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Uses of Foreign Exchange Markets
2. Hedging • Hedging refers to trying to reduce the risk from exchange rate fluctuations. You are fully hedged when you have neither a net asset nor a net liability position in an asset.
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• US firm sells Japanese radios at $100 each • Firm will take delivery of radios in 30 days at an agreed price of ¥9000 each • Spot rate e=0.0105 → ¥9000 = $94.50 • Exchange rate risk (30 days ):
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Interest Rate Parity Defined
Since both of these investments have the same risk, they must have the same future value—otherwise an arbitrage would exist. (F/S)(1 + iUK) = (1 + ius)
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Exposure to Exchange Rate Risk
You are exposed to exchange rate risk if the value of your income or wealth or net worth will change if exchange rates in the future change in ways that are not expected.
e=0.010→¥9000 = $90.00
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Uses of Foreign Exchange Markets
1. Clearing • Foreign exchange markets allow people to end up holding the national currency they need to purchase goods and services. • foreigners demand dollars to buy U.S. goods and services buy U.S. assets • Americans sell dollars to buy foreign goods and services buy foreign assets
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How can you hedge your Japanese Yen position?
1. Currency forward contract You can hedge your Yen risk by entering into a forward contract in 1 month at an exchange rate agreed to today.
Time line
Now One year later
@10%
$ Investment
$1
$1.10
?
SF investment 1 3
Which Better?
Currency line
SF2.00
@20%
2
SF2.40
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• US firm sells Japanese radios at $100 each • Firm will take delivery of radios in 30 days at an agreed price of ¥9000 each • Spot rate e=0.0105 → ¥9000 = $94.50 • Exchange rate risk (30 days ):
CHAPTER FOUR
Forward Exchange and International Financial Investment
Chapter Objective:
This chapter examines a key international parity relationship, interin
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Interest Rate Parity
• Interest rate parity tell us how the forward exchange rate establishes.
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Example: International Financial
Investment
Suppose we have the following information:
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• •
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Interest Rate Parity Defined
Suppose you have $100,000 to invest for one year. You can either 1. invest in the U.S. at i$. Future value = $100,000(1 + ius) 2. trade your dollars for pound at the spot rate, invest in Britain at iUK and hedge your exchange rate risk by selling the future value of the British investment forward. The future value = $100,000(F/S)(1 + iUK)
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Comparing $ and SF investments
• If you invest in SF, you have to do three transactions today: 1.Convert $1 into SF at SSF/$ (foreign exchange market transaction) 2.Invest in SF at iSF (money market transaction) 3.Sign forward contract (for one year) to sell Principle and interest in SF forward at FSF/$ (Foreign exchange market transaction) – Please note: this is a covered investment! – Finally $1.00008
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Chapter Outline
• • • • Exposure to Exchange Rate Risk Uses of Foreign Exchange Markets Covered Interest Rate Parity Uncovered Interest Rate Parity
e=0.010→¥9000 = $90.00 • Forward rate (30 days)F=0.0103→¥9000 = $92.70
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