IMF Lecturer 3 Linton and Shaw

Objectives
• To explain how exchange rate movements

are measured;
• To explain how the equilibrium exchange
rate is determined; and
• To examine the factors that affect the
equilibrium exchange rate.
Measuring
Exchange Rate Movements
• An exchange rate measures the value of one
currency in units of another currency.
• When a currency declines in value, it is said to
depreciate. When it increases in value, it is
said to appreciate.
• On the days when some currencies appreciate
while others depreciate against the dollar, the
dollar is said to be “mixed in trading.”
Measuring
Exchange Rate Movements
• The percentage change (%  in the value of
a foreign currency is computed as
St – St-1
St-1
where St denotes the spot rate at time t.
• A positive %  represents appreciation of
the foreign currency, while a negative % 
represents depreciation.
Exchange Rate Equilibrium
• An exchange rate represents the price of a
currency, which is determined by the
demand for that currency relative to the
supply for that currency.
Value of £
S: Supply of £
$1.60
$1.55 equilibrium
exchange rate
$1.50
D: Demand for £
Quantity of £
Factors that Influence
Exchange Rates
Relative Inflation Rates
$/£
U.S. inflation 
S1   U.S. demand for
S0
r1 British goods, and
r0 hence £.
D1   British desire for U.S.
D0
goods, and hence the
Quantity of £ supply of £.
Exchange Rates
Relative Interest Rates
$/£
U.S. interest rates 
S0   U.S. demand for
S1
r0 British bank deposits,
r1 and hence £.
D0   British desire for U.S.
D1
bank deposits, and
Quantity of £ hence the supply of £.
Exchange Rates
Relative Income Levels
$/£
U.S. income level 
  U.S. demand for
S0 ,S1
British goods, and
r1
r0 hence £.
D1  No expected change for
D0
the supply of £.
Quantity of £
Objectives
• To explain how forward contracts

are used for hedging based on
anticipated exchange rate movements; and
• To explain how currency futures contracts
and currency options contracts are used for
hedging or speculation based on
anticipated exchange rate movements.
Forward Market
• The forward market facilitates the trading of
forward contracts on currencies.
• A forward contract is an agreement between a
corporation and a commercial bank to
exchange a specified amount of a currency at
a specified exchange rate (called the forward
rate) on a specified date in the future.
Forward Market
• When MNCs anticipate future need or future
receipt of a foreign currency, they can set up
forward contracts to lock in the exchange
rate.
• Forward contracts are often valued at $1
million or more, and are not normally used by
consumers or small firms.
Forward Market
• As with the case of spot rates, there is a
bid/ask spread on forward rates.
• Forward rates may also contain a premium or
discount.
– If the forward rate exceeds the existing spot rate,
it contains a premium.
– If the forward rate is less than the existing spot
rate, it contains a discount.
Forward Market
• annualized forward premium/discount
=
forward rate – spot rate 
360
spot rate n
where n is the number of days to maturity
• Example: Suppose £ spot rate = $1.681,
90-day £ forward rate = $1.677.
$1.677 – $1.681 x
360 = – 0.95%
$1.681 90
So, forward discount = 0.95%
Currency Futures Market
• Currency futures contracts specify a standard
volume of a particular currency to be
exchanged on a specific settlement date,
typically the third Wednesdays in March, June,
September, and December.
• They are used by MNCs to hedge their currency
positions, and by speculators who hope to
capitalize on their expectations of exchange
rate movements.
• The contracts can be traded by firms or
individuals through brokers on the trading
floor of an exchange (e.g. Chicago Mercantile
Exchange), on automated trading systems
(e.g. GLOBEX), or over-the-counter.
• Participants in the currency futures market
need to establish and maintain a margin when
they take a position.
Forward Markets Futures Markets
Contract size Customized. Standardized.
Delivery date Customized. Standardized.
Participants Banks, brokers, Banks, brokers,
MNCs. Public MNCs. Qualified
speculation not public speculation
encouraged. encouraged.
Security Compensating Small security
deposit bank balances or deposit required.
credit lines needed.
Forward Markets Futures Markets
Clearing Handled by Handled by
operation individual banks exchange
& brokers. clearinghouse.
Daily settlements
to market prices.
Marketplace Worldwide Central exchange
telephone floor with global
network. communications.
• Speculators often sell currency futures when
they expect the underlying currency to
depreciate, and vice versa.
April 4 June 17
1. Contract to sell 2. Buy 500,000 pesos
500,000 pesos @ $.08/peso
@ $.09/peso ($40,000) from the
($45,000) on spot market.
June 17. 3. Sell the pesos to
fulfill contract.
Gain $5,000.
• Currency futures may be purchased by MNCs
to hedge foreign currency payables, or sold to
hedge receivables.
April 4 June 17
1. Expect to receive 2. Receive 500,000
500,000 pesos. pesos as expected.
Contract to sell
500,000 pesos 3. Sell the pesos at
@ $.09/peso on the locked-in rate.
June 17.
• Currency futures contracts have no credit risk
since they are guaranteed by the exchange
clearinghouse.
• To minimize its risk in such a guarantee, the
exchange imposes margin requirements to
cover fluctuations in the value of the
contracts.
Currency Options Market
• A currency option is another type of contract
that can be purchased or sold by speculators
and firms.
• The standard options that are traded on an
exchange through brokers are guaranteed,
but require margin maintenance.
• U.S. option exchanges (e.g. Chicago Board
Options Exchange) are regulated by the
Securities and Exchange Commission.
Currency Call Options
• A currency call option grants the holder the
right to buy a specific currency at a specific
price (called the exercise or strike price) within
a specific period of time.
• A call option is
– in the money if spot rate > strike price,
– at the money if spot rate = strike price,
– out of the money
if spot rate < strike price.
• Option owners can sell or exercise their
options. They can also choose to let their
options expire. At most, they will lose the
premiums they paid for their options.
• Call option premiums will be higher when:
– (spot price – strike price) is larger;
– the time to expiration date is longer; and
– the variability of the currency is greater.
• Firms with open positions in foreign
currencies may use currency call options to
cover those positions.
• They may purchase currency call options
– to hedge future payables;
– to hedge potential expenses when bidding on
projects; and
– to hedge potential costs when attempting to
acquire other firms.
Currency Put Options
• A currency put option grants the holder the
right to sell a specific currency at a specific
price (the strike price) within a specific period
of time.
• A put option is
– in the money if spot rate < strike price,
– at the money if spot rate = strike price,
– out of the money
if spot rate > strike price.
• Put option premiums will be higher when:
– (strike price – spot rate) is larger;
– the time to expiration date is longer; and
– the variability of the currency is greater.
• Corporations with open foreign currency
positions may use currency put options to
cover their positions.
– For example, firms may purchase put options to
hedge future receivables.
• Speculators who expect a foreign currency to
depreciate can purchase put options on that
currency.
– Profit = selling (strike) price – buying price
– option premium
• They may also sell (write) put options on a
currency that they expect to appreciate.
– Profit = option premium + selling price
– buying (strike) price
Contingency Graphs for Currency Options
For Buyer of £ Call Option For Seller of £ Call Option
Strike price = $1.50 Strike price = $1.50
Premium = $ .02 Premium = $ .02
Net Profit Net Profit
per Unit per Unit
+$.04 +$.04
Future
+$.02 +$.02 Spot
Rate
0 0
$1.46 $1.50 $1.54 $1.46 $1.50 $1.54
- $.02 Future - $.02
Spot
- $.04 Rate - $.04
Contingency Graphs for Currency Options
For Buyer of £ Put Option For Seller of £ Put Option
Strike price = $1.50 Strike price = $1.50
Premium = $ .03 Premium = $ .03
Net Profit Net Profit
per Unit per Unit
+$.04 +$.04
Future
+$.02 Spot +$.02
Rate
0 0
$1.46 $1.50 $1.54 $1.46 $1.50 $1.54
- $.02 - $.02 Future
Spot
- $.04 - $.04 Rate
Efficiency of
Currency Futures and Options
• If foreign exchange markets are efficient,
speculation in the currency futures and
options markets should not consistently
generate abnormally large profits.
• A speculative strategy requires the speculator
to incur risk. On the other hand, corporations
use the futures and options markets to reduce
their exposure to fluctuating exchange rates.
Call Option holder
Call Option Writer/Broker
Copyright © 2009 Pearson

Prentice Hall. All rights 2-31
reserved.
Put Option Holder

reserved.
Put option Writer/Broker

reserved.
Using Currency Call Options for Hedging Payables
British Pound Call Option:

Exercise Price = $1.60, Premium = $.04.
For each £ :
Nominal Cost Nominal Cost
Scenario without Hedging with Hedging
= Spot Rate = Min(Spot,$1.60)+
$.04
1 $1.58 $1.62
2 $1.62 $1.64
3 $1.66 $1.64
Using Put Options for Hedging Receivables
New Zealand Dollar Put Option:

Exercise Price = $0.50, Premium = $.03.
For each NZ$ :

Nominal Income Nominal Income
Scenario without Hedging with Hedging
= Spot Rate = Max(Spot,$0.50)- $.03
1 $0.44 $0.47
2 $0.46 $0.47
3 $0.51 $0.48

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IMF Lecturer 3 Linton and Shaw

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Objectives

• To explain how exchange rate movements

• To explain how forward contracts

Copyright © 2009 Pearson

Copyright © 2009 Pearson

Copyright © 2009 Pearson

British Pound Call Option:

New Zealand Dollar Put Option:

For each NZ$ :

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