SPECULATION, Aqsa Saeed

(Fa21- baf-004)

ARBITRAGE AND Shakeela Naz

(Fa21- baf-004)

HEDGING
Alishba Ahsan
(Fa21- baf-004)
SPECULATION
 Definition:

“Speculation refers to the practice of engaging in financial

transactions with the expectation of profiting from short-term
fluctuations in prices. It involves taking calculated risks based on
market analysis and forecasting.”
KEY CHARACTERISTICS:
 Risk and Reward: Speculators embrace risk with the anticipation of higher
returns, understanding that the outcome is uncertain.

 Short-Term Focus: Speculative activities typically target short-term market

movements rather than long-term investments.

 Market Analysis: Informed decisions rely on thorough analysis of market

trends, economic indicators, and other relevant factors.
SPECULATION CONTI…
Common Instruments:
Speculation can occur in various financial instruments, including stocks, bonds,
commodities, currencies, and derivatives.

Role in Markets:
Speculation adds liquidity to markets and can contribute to price discovery.
However, excessive speculation can lead to increased volatility.
INSTITUTIONAL
SPECULATION BASED ON
EXPECTED APPRECIATION
Financial institutions may invest in a currency perceived as undervalued in
the foreign exchange market.

By investing before anticipated appreciation, they aim to later liquidate the
investment at a higher price, capitalizing on the currency's value increase for
a profitable outcome.
CONTI…
EXAMPLE

 Chicago Co. expects the exchange rate of the New Zealand dollar (NZ$) to
appreciate from its present level of $.50 to $.52 in 30 days.
 Chicago Co. is able to borrow $20 million on a short-term basis from other banks.
 Present short-term interest rates (annualized) in the interbank market are as follows:
CURRENCY LENDING RATE BORROWING RATE
U.S. dollars 6.72% 7.20%
New Zealand dollars (NZ$) 6.48% 6.96%
CONTI…
1. Borrow $20 million.

2. Convert the $20 million to NZ$40 million($20,000,000/$.50).

3. Invest the New Zealand dollars at 6.48% annualized, which represents a .54% return over the
30-day period [6.48% × (30/360)]. After 30 days, Chicago Co. will receive NZ$40,216,000
[NZ$40,000,000 × (1 + .0054)].

4. Use the proceeds from the New Zealand dollar investment (on day 30) to repay the U.S.
dollars borrowed. The annual interest on the U.S. dollars borrowed is 7.2%, or .6% over the 30-
day period [7.2% × (30/360)]. The total U.S. dollar amount necessary to repay the U.S. dollar
loan is therefore $20,120,000 [$20,000,000 × (1 + .006)].
CONTI…
 Assuming that the exchange rate on day 30 is $.52 per New Zealand dollar as
anticipated, the number of New Zealand dollars necessary to repay the U.S.
dollar loan is NZ$38,692,308 ($20,120,000/$.52 per New Zealand dollar).
 Given that Chicago Co. accumulated NZ$40,216,000 from lending New
Zealand dollars, it would earn a speculative profit of NZ$1,523,692
(NZ$40,216,000- NZ$38,692,308)
 It would earn this speculative profit without using any funds from deposit
accounts because the funds would have been borrowed through the interbank
market.
INSTITUTIONAL
SPECULATION BASED ON
EXPECTED DEPRICIATION
Financial institutions may take advantage of an overvalued currency in the
foreign exchange market by borrowing funds in that currency, converting it to
their local currency before its value declines, and then repaying the loan after
the currency depreciates.

This strategy aims to allow them to buy the currency back at a lower price
than the initial conversion rate.
CONTI…
EXAMPLE

Assume that Carbondale Co. expects an exchange rate of $.48 for the New
Zealand dollar on day 30. It can borrow New Zealand dollars, convert them to
U.S. dollars, and lend the U.S. dollars out. On day 30, it will close out these
positions. Using the rates quoted in the previous example, and assuming the
bank can borrow NZ$40 million, Carbondale takes the following steps:
CONTI…
1. Borrow NZ$40 million.

2. Convert the NZ$40 million to $20 million (NZ$40,000,000 × $.50).

3. Lend the U.S. dollars at 6.72%, which represents a .56% return over the 30-day period.
After 30 days, it will receive $20,112,000 [$20,000,000 × (1 +.0056)].

4. Use the proceeds of the U.S. dollar loan repayment (on day 30) to repay the New Zealand
dollars borrowed. The annual interest on the New Zealand dollars borrowed is 6.96%, or
0.58% over the 30-day period [6.96% × (30/360)]. The total New Zealand dollar amount
necessary to repay the loan is therefore NZ$40,232,000 [NZ$40,000,000 × (1 + .0058)].
CONTI…

Assuming that the exchange rate on day 30 is $.48 per New Zealand dollar as
anticipated, the number of U.S. dollars necessary to repay the NZ$ loan is
$19,311,360 (NZ $40,232,000 × $.48 per New Zealand dollar).

Given that Carbondale accumulated $20,112,000 from its U.S. dollar loan, it would
earn a speculative profit of $800,640 without using any of its own money
($20,112,000 - $19,311,360).
ARBITRAGE
Definition:

“Arbitrage is a financial strategy that exploits price differences of

the same asset in different markets or exchanges. Traders engage
in arbitrage to take advantage of the temporary mispricing of
assets, aiming to generate risk-free profits.”
ARBITRAGE CONTI…
Key Components:

Price Discrepancies: Identify variations in the price of an asset across different markets.

Simultaneous Transactions: Execute buy and sell orders of the same asset in different
markets simultaneously.

Risk-Free Profit: Capitalize on market inefficiencies to secure a profit without exposing

oneself to market risks.
TYPES OF ARBITRAGE
There are 3 types of arbitrage:

1. Locational arbitrage
2. Triangular arbitrage
3. Covered interest arbitrage
LOCATIONAL ARBITRAGE
Definition:

“Locational arbitrage involves exploiting price differences for the

same currency in different locations by buying at a lower rate and
selling at a higher rate to make a profit.”
LOCATIONAL ARBITRAGE
Gains from Locational Arbitrage:

Gain from locational arbitrage is based on the amount of money

that you use to capitalize on the exchange rate discrepancy, along
with the size of the discrepancy.
TRIANGULAR ARBITRAGE
Definition:

“Triangular arbitrage is a currency trading strategy where a trader

exploits inconsistencies in exchange rates between three
currencies, executing a series of transactions to secure a risk-free
profit.”
TRIANGULAR ARBITRAGE

Gains from Triangular Arbitrage:

1. Triangular arbitrage allows traders to exploit inefficiencies in
exchange rates between three currencies, leading to the potential for
quick and risk-free profits.

2. By capitalizing on the discrepancies in currency cross rates, traders

can execute a series of transactions to end up with more of the initial
currency than they started with, creating a gain through the arbitrage
process.
COVERED INTEREST
ARBITRAGE
Definition:

“Covered interest arbitrage involves using forward contracts to

capitalize on interest rate differentials between two currencies,
ensuring a risk-free profit by simultaneously borrowing and
investing in the currencies.”
TRIANGULAR ARBITRAGE

Gains from Triangular Arbitrage:

1. Covered interest arbitrage allows investors to take advantage of interest
rate differentials between two currencies by borrowing in a low-interest-
rate currency and investing in a higher-interest-rate currency.

2. The gain in covered interest arbitrage is achieved through the use of

forward contracts, ensuring a risk-free profit as the future exchange rate is
predetermined, allowing investors to capitalize on the interest rate spread.
HEDGING
“Hedging is a risk management strategy employed by individuals
and institutions to mitigate or offset potential losses in the
financial markets.”

The primary objective of hedging is to minimize the impact of

adverse price movements in assets, currencies, or commodities.
HEDGING EXAMPLE
Common Examples:
1. Currency Hedging: Protecting against exchange rate fluctuations.

2. Commodity Hedging: Managing price volatility in raw materials.

3. Interest Rate Hedging: Guarding against fluctuations in interest

rates.
HEDGING EXPOSURE TO
PAYABLES
An MNC decide to hedge part or all of its known payables transactions so that it is insulated
from possible appreciation of the currency. It selects from the following hedging techniques
to hedge its payables:

 Futures hedge/Forward hedge

 Money market hedge
Currency option hedge

 Before selecting a hedging technique, MNCs normally compare the cash flows that would
be expected when using each technique. The selection of the optimal hedging technique can
vary over time, as the relative advantages of the various techniques may change over time.
FUTURES HEDGE
 Definition:
“Forward or futures hedge on payables involves using a financial
derivative contract (such as a forward or futures contract) to lock in
a future exchange rate, protecting a company from unfavorable
currency movements when paying for future international
purchases. This strategy helps mitigate the risk of increased costs
due to adverse exchange rate fluctuations.”
FUTURES HEDGE EXAMPLE
 Example:
Coleman Co. is a U.S.–based MNC that will need 100,000 euros in 1 year. It
could obtain a forward contract to purchase the euros in 1 year. The 1-year
forward rate is $1.20, the same rate as currency futures contracts on euros. If
Coleman purchases euros 1 year forward, its dollar cost in 1 year is:
Cost in $ = Payables /Forward rate
=100;000 euros $1.20
=$120;00
MONEY MARKET HEDGE
 Definition:
“A money market hedge on payables involves using short-term
financial instruments, such as currency forward contracts, to
protect against exchange rate fluctuations when a company owes
payments in a foreign currency, ensuring a more predictable cost
for the payable.”
MONEY HEDGE
 Example:
If Coleman Co. needs 100,000 euros in 1 year, it could convert dollars to
euros and deposit the euros in a bank today. Assuming that it could earn 5
percent on this deposit, it would need to establish a deposit of 95,238 euros in
order to have 100,000 euros in 1 year, as shown below:
Deposit amount to hedge payables: 100,000 euros/ (1+ 0.05) =95,238 euros
 Assuming a spot rate today of $1.18, the dollars needed to make the deposit
today are estimated below:
Deposit amount in dollars: 95,238 euros * $1.18 =$112,381
MONEY HEDGE
 Example:

Assuming that Coleman can borrow dollars at an interest rate of

8 percent, it would borrow the funds needed to make the deposit,
and at the end of the year it would repay the loan:
Dollar amount of loan repayment: $112,381 /(1+0.08) =$121,371
CURRENCY OPTION HEDGE
 Definition:

“A Currency Option Hedge on Payables involves using financial derivatives

known as currency options to protect against unfavorable exchange rate
movements when making future payments in a foreign currency, providing the
option but not the obligation to buy or sell the currency at a predetermined
rate. This strategy helps manage currency risk associated with payables and
provides flexibility in mitigating potential losses.”
CURRENCY OPTION HEDGE
 Example:
A U.S. company is expecting to pay €100,000 in 3 months for goods
imported from Europe.

The current exchange rate is $1.10/€.

The company is concerned about potential currency appreciation, which

would increase the cost in U.S. dollars.
CURRENCY OPTION HEDGE
 Currency option hedge:
The company decides to purchase a call option on euros with a
strike price of $1.12/€. The premium paid for the option is $1,000.

If the euro appreciates beyond $1.12/€ in 3 months, the company

can exercise the option and buy euros at the agreed-upon lower
rate.
CURRENCY OPTION HEDGE
 Example Outcome:
If the exchange rate in 3 months is $1.15/€, the company exercises the
option, buying €100,000 at the agreed-upon rate of $1.12/€.
Without the option, at the spot rate of $1.15/€, the payment would have cost
$115,000.
The total cost with the premium and the exercised option is $113,000
($100,000 + $1,000 option premium + $12,000 due to exercising the option).
(This example demonstrates how the currency option hedge protects the
company from adverse exchange rate movements and provides a known
maximum cost for the payable)
Thankyou