International financial management exam II (madura 12th edition, chapters 5, 7, 8) – Flashcards
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What is a currency derivative?
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a contract whose price is derived from the value of an underlying currency. Examples: forward/futures contracts and options contracts.
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Currency derivatives are used by MNCs to?
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1) speculate on future exchange rate movements 2) hedge exposure to exchange rate risk
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What is a forward contract?
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It is an agreement between a corporation and a financial institution: 1) to exchange a specified amount of currency, 2) at a specified exchange rate (*forward rate*), 3) on a specific date in the future
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How do MNCs use forward contracts?
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*hedge* their imports by locking in the rate at which they can obtain the currency
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the *Bid/Ask Spread* is wider for...
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less liquid currencies
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When can an *offsetting trade* occur?
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Bank may negotiate an offsetting trade if an MNC enters into a forward sale and a forward purchase with the same bank.
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Non-deliverable forward contracts (NDFs) can be used for
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emerging market currencies where no currency delivery takes place at settlement, instead one party makes a payment to the other party.
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*Arbitrage* can occur when
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the forward rate is the same as the spot rate.
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Premium or Discount on the forward rate equation is?
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F = S(1 + p) p is the forward premium, or the percentage by which the forward rate exceeds the spot rate
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Movements in the Forward Rate over time -
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The forward premium is influenced by the interest rate differential between the two countries and can change over time.
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Offsetting a Forward Contract -
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An MNC can offset a forward contract by negotiating with the original counterparty bank.
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How is the Currency Futures Market similar to the Forward Contracts market?
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similar to forward contracts in terms of obligation to purchase or sell a currency on a specific settlement date in the future.
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What are the differences in the *contract specifications* of futures contracts compared to forward contracts?
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In a futures contract, there are a 1) standardized number of units per contract, 2) offer greater liquidity than forward contracts, 3) typically based on the US dollar, but may be offered on cross-rates, 4) commonly traded on the Chicago Mercantile Exchange (CME).
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Currency Futures Contracts and Forward Contracts are similar how?
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They allow a customer to lock in the exchange rate at which a specific currency is purchased or sold for a specific date in the future.
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Purchasing Futures to Hedge Payables:
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The purchase of futures contracts locks in the price at which a firm can purchase a currency
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Selling futures to hedge receivables:
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The sale of futures contracts locks in the price at which a firm can sell a currency
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Closing out a futures position:
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1) Sellers (buyers) of currency features can close out their positions by buying (selling) identical futures contracts prior to settlement. 2) Most currency futures contracts are closed out before the settlement date
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Speculation with currency futures
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1) currency futures contracts are sometimes *purchased* by speculators attempting to capitalize on their expectation of a currency's future movement 2) *often sold* by speculators who expect that the spot rate of a currency will be less than the rate at which they would be obligated to sell it.
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What does it mean if the futures market is *efficient*?
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the futures price should reflect all available information.
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what is the over-the-counter market?
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Where currency options are offered by commercial banks and brokerage firms. Unlike the currency options traded on an exchange, the over-the-counter market offers currency options that are tailored to the specific needs of the firm.
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What is a currency call option?
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grants the *right to buy* a specific currency at a designated *strike price* or *exercise price* within a specific period of time.
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When does the buyer of a call option pay a *premium*?
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When the spot rate rises above the strike price.
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Currency call options: in the money means...
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the spot exchange rate is greater than the strike price
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currency call options: *out of the money* means...
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the spot rate is lower than the strike price
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How do firms use currency call options?
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1) to hedge payables 2) to hedge project bidding to lock in the dollar cost of potential expenses 3) to hedge target bidding of a possible acquisition.
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What do MNCs usually use for hedging?
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currency futures derivatives, not speculation.
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What is a currency put option?
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grants the right to sell a currency at a specified strike price or exercise price within a specified period of time.
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currency put options: when are you *in the money*?
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when the spot exchange rate is lower than the strike price.
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currency put options: when are you *out of the money*?
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When the spot exchange rate is higher than the strike price.
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What does it mean to *straddle* when speculating with put and call options?
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means you use both a put option and a call option at the same exercise price. Good when speculators expect strong movement in one direction or another.
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What different ways do MNCs hedge receivables?
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1) MNCs buy *currency put options* to hedge receivables in a currency that is expected to *depreciate*. 2) MNCs sell futures contracts
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What different ways do MNCs hedge payables?
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1)MNCs buy *currency call options* that have payables in a currency that is expected to *appreciate*. 2) MNCs buy futures contracts
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Definition of *Arbitrage*?
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can be loosely defined as capitalizing on a discrepancy in quoted prices by making a risk-less profit.
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Definition of *Locational Arbitrage*?
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the process of buying a currency at the location where it is priced cheap and immediately selling it at another location where it is priced higher.
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Definition of *Triangular Arbitrage*?
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currency transactions in the spot market to capitalize on discrepancies in the *cross exchange rates* between two currencies (trade a for b, b for c, then trade c for a.)
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Definition of *Covered Interest Arbitrage*?
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the process of capitalizing on the interest rate differential between two countries while covering your exchange rate risk with a forward contract (two parts). Simply: capitalize on discrepancies between the forward rate and the interest rate differential.
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What is the realignment process due to locational arbitrage?
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it drives prices to adjust in different locations so as to eliminate discrepancies; *quoted exchange rates are similar*.
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What is the realignment process due to triangular arbitrage?
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forces exchange rates back into equilibrium; *cross exchange rates are property set*.
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What is the realignment process due to covered interest arbitrage?
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causes market realignment. *Timing of alignment* may require several transactions before realignment is completed. As many investors capitalize on this method, there is a downward pressure on the forward rate. Arbitrage is no longer feasible when the forward rate has a discount from the spot rate that is about equal to the interest rate advantage. *forward exchange rates are properly set*
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What is *Interest Rate Parity (IRP)*?
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Term used to describe when market forces cause interest rates and exchange rates to adjust such that covered interest arbitrage is no longer feasible (equilibrium state, *forward premium (or discount) should be equal to interest rate differential*)
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What if the forward premium is equal to the interest rate differential?
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the covered interest arbitrage will not be feasible.
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Analyze a graphic analysis of IRP: 1) what does it mean to be below the IRP line? 2) on the line (sector 1 vs. sector 3)? 3) above the IRP line?
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1) should consider covered interest arbitrage. 2) points in sector 1 represent a premium; sector 3 represents a discount in the interest rates. On the line = IRP achieved. 3) investors would achieve a higher return on a domestic investment compared to a foreign investment.
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What are some considerations when assessing Interest Rate Parity?
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Transaction costs, Political risk, and differential tax laws.
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Points representing a *premium* and points representing a *discount* on an IRP graph: what does each term mean?
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premium = foreign interest rate is *lower* than the home interest rate. discount = foreign interest rate is *higher* than the home interest rate.
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What is the *Absolute form of PPP*?
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without international barriers, consumers shift their demand to wherever prices are lower. *Price of the same basket of products in two different countries should be equal* when measured in common currency.
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What is the *Relative form of PPP*?
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Due to market imperfections, prices of the same basket of products will not necessarily be the same, but the *rate of change in prices should be similar* when measured in common currency.
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If purchasing power is not equal,...
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consumers will shift purchases to wherever the products are cheaper until the purchasing power is equal. *Exchange rate adjustment is necessary* for relative purchasing power to be the same.
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What can the relative form of PPP be used to estimate?
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It can estimate how an exchange rate will change in response to differential inflation rates between countries. Percentage change in exchange rate should be approximately equal to the difference in inflation rates between the two countries (according to simplified PPP relationship)
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If a point is below the PPP line, it means?
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points below the PPP line represent greater purchasing power for home country goods than for foreign goods (deprecation has not yet reached in difference in interest rates)
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Results of statistical tests of PPP: the longer the time period used,
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the less pronounced deviations from PPP seem.
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When testing the PPP theory, the base period chosen...
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should reflect an equilibrium position since subsequent periods are evaluated in comparison to it. If not, test could show higher appreciation than what actually occurred.
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Why does PPP theory not hold?
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Because PPP theory presumes that exchange rate movements are driven completely by the inflation differential between two countries. Other factors that affect exchange rate include differentials in: interest rates, income levels, governmental controls, and expectations of future exchange rates. ALSO, there may not be substitutes for traded goods.
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Describe the Fisher effect.
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Suggests that the nominal interest rate contains two components: expected inflation rate and real interest rate. *real interest rate* represents the return on an investment after accounting for expected inflation.
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The International Fisher Effect theory suggests:
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currencies with high interest rates will have high expected inflation (fisher effect), and the relatively high inflation will cause the currencies to depreciate.
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Points below the IFE line reflect...
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higher returns from investing in foreign deposits.
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Points above the IFE line reflect...
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returns from foreign deposits that are lower than the returns that are possible domestically.
