

12.1 Why Do We Care about Translation?

Consider the subsidiary of a U.S. firm, and assume that the subsidiary is located in France.
The accounts of the subsidiary will be maintained in terms of EUR. There are a number of
reasons why the financial statements of the subsidiary need to be translated into other
currencies – most often, the parent company’s home currency.

• Translation is often necessary for tax purposes.

• Legal requirement to consolidate financial statements.
• One needs to consolidate data in order to make investment and financial decisions,
and to evaluate the performance of the subsidiary.
• In order to make performance measures comparable, foreign data need to be
translated into a common currency.
• To value the entire firm as an outside investor or financial analyst, it is often based on
accounting values. Accounting value serves as a benchmark to evaluate a discounted
cash flow valuation.

12.2 Accounting Exposure

Accounting exposure arises because the outcome of translating a subsidiary’s balance sheet
from foreign currency to home currency depends on the exchange rate at the date of
consolidation, an exchange rate that is uncertain.

Firms may like to hedge this exposure to reduce or eliminate the swings in reported profits
that arise simply due to these translation effects. This exposure, of course, depends on the
rules used to translate the accounts of the subsidiary into the currency of the parent firm.

When converting financial statement items denominated in currencies other than the parent
currency, two choices of exchange rate are possible:

• The historical rate, the exchange rate prevailing at the time of the transaction.
• The current rate, the exchange rate prevailing at the balance sheet date or during the
income statement period.

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And the choice will create the following concerns:

• The exposure to exchange rate changes.

• The treatment of translation gains or losses.

In practice, accountants do not agree which assets should be translated at the historical
exchange rate and which at the current exchange rate. There is also some disagreement about
whether and when exchange rate gains or losses should be recognized in income.

In the following, we describe three different translation methods and the philosophy
underlying each method.

Consider the example of a Swedish subsidiary of a German firm. A simplified balance sheet
of the Swedish subsidiary is shown below.

SEK
Assets
Cash 1,000
A/R 1,000
Inventory 1,000
PPE 5,000
Total Assets 8,000

Debts
A/P 500
Short-term debt 2,000
Long-term debt 2,400
Total Debt 4,900

Retained earnings 0
Equity 3,100
Total 8,000

We shall explain the notion of accounting exposure by considering translation at two

different exchange rates, EUR/SEK 0.333 and EUR/SEK 0.300, and by seeing how the value
of the subsidiary changes depending on the accounting method being used.

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12.3 The Current Rate Method

According to this method,

• All assets and liabilities are translated at the rate in effect on the balance sheet date.
• All items on the income statement are translated at an appropriate average exchange
rate or at the rate prevailing when the various revenues, expenses, gains and losses
were incurred.
• Dividends paid are translated at the rate in effect on the payment date.
• Common stock, paid-in capital and retained earnings are translated at historical rates.

The logic:

• Maximal consistency with conventional accounting and maximum consistency of the

consolidated balance sheet with the parent’s and subsidiary’s accounts.
• Thus, the effect of S is:
o Assets  S  Debts  S  Net Worth  S

SEK EUR/SEK EUR/SEK

0.333 0.300
Assets
Cash 1,000 333 300
A/R 1,000 333 300
Inventory 1,000 333 300
PPE 5,000 1,665 1,500
Total Assets 8,000 2,664 2,400 Assets  264

Debts
A/P 500 166.5 150
Short-term debt 2,000 666.0 600
Long-term debt 2,400 799.2 720
Total Debt 4,900 1,631.7 1,470 Debts  161.7
Net  102.3
Retained earnings 0 0 0
Equity 3,100 1,007.5 1,007.5 Historic rate = 0.325
Equity adjustment - 24.8 -77.5 Net  102.3
Total 8,000 2,664.0 2,402.4

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Translate at each of the two possible current rates (at historic rate for Net Worth items), and
compute the adjustments as the residuals.

12.4 The Current / Non-Current Method

According to this method,

• Current assets and liabilities in the balance sheet are translated at the current
exchange rate, while non-current items, such as long-term debt, are translated at the
historical rate.
• Income statement items are translated at either the actual exchange rate on the date
when the item was incurred or a t a weighted average exchange rate for the period.

The logic:

•The value of short-term assets and liabilities is fixed in SEK terms and changes with
the exchange rate.
• Long-term assets and liabilities, in contrast, will not be realized in the short run – and
by the time they are realized, the current exchange rate change may very well turn out
to have been undone by later, opposite changes in the spot rate. That is, the effect of
a current exchange rate change on the realization value of long-term assets and
liabilities is very uncertain.
• As accountants hesitate to recognize gains or losses that are very uncertain, the
current / non-current method simply prefers to classify the long-term assets and
liabilities as unexposed.
• Thus, Exposure = Net Working Capital:
o Net Worth + LT Liabilities – LT Assets

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 SEK EUR/SEK EUR/SEK
0.333 0.300
Assets
Cash 1,000 333 300
A/R 1,000 333 300
Inventory 1,000 333 300
PPE 5,000 1,625 1,625 Historic rate = 0.325
Total Assets 8,000 2,624 2,525 Assets  99

Debts
A/P 500 166.5 150
Short-term debt 2,000 666.0 600
Long-term debt 2,400 780.0 780 Historic rate = 0.325
Total Debt 4,900 1,612.5 1,530 Debts  82.5
Net  16.5
Retained earnings 0 0 0
Equity 3,100 1,007.5 1,007.5 Historic rate = 0.325
Equity adjustment - 4.0 -12.5 Net  16.5
Total 8,000 2,624.0 2,525.0

Translate at each of the two possible current rates (at historic rate for Net Worth and LT
items), compute the adjustments as the residuals.

This method suffers from several limitations.

• Implicit view of mean-reverting. But S is shaky: S is close to random walk.

• The consolidated accounts are not compatible with the subsidiary’s accounts.
• The value of the long-term asset & liability seems to differ depending whether they
are held by an independent Swedish company or a foreign-owned entity.

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12.5 The Monetary / Non-Monetary Method

According to this method,

• It translates monetary items in the balance sheet using he current exchange rate, and
non-monetary items at historical rate.

The logic:

• PPP: the value of real assets is not affected by a de/revaluation, so these items are
translated at the historic rate.
• Thus, Exposure = Net Foreign Currency Monetary Position
o Financial Assets – Debt

SEK EUR/SEK EUR/SEK

0.333 0.300
Assets
Cash 1,000 333 300
A/R 1,000 333 300
Inventory 1,000 325 325 Historic rate = 0.325
PPE 5,000 1,625 1,625 Historic rate = 0.325
Total Assets 8,000 2,616 2,550 Assets  66

Debts
A/P 500 166.5 150
Short-term debt 2,000 666.0 600
Long-term debt 2,400 799.2 720
Total Debt 4,900 1,631.7 1,470 Debts  161.7
Net  95.7
Retained earnings 0 0 0
Equity 3,100 1,007.5 1,007.5 Historic rate = 0.325
Equity adjustment - -23.2 72.5 Net  95.7
Total 8,000 2,616.0 2,550.0

Translate at each of the two possible current rates (at historic rate for Net Worth and
Monetary items), compute the residuals.

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This method suffers from several limitations.

• Net Monetary Position is usually negative. So devaluation produces a “gain”.

o Devaluations improve the competitive position and should typically increase
the (economic) value of the firm.
• Inconsistency between the parent and the consolidated accounts: Parent claims that it
got the wrong value of the long-term real assets.
• Empirically, PPP does not hold.
• Even if PPP hold, it would not necessarily mean that the EUR value of an asset is
constant.

12.6 The (Ir)relevance of Translation Exposure

Economic exposure is far more relevant.

Economic Exposure Accounting Exposure

1. A forward looking concept: it focuses 1. A backward-looking concept: it reflects
on future cash flows. past decisions as reflected in the
subsidiary's assets and liabilities.
2. Involves real cash flows, not just 2. A change in an accounting value due to
accounting figures. translation is not a “realized” gain or
loss; no change in the cash situation is
involved – except possibly through
taxation effects.
3. Relates to changes in the economic 3. Changes the firm’s accounting value,
value (or, in an efficient market, the but not necessarily its market value.
market value) of the firm.
4. Contractual exposure depends on the 4. Depends on the accounting rules
firm’s portfolio of FC engagements chosen. This is because the
undertaken in the past. Operating subsidiary’s own internal rules affect its
exposure depends on the environment accounting values (e.g., type of
(especially the market structure and the depreciation, or inventory valuation
input-output mix) and on the firm's methods) and also because the
strategic response (e.g., relocation of translation process itself can be done in
production, changes in the marketing different ways (see below).
mix or financial structure, etc.).
5. Also exists for firms without foreign 5. Accounting exposure only exists in the
subsidiaries, such as exporting firms, case of foreign direct investment, since
import-competing firms, and notably pure exporting or import-substituting
potential import-competing firms. firms have no foreign subsidiaries.

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Relevance of accounting exposure:

1. Should we worry about translation exposure at all? If so, should we worry what the best
translation method is?

• Choice of valuation method is as (ir)relevant as choice between, say, LIFO/FIFO or

straight-line / accelerated depreciation:
o The choice doesn’t affect any real cash flow except for taxes.
o The only correct method is economic value anyway.
• Simplicity / consistency: Current rate method.

2. Should the exchange rate effect be shown as part of the reporting period’s P&L, or should
it just be mentioned on the balance sheet, as an unrealized gain or loss?

• Marking-to-market sounds great, but none of the three methods produces the true
economic value.
• Most of the gains are not realized.
• Keep gains / losses out of income statement.

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