Management of Forex
Transactions
Assignment ‘A’
Ques 1: What do you
mean by the term “foreign exchange”?
The term 'foreign
exchange' is used in its narrow as well as broad senses.
In the narrow
sense, foreign exchange simply means the money of a foreign country. Thus,
American dollars are foreign exchange to an Indian and Indian rupees arc foreign
exchange to an American. In practice, foreign exchange is often used to refer
to a country's actual stock of foreign currency, i.e., foreign currency notes
or the means of obtaining such money through travelers cheques or letters of
credit.
In the broader sense, the foreign exchange is
related to the mechanism of foreign payments. It refers to the system whereby
one currency is exchanged for or converted into another. It means a market, where one country’s currency is exchanged for that
of another country through an exchange-rate system.
Foreign exchange
market is a market where foreign currencies are bought and sold by the traders'
to meet their obligations abroad.
According to
Encyclopedia Britannica. "Foreign exchange is the system by which commercial
nations discharge their debts to each other." In the words of Hartly
Wethers, "Foreign exchange is the art and science of international
monetary exchange."
How can
we determine foreign exchange rate?
Numerous factors determine exchange rates,
and all are related to the trading relationship between two countries.
Remember, exchange rates are relative, and are expressed as a comparison of the
currencies of two countries. The following are some of the principal
determinants of the exchange rate between two countries. Note that these
factors are in no particular order; like many aspects of economics, the
relative importance of these factors is subject to much debate.
1. Inflation
As a general rule, a country with a consistently lower inflation rate exhibits
a rising currency value, as its purchasing power increases relative to other
currencies. During the last half of the twentieth century, the countries with
low inflation included Japan, Germany and Switzerland, while the U.S. and
Canada achieved low inflation only later. Those countries with higher inflation
typically see depreciation in their currency in relation to the currencies of
their trading partners. This is also usually accompanied by higher interest
rates.
2. Interest Rates
Interest rates, inflation and exchange rates are all highly correlated. By
manipulating interest rates, central banks exert influence over both inflation
and exchange rates, and changing interest rates impact inflation and currency
values. Higher interest rates offer lenders in an economy a higher return
relative to other countries. Therefore, higher interest rates attract foreign
capital and cause the exchange rate to rise. The impact of higher interest
rates is mitigated, however, if inflation in the country is much higher than in
others, or if additional factors serve to drive the currency down. The opposite
relationship exists for decreasing interest rates - that is, lower interest
rates tend to decrease exchange rates.
3. Current-Account
The current account is the balance of trade between a country and its trading
partners, reflecting all payments between countries for goods, services,
interest and dividends. A deficit in the current account shows the country is
spending more on foreign trade than it is earning, and that it is borrowing
capital from foreign sources to make up the deficit. In other words, the
country requires more foreign currency than it receives through sales of
exports, and it supplies more of its own currency than foreigners demand for
its products. The excess demand for foreign currency lowers the country's
exchange rate until domestic goods and services are cheap enough for
foreigners, and foreign assets are too expensive to generate sales for domestic
interests.
4. Public Debt
Countries will engage in large-scale deficit financing to pay for public sector
projects and governmental funding. While such activity stimulates the domestic
economy, nations with large public deficits and debts are less attractive to
foreign investors. The reason? A large debt encourages inflation, and if
inflation is high, the debt will be serviced and ultimately paid off with
cheaper real dollars in the future.
In the worst case scenario, a government may
print money to pay part of a large debt, but increasing the money supply
inevitably causes inflation. Moreover, if a government is not able to service
its deficit through domestic means (selling domestic bonds, increasing the
money supply), then it must increase the supply of securities for sale to
foreigners, thereby lowering their prices. Finally, a large debt may prove
worrisome to foreigners if they believe the country risks defaulting on its
obligations. Foreigners will be less willing to own securities denominated in
that currency if the risk of default is great. For this reason, the country's
debt rating (as determined by Moody's or Standard & Poor's, for example) is
a crucial determinant of its exchange rate.
5. Terms of Trade
A ratio comparing export prices to import prices, the terms of trade is related
to current accounts and the balance of payments. If the price of a country's
exports rises by a greater rate than that of its imports, its terms of trade
have favorably improved. Increasing terms of trade shows greater demand for the
country's exports. This, in turn, results in rising revenues from exports,
which provides increased demand for the country's currency (and an increase in
the currency's value). If the price of exports rises by a smaller rate than
that of its imports, the currency's value will decrease in relation to its
trading partners.
6. Political Stability and Economic Performance
Foreign investors inevitably seek out stable countries with strong economic
performance in which to invest their capital. A country with such positive
attributes will draw investment funds away from other countries perceived to
have more political and economic risk. Political turmoil, for example, can
cause a loss of confidence in a currency and a movement of capital to the
currencies of more stable countries.
Discuss the
theories in brief.
Many theories there have been
written in respect to the main determinant of future exchange rates. Although
the majority of these theories give adequate reasons in order to explain what
actually determines the rates between the currencies, we can argue that there
are many factors that may cause a currency fluctuation. Consequently, there is
little that can be alleged in respect to the theory that better answers the
question of what finally determines the exchange rates.
Here below, we will refer to
the main theories regarding the determinants of the exchange rates.
1.Supply and
demand
The exchange rate,
just like commodities, determines its price responding to the forces of supply
and demand. Therefore, if for some reason people increase their demand for a
specific currency, then the price will rise, provided the supply remains
stable. On the contrary, if the supply is increased, the price will decline
from provided the demand remains stable. Any excess supply (above the
equilibrium point) or excess demand (below the equilibrium point) will increase
or decrease temporarily foreign currency reserves accordingly. Finally, such
disequilibrium situations will be eliminated through the pricing, e.g. the
market itself.
Although, one could assume that
the international trade, investments and finance (when transactions in
different currencies are needed) are the major reasons for change in the supply
and demand of currencies, it is currency speculation that mainly causes the
change of the market forces. The ‘derived demand’ for a foreign currency arises
because of goods and services imported, international investments in assets,
and international finance.
2. Purchasing Power Parity
(PPP)
By definition, the PPP states
that using a unit of a currency, let us say one euro, which is the purchasing
power that can purchase the same goods worldwide. The theory is based on the
‘law of one price’, which argues that should a euro price of a good be
multiplied by the exchange rate (€ /US$) then it will result in an equal price
of the good in US dollars. In other words, if we assume that the exchange rate
between the € and US $ states at 1/1.2, then goods that cost € 10 in the EU
should cost US$ 12 in the
United States. Otherwise,
arbitrage profits will occur.
However, it is finally the
market that through supply and demand will force accordingly the euro and US
dollar prices to the equilibrium point. Thus, the law of one price will be
reinstated, as well as the purchase power parity between the euro and US
dollar.
Inflation differentials
between countries will also be eliminated in terms of their effect on the
prices of the goods because the PPP will adjust to equal the ratio of their
price levels. More specifically, as stated in their book (Lumby S. & Jones
C. 1999) “the currency of the country with the higher rate of inflation will depreciate
against the other country’s currency by approximately the inflation
deferential”.
In conclusion, it can be
argued that the theory, although it describes in a sufficient way the
determination of the exchange rates, is not of good value, mainly because of
the following two disadvantages. Firstly, not all goods are traded
internationally (for example, buildings) and secondly, the transportation cost
should represent a small amount of the good’s worth.
3. The Balance of Payments
(BOP) Approach
The balance of payments
approach is another method that explains what the factors are that determine
the supply and demand curves of a country’s currency.
As it is known from
macroeconomics, the balance of payments is a method of recording all the
international monetary transactions of a country during a specific period of
time. The transactions recorded are divided into three categories: the current
account transactions, the capital account transactions, and the central bank
transactions.
The aforementioned categories
can show a deficit or a surplus, but theoretically the overall payments (the
BOP as a whole) should be zero – which rarely happens.
As stated earlier, a
currency’s price depreciation or appreciation (the change in the value of
money), directly affects the volume of a country’s imports and exports and,
consequently, a likely fluctuation in the exchange rates can add to BOP
discrepancies.
For example, a likely
depreciation will increase the value of exports in home currency terms (the
larger the exports demand elasticity the greater the increase).
Conversely, the imports will
become ‘more expensive’ and their value will be reduced in home currency (the
larger the imports demand elasticity the greater the decrease).
Consequently, we can argue
that unless the value of exports increases less than the value of imports, the
depreciation will improve the current account. More specifically, we can
finally assess the impact of the currency’s depreciation on the current account
only by considering the price sensitivity of imports and exports.
The Marshall Lerner Condition
shows that if the sum of the price elasticity of demand for imports and exports
is greater than one, then a fall in the exchange rate will improve the current
account of BOP.
The J curve effect
illustrates that in the short-term a depreciation of the currency can initially
worsen the current account balance before it improves its position. This is due
to the low price elasticity of demand for imports and exports in the immediate
outcome of an exchange rate change.
4. The Monetary Approach
In this approach attention is
given to the stock of currencies in comparison to the willingness of people to
hold these stocks.
According to the monetary
theory, exchange rates adjust to ensure that the quantity of money in each
currency supplied is equal to the quantity demanded (Parkin M. & King D.
1992).
Both Quantity Theory of
Money(QTM) and Purchasing Power Parity(PPP) have been used in support of the
aforementioned theory. The QTM states that there is a direct relationship
between the quantity of money and the level of prices of goods and services
sold (Investopedia.com). In other words, more money equals more inflation.
In a domestic framework, the
following equation has been formulated.
MV = PY
M: Money supply/demand
V: Velocity of circulation
(the number of times money change hands)
P: Average price levels
Y: GDP
Finally, we can conclude that an increase in
the money supply leads to inflation, which in turn results in the decrease in
the value of money or purchasing power.
The main merit of the theory is that it is
compatible with the general theory of value. Furthermore, it shows the
determination of the equilibrium rate of exchange under the span of the general
equilibrium theory.
Secondly, the theory stresses the fact that
there are many predominant forces besides merchandise items (exports and
imports of goods) included in the balance of payments which influence the
supply of and demand for foreign exchange which in turn determine the rate of
exchange. Thus, the theory is more realistic in that the domestic price of
foreign money is seen as a function of many significant variables, not just the
purchasing power expressing general price levels.
The theory has, however, the following limitations:
1. It assumes perfect competition and
non-intervention of the government in the foreign exchange market. This is not
very realistic in the present day of exchange controls.
2. The theory does not explain what
determines the internal value of a currency. For this, we have to resort to
purchasing power parity theory.
3. It unrealistically assumes the balance of
payments to be at a fixed quantity.
4. According to the theory, there is no
causal connection between the rate of exchange and the internal price level.
But, in fact, there should be some such connection, as the balance of payments
position may be influenced by the price-cost structure of the country.
5. The theory is indeterminate at a time. It
states that the balance of payments determine the rate of exchange. However,
the balance of payments itself is a function of the rate of exchange. Thus,
there is a tautology, so what determines what, is not clear.
5. The Portfolio Balance
Approach
The portfolio balance
approach takes into consideration the diversification of investors’ portfolio
assets. Diversification is a technique that attempts to reduce risk by
investing both among various financial instruments and across national borders,
to mention just a few.
What the theory argues is
that an increase in the money supply will lead to a depreciation of the
exchange rate. For example, if we consider an increase in the domestic money
supply, we will anticipate that a lower interest rate and /or a higher exchange
rate can only absorb the excess supply, which in turn will result in the
reduction of bonds.
In this discourse, we analyzed the theories of exchange rate
determination, and we concluded that the exchange rate of a currency, just like
commodities, determine its price responding to the forces of supply and demand.
However, it remains difficult to evaluate the ‘weight’ of each factor that
influences the supply and demand flows. In this respect, we can argue that in
the long term fundamental forces drive the currency’s movements, e.g.,
inflation rates, interest rates, and GDP levels, to mention just a few, while
in the short run, news and events drive the exchange rates movements. Moreover,
we still remain unsure as to the ranking of the factors that finally determine
the exchange rates.
Ques 2: Outline the differences between a
‘market’ and a ‘Financial Market’.
Market can be more than a few types as there
can be markets for food like supermarkets, flea markets and other entities for
buying and selling physical goods and services. Financial markets in contrast
would imply that the products have monetary values to be exchanged and may not
be consumed as stocks and bonds are rarely eaten unlike food.
As JAGAnalyst points out, "A Financial
market would trade in financial products such as stocks, bonds, commercial
paper, options, etc. that represent an ownership or similar value position in a
company, rather than consumer markets/products. Markets more broadly can be any
exchange that brings together a buyer and seller. " In economics,
typically, the term market means the aggregate of possible buyers and
sellers of a certain good or service and the transactions between them.
The term "market" is sometimes used
for what are more strictly exchanges, organizations that facilitate the
trade in financial securities, e.g., a stock exchange or commodity exchange.
This may be a physical location (like the NYSE, BSE, NSE) or an electronic system (like
NASDAQ). Much trading of stocks takes place on an exchange; still, corporate
actions (merger, spinoff) are outside an exchange, while any two companies or
people, for whatever reason, may agree to sell stock from the one to the other without
using an exchange.
Again, in a market, the exchange occurs
between a currency and other materials like commodity while in financial
markets, it is only currencies which are borrowed and lent.
Another difference between a financial and a common
market is the need for warehousing.
Explain
the features of a financial market.
The major features of a financial market,
which somehow border on its functions in a modern financial system, are:
Channel savings to real
investment: The savings of individual investors are made available for real
investments by corporations and other business entities by way of financial
markets and institutions. Financial markets offer a platform for
borrowers to meet lenders. Investors needing money to further their interest
have a platform to meet their potential lenders. For example, a company needing
money for investing may float bonds to the public. The money they collect from
selling the company bonds will further their business interest. This also
applies when the government sells bonds to raise its revenue. Companies also
sell shares to the public, other companies and governments in a bid to raise
investments money(Copeland, 2005).
Volatile; Financial markets
are markets for stocks of assets, the value of which today is dependent on the expectation
of their future value. Any factor that leads to a shift in expected future
values will have an immediate impact on financial markets, and on the major
macro-financial variables, the interest rate and the exchange rate. So the
failure of a single firm can, by influencing expectations, have an influence
not only on its immediate counterparties, or even firms dealing in similar
products, but also, through its impact on expectations, on financial markets as
a whole, and, via macro variables, on the real economy at home and abroad.
Indices; A financial market
is also characterize by certain indices. For example, in India the following Financial Indices prevail- BSE 30 Index, various
sector indexes, stock quotes, Sensex charts, bond prices, foreign exchange,
Rupee & Dollar Chart.
Price
determination: Financial markets offer grounds for analyzing and determining
the net value of traded assets. Through the process of price discovery, they
show a sign for fund allocation in accordance to the market forces of demand
and supply
A financial market is also
characterized by financial intermediaries and institutions, which serve as
participants in the market. By definition, financial institutions are
institutions that participate in financial markets, i.e., in the creation
and/or exchange of financial assets. For example, at present in the United
States, financial institutions can be roughly classified into the following
four categories: "brokers;" "dealers;" "investment
bankers;" and "financial intermediaries."
Ques 3: Define
‘Derivatives’.
A derivative in Finance can be defined as a
financial contract that gets (derives) its value from an underlying asset. It
is, at heart, an agreement between a buyer and a seller that says how much the
price of the asset will change over a specific period of time. The underlying
asset can be a commodity, such as oil, gasoline or gold. Many derivatives are based
on stocks or bonds. Others use currencies, especially the U.S. dollar, as their
underlying asset. Still others use interest rates, such as the yield on the
10-year Treasury note, as their base. These assets can be, but do not have to
be, owned by either party to the agreement. This makes derivatives much easier
to trade than the asset itself.
A Derivative includes:
(a) a security derived from a debt
instrument, share, loan, whether secured or unsecured, risk instrument or
contract for differences or any other form of security ;
(b) a contract which derives
its value from the prices, or index of prices, of underlying securities.
What are the types of derivative instruments?
Derivative instruments or contracts are of
several types. The most common types are forwards, futures, options and swap.
Forward Contracts
A forward contract
is an agreement between two parties – a buyer and a seller to purchase or sell
something at a later date at a price agreed upon today. Forward contracts,
sometimes called forward commitments, are very common in everyone life. Any
type of contractual agreement that calls for the future purchase of a good or
service at a price agreed upon today and without the right of cancellation is a
forward contract. Forward contracts are especially important in the foreign exchange
markets because they allow individuals and firms to protect themselves against
foreign exchange risk. Suppose a company
is going to import electronic parts from a French manufacturer in three months
time at a price fixed in terms of francs.
If the company waits for three months to buy the francs that it knows it
is going to need, it assumes foreign exchange risk: the dollar price of the franc may appreciate,
raising the dollar price of the electronic parts. Instead of assuming the risk, the company may
choose to purchase a forward contract today for the delivery of francs three
months from now. Then even if the price
of francs appreciates, the company has guaranteed that it will be able to
purchase the electronic parts at a price in dollars that it is willing to pay.
In the foreign exchange market, the forward price and
the spot price are linked by the interest parity condition. This condition says that the percentage
difference between the forward rate (F) and the spot rate (S), called the
forward premium, will equal the difference between the real (inflation
adjusted) foreign interest rate (if)
and the real domestic interest rate (id):
(F - S)
_____ =
if - id
S
If, for
example, the real foreign interest rate is 10 percent and the real domestic
rate is 8 percent, the interest parity condition implies that the forward rate
will be 2 percentage points higher than the spot rate.
This condition holds because rational investors who
need foreign currency in the future always have the option of buying the
currency now on the spot market and investing it in an interest-earning foreign
bank account until needed or buying a forward contract for the future purchase
and delivery of the foreign currency and investing the funds in an
interest-earning domestic bank account until the foreign currency is
delivered. The normal operations of
efficient markets and rational investors insure that the expected cost of these
two alternatives will always be equal; therefore, the difference between the
spot rate and the forward rate reflects differences in real interest rates.
A forward contract is very similar to a futures
contract, but there are two important differences. First, forward contracts are negotiated
between two parties so that they may reflect individualized terms and
conditions. In contrast, a futures
contract is traded on an price, including size of the contract, delivery date,
grade of commodity, etc. Second, forward
contracts are not marked to market each day by an exchange as is the case with
futures contracts. As a result, gains
and losses on forward contracts are recognized only when the contract matures,
while holders of future contracts must recognize the rise or fall in the value
of their contracts as they are marked to market by the exchange.
Future Contracts
A futures contract is an agreement between
two parties – a buyer and a seller – to buy or sell something at a future date.
The contact trades on a futures exchange and is subject to a daily settlement
procedure. Future contracts evolved out of forward contracts and possess many
of the same characteristics. Unlike forward contracts, futures contracts trade
on organized exchanges, called future markets. Future contacts also differ from
forward contacts in that they are subject to a daily settlement procedure. In
the daily settlement, investors who incur losses pay them every day to
investors who make profits.
The most common features of futures include;
- Terms
and conditions are standardized.
- Trading
takes place on a formal exchange wherein the exchange provides a place to
engage in these transactions and sets a mechanism for the parties to trade
these contracts.
- There
is no default risk because the exchange acts as a counterparty,
guaranteeing delivery and payment by use of a clearing house.
- The
clearing house protects itself from default by requiring its
counterparties to settle gains and losses or mark to market their
positions on a daily basis.
- Futures
are highly standardized, have deep liquidity in their markets and trade on
an exchange.
- An
investor can offset his or her future position by engaging in an opposite
transaction before the stated maturity of the contract.
The
profits and losses of a futures contract are calculated on a daily basis.
On the surface, futures contracts are an
instrument of price speculators who want to hedge a price risk or profit from
coming changes. In the jargon of the futures market, these participants might
be called "hedgers" and "speculators," respectively.
However, there are other, more significant social and economic functions that
futures contracts play. These intangible financial instruments help to foster a
greater specialization that benefits all consumers by allocating resources more
efficiently and providing an insurance policy for businesses.
Futures contracts have drawn plenty of
critics ever since their inception. These critics often claim forward contracts
might serve an important purpose, but standardized and traded futures contracts
are inherently speculative and therefore add unnecessary risk to the financial
markets. These concerns make sense in a vacuum but are poorly represented among
dynamic and fluctuating futures contract prices.
Options Contracts
An options contract is an agreement between a
buyer and seller that gives the purchaser of the option the right to buy
or sell a particular asset at a later date at an agreed upon price. Options
contracts are often used in securities, commodities, and real estate
transactions.
Options are of two types – calls and puts.
Calls give the buyer the right but not the obligation to buy a given quantity
of the underlying asset, at a given price on or before a given future date.
Puts give the buyer the right, but not the obligation to sell a given quantity
of the underlying asset at a given price on or before a given date. There are
four key advantages (in no particular order) that options may give an investor:
they may provide increased cost efficiency; they may be less risky than
equities; they have the potential to deliver higher percentage returns; and
they offer a number of strategic alternatives. With advantages like these, you
can see how those who have been using options for a while would be at a loss to
explain options' lack of popularity in the past. Let's look into these
advantages one by one.
Cost Efficiency; Options
have great leveraging power. As such, an investor can obtain an option position
that will mimic a stock position almost identically, but at a huge cost
savings. For example, in order to purchase 200 shares of an $80 stock, an
investor must pay out $16,000. However, if the investor were to purchase two $20 calls (with
each contract representing 100 shares), the total outlay would be only $4,000
(2 contracts x 100 shares/contract x $20 market price). The investor would then
have an additional $12,000 to use at his or her discretion. Obviously, it is
not quite as simple as that. The investor has to pick the right call to
purchase in order to mimic the stock position properly. However, this strategy,
known as stock replacement, is not only viable but also practical and cost
efficient.
Less Risk - Depending on How You
Use Them; There are
situations in which buying options is riskier than owning equities, but there
are also times when options can be used to reduce risk. It really depends on
how you use them. Options can be less risky for investors because they require
less financial commitment than equities, and they can also be less risky due to
their relative imperviousness to the potentially catastrophic effects of gap
openings.
Options are the most dependable form of
hedge, and this also makes them safer than stocks. When an investor purchases
stocks, a stop-loss order is frequently placed to protect the position. The
stop order is designed to "stop" losses below a predetermined price
identified by the investor. The problem with these orders lies in the nature of
the order itself. A stop order is executed when the stock trades at or below
the limit as indicated in the order.
Unlike stop-loss orders, options do not shut
down when the market closes. They give you insurance 24 hours a day, seven days
a week. This is something that stop orders can't do. This is why options are
considered a dependable form of hedging.
Furthermore, as an alternative to purchasing
the stock, you could have employed the strategy mentioned above (stock
replacement), where you purchase an in-the-money call instead of purchasing the
stock. There are options that will mimic up to 85% of a stock's performance,
but cost one-quarter the price of the stock. If you had purchased the $45
strike call instead of the stock, your loss would be limited to what you spent
on the option. If you paid $6 for the option, you would have lost only that $6,
not the $31 you'd lose if you owned the stock. The effectiveness of stop orders
pales in comparison to the natural, full-time stop offered by options.
Higher Potential Returns; You don't need a calculator to figure out that if
you spend much less money and make almost the same profit, you'll have a higher
percentage return. When they pay off, that's what options typically offer to
investors.
For example, using the scenario from above,
let's compare the percentage returns of the stock (purchased for $50) and the
option (purchased at $6). Let us also say that the option has a delta of 80,
meaning that the option's price will change 80% of the stock's price change. If
the stock were to go up $5, your stock position would provide a 10% return.
Your option position would gain 80% of the stock movement (due to its 80
delta), or $4. A $4 gain on a $6 investment amounts to a 67% return - much
better than the 10% return on the stock. Of course, we must point out that when
the trade doesn't go your way, options can exact a heavy toll: there is the
possibility that you will lose 100% of your investment.
More Strategic Alternatives;
The final major advantage of options is that they offer more investment
alternatives. Options are a very flexible tool. There are many ways to use
options to recreate other positions. We call these positions synthetics.
Synthetic positions present investors with
multiple ways to attain the same investment goals, and this can be very, very
useful. While synthetic positions are considered an advanced option topic,
there are many other examples of how options offer strategic alternatives. For
example, many investors use brokers that charge a margin when an investor wants
to short a stock. The cost of this margin requirement can be quite prohibitive.
Other investors use brokers that simply do not allow for the shorting of
stocks, period. The inability to play the downside when needed virtually
handcuffs investors and forces them into a black-and-white world while the market
trades in color. But no broker has any rule against investors purchasing puts
to play the downside, and this is a definite benefit of options trading.
The use of options also allows the investor
to trade the market's "third dimension", if you will: no direction.
Options allow the investor to trade not only stock movements, but also the
passage of time and movements in volatility. Most stocks don't have large moves
most of the time. Only a few stocks actually move significantly, and then they
do it rarely. Your ability to take advantage of stagnation could turn out to be
the factor that decides whether your financial goals are reached or whether
they remain simply a pipe dream. Only options offer the strategic alternatives
necessary to profit in every type of market.
Swaps
Swaps are private agreements between two parties to exchange cash flows in the
future according to a prearranged formula. They can be regarded as portfolios
of forward contracts. The two commonly used swaps are interest rate swaps and
currency swaps.
1. Interest rate swaps: These involve swapping only the interest related cash
flows between the parties in the same currency.
2. Currency swaps: These entail swapping both principal and interest between the parties,
with the cash flows in one direction being in a different currency than those
in the opposite direction.
A party would enter a swap typically for one
of two reasons, as a hedge for another position or to speculate on the future
value of the floating leg's underlying index/currency/etc.
For speculators looking to place bets on the
direction of interest rates (such as hedge funds), interest rate swaps are an
ideal instrument. While traditionally one would trade bonds to make such bets,
by entering into either side of an interest rate swap agreement, you would gain
immediate exposure to interest rate movements with virtually no initial cash
outlay.
One major risk (other than the obvious
interest rate risk) for swap investors is that of counterparty risk. Since any
gains over the course of a swap agreement are considered unrealized until the
next settlement date, timely payment from the counterparty determines profit.
If the counterparty cannot meet their obligation you may be unable to collect
your rightful payments.
Additionally, if one party decides it is time
to exit a swap agreement, they have several options for a successful exit. With
the swap market having so many participants, it can be relatively easy to sell
your position to another party willing to take on the exposure. Also, much like
with other derivatives the exiting party could simply just take an offsetting
position in another swap to zero out the position. Other strategies include
entering into an offsetting swap positions which effectively cancels out the
original.
Ques 4: Differentiate
Futures And Forwards.
A futures contract is an
agreement between two parties – a buyer and a seller – to buy or sell something
at a future date while a forward contract is an agreement between two parties –
a buyer and a seller to purchase or sell something at a later date at a price
agreed upon today.
Fundamentally, forward and futures contracts
have the same function: both types of contracts allow people to buy or sell a
specific type of asset at a specific time at a given price. However, the two
are different in many respects.
The fundamental difference
between futures and forwards is that futures are traded on exchanges and
forwards trade Over The Counter(OTC). The difference in trading venues gives
rise to notable differences in the two instruments:
- Futures
are standardized instruments transacted through brokerage firms that hold
a "seat" on the exchange that trades that particular contract.
The terms of a futures contract - including delivery places and dates,
volume, technical specifications, and trading and credit procedures - are
standardized for each type of contract. Like an ordinary stock trade, two
parties will work through their respective brokers, to transact a futures
trade. An investor can only trade in the futures contracts that are
supported by each exchange. In contrast, forwards are entirely customized
and all the terms of the contract are privately negotiated between
parties. They can be keyed to almost any conceivable underlying asset or
measure. The settlement date, notional amount of the contract and
settlement form (cash or physical) are entirely up to the parties to the
contract.
- Forwards
entail both market risk and credit risk. Those who engage in futures
transactions assume exposure to default by the exchange's clearing house.
For OTC derivatives, the exposure is to default by the counterparty who
may fail to perform on a forward. The profit or loss on a forward contract
is only realized at the time of settlement, so the credit exposure can
keep increasing.
- With
futures, credit risk mitigation measures, such as regular mark-to-market
and margining, are automatically required. The exchanges employ a system
whereby counterparties exchange daily payments of profits or losses on the
days they occur. Through these margin payments, a futures contract's
market value is effectively reset to zero at the end of each trading day.
This all but eliminates credit risk.
- The
daily cash flows associated with margining can skew futures prices,
causing them to diverge from corresponding forward prices.
- Futures
are settled at the settlement price fixed on the last trading date of the
contract (i.e. at the end). Forwards are settled at the forward price
agreed on at the trade date (i.e. at the start).
- Futures
are generally subject to a single regulatory regime in one jurisdiction,
while forwards - although usually transacted by regulated firms - are
transacted across jurisdictional boundaries and are primarily governed by
the contractual relations between the parties.
- In
case of physical delivery, the forward contract specifies to whom the
delivery should be made. The counterparty on a futures contract is chosen
randomly by the exchange.
- In
a forward there are no cash flows until delivery, whereas in futures there
are margin requirements and periodic margin calls.
The table below
gives the contrasting dynamics of each instrument.
|
|
Forward Contract
|
Futures Contract
|
|
Definition
|
A forward
contract is an agreement between two parties to buy or sell an asset (which
can be of any kind) at a pre-agreed future point in time at a specified
price.
|
A futures
contract is a standardized contract, traded on a futures exchange, to buy or
sell a certain underlying instrument at a certain date in the future, at a
specified price.
|
|
Structure & Purpose
|
Customized to
customer needs. Usually no initial payment required. Usually used for
hedging.
|
Standardized.
Initial margin payment required. Usually used for speculation.
|
|
|
Negotiated
directly by the buyer and seller
|
Quoted and
traded on the Exchange
|
|
Transaction method
|
||
|
Market regulation
|
Not regulated
|
Government
regulated market
|
|
Institutional guarantee
|
The contracting
parties
|
Clearing House
|
|
Risk
|
High
counterparty risk
|
Low
counterparty risk
|
|
Guarantees
|
No guarantee of
settlement until the date of maturity only the forward price, based on the
spot price of the underlying asset is paid
|
Both parties
must deposit an initial guarantee (margin). The value of the operation is
marked to market rates with daily settlement of profits and losses.
|
|
Contract Maturity
|
Forward
contracts generally mature by delivering the commodity.
|
Future
contracts may not necessarily mature by delivery of commodity.
|
|
Expiry date
|
Depending on
the transaction
|
Standardized
|
|
Method of pre-termination
|
Opposite
contract with same or different counterparty. Counterparty risk remains while
terminating with different counterparty.
|
Opposite
contract on the exchange.
|
|
Contract size
|
Depending on
the transaction and the requirements of the contracting parties.
|
Standardized
|
|
Market
|
Primary &
Secondary
|
Primary
|
Outline
the features of both of them.
The
following is a list of key features/ characteristics of futures:
1. Futures contracts are traded on an exchange and not
privately traded.
2. Since they are traded on exchange, futures contracts
are highly standardized. This means that they are not customized as per the
requirements of the counterparties.
3. A single clearinghouse acts as the counterparty for
all futures contracts. This means that the clearinghouse is the buyer for every
seller and seller for every buyer. This eliminates the risk of default, and
also allows traders to reverse their positions at a future date.
4. Futures contracts require a margin to be posted at the
contract initiation, which fluctuates as the futures prices fluctuate. There is
no such margin requirement in a forward contract.
5. The government regulates futures market.
A
standardized futures contract has a specific:
- Underlying instrument--the commodity, currency, financial instrument or
index upon which the contract is based;
- Size--the amount of the underlying item covered by the contract;
- Delivery cycle--the specified months for which contracts can be
traded;
- Expiration date--the date by which a particular futures trading
month ceases to exist and therefore all obligations under it terminate;
- Grade or quality specification and
delivery location--a detailed
description of the "par" commodity, security or other item that
is being traded and, as permitted by the contract, a specification of
items of higher or lower quality or of alternate delivery locations
available at a premium or discount; and
- Settlement mechanism--the terms of the physical delivery of
the underlying item or of a terminal cash payment. The only non-standard
item of a futures contract is the price of an underlying unit, which is determined in the trading arena.
In a futures contract, the buyer of the
contract is said to have a long position and the seller is said to have a short
position. The long is required to buy the underlying asset as per the specified
time and price and the short is required to deliver this underlying asset.
In terms of standardization, the futures
markets have specifications for various things such as the quality of the
underlying asset, quantity, delivery dates, price movements, etc. For example,
100 shares of a company may form one futures contract.
Futures contracts are used by both
speculators to gain market exposure, and hedgers to mitigate their risks or
reduce their exposure to price changes.
Key
features of forward contracts are:
- Highly customized - Counterparties can determine and define the
terms and features to fit their specific needs, including when delivery
will take place and the exact identity of the underlying asset.
- All parties are exposed to counterparty default risk - This is the
risk that the other party may not make the required delivery or payment.
- Transactions take place in large, private and largely unregulated
markets consisting of banks, investment banks, government and
corporations.
- Underlying assets can be a stocks, bonds, foreign currencies,
commodities or some combination thereof. The underlying asset could even
be interest rates.
- They tend to be held to maturity and have little or no market
liquidity.
- Any commitment between two parties to trade an asset in the future
is a forward contract.
- Forward contracts are privately traded and not traded on exchange.
- The delivery periods are
specified.
Ques 5: Calculate
the future price.
a)The spot price of WALMART is USD 300. The bank rate
is 10%. What will be the price of 1 month future
$300
× 10% = $30 ÷12 months = $2.50 per month.
Therefore
the price in 1 month future = $300 + $2.50 = $302.5
b)What would be the price if company
pays a dividend of 5%.
$302.5 × 5% = $15.125
ASSIGNMENT
B
Ques 1: What do you
mean by ‘International Financial Market’?
International Financial
Market is a global, worldwide, decentralized market for trading financial
instruments such as bonds, stocks, and mortgages, T-bills, Commercial Papers
etc.
The International Financial
Market is the place where financial wealth is traded between individuals (and
between countries). It can be seen as a wide set of rules and institutions
where assets are traded on an international level between agents in surplus and
agents in deficit and where institutions lay down the rules.
International financial
markets undertake intermediation by transferring purchasing power from lenders
and investors to parties who desire to acquire assets that they expect to yield
future benefits. International financial transactions involve exchange of
assets between residents of different financial centers across national
boundaries. International financial centers are reservoirs of savings and
transfer them to their most efficient use irrespective of where the savings are
generated.
Like their domestic counterpart, international
financial markets may be divided into money and capital markets. Money markets
deal with assets created or traded with relatively short maturity, say less
than a year. Capital markets deal with instruments whose maturity exceeds one
year or which lack definite maturity.
Again, on lines similar to
domestic markets, in the international financial markets also we have primary
and secondary markets dealing with issue of new instruments and trading in
existing instruments and negotiable debt instruments, respectively. In
international financial markets as in the domestic markets there is a symbiotic
relationship between primary and secondary market.
According to Garbbe
international financial markets consist of international markets for foreign
exchange, Euro currencies and Euro bonds. In view of the development and rapid
growth of swaps and globalization of equity markets, international financial
markets have been categorized into five markets here: foreign exchange market;
lending by financial institutions; issue and trading of negotiable instruments
of debt; issue and trading of equity securities; and lastly internationally
arranged swaps. The rates of foreign exchange as well as interest rates
fluctuate and to hedge against the risk of loss arising out of changes in them
derivative instruments are traded in the organized exchanges as well as in
over-the-counter markets. Most of the derivatives except the interest rate
swaps are short term in nature. Derivatives involve creation of assets that are
based on other financial assets.
Explain
in role in promoting international trade and development.
The international financial
market plays a significant role in promoting world trade and development.
International financial markets and the
transactions therein have facilitated and helped the expansion of international
trade based on comparative absolute advantage resulting in welfare benefits in
terms of higher income among participant nations. Further, the growth of
international financial markets has facilitated cross-country financial flows
which contribute to a more efficient allocation of resources. Efficiency in use
rather than origin of or abundance governs allocation of resources
internationally. This means that potentially high return projects in countries
with low savings will not be neglected in favor of low return projects in high
saving countries simply because of where savings are generated.
There are three important
functions of international financial markets. First, the interactions of buyers
and sellers in the markets determine the prices of the assets traded which is
called the price discovery process. Secondly, such markets ensure liquidity by
providing a mechanism for an investor to sell a financial asset. Finally, the
financial markets reduce the cost of transactions and information in
international trade and development.
Furthermore, the
international financial market is important not only because it provides
significant economic services to the global economy by aiding capital formation
for businesses, but also because it is large and magnifies the
interconnectedness of different countries’ economies.
This market arrangement also
helps create money, which are of different types. A noteworthy point is that
the creation of these different kinds of money claims facilitates transactions
of various types in the economy, thereby fostering economic growth. Thus, we
need the large variety of institutions operating in the international financial
market in order to ensure the creation and smooth flow of money in the
financial system.
Moreover, these various
institutions are all interconnected in many ways, which means that we not only
need variety in financial institutions, but we also need to be cognizant of how
these institutions are related to each other. This as a result helps in
promoting trade and development among countries.
More related to the point
just mentioned above is that this financial system also facilitates global
trade by way of allocating liquidity (money-like claims) from liquidity-surplus
areas of the world to liquidity-starved areas. For example, China’s high
savings rate led to the accumulation of large liquidity stockpiles left over
after the country’s investment needs were met during the past decade or so.
This liquidity was used by the Chinese government to buy U.S. government debt
instruments, namely Treasury bonds. This, in turn, financed the debt of the
U.S. government, which was used to meet the investment needs within the United
States the past decade.
As the global financial
market and system evolves, it develops a greater variety of risk management
instruments and processes. This enables individuals and firms to hedge against
a growing variety of risks, benefiting not only them but also society because
it enables them to invest more in economic growth.
The international financial
market also helps in mobilization of resources on a global scale. This global
mobilization of resources that the financial market facilitates manifests
itself in cross-border commerce and exchanges that display connectedness across
a large number of countries and cities. Participating in the global
mobilization of resources is enormously beneficial to a country; hence, a
global financial market that fosters this mobilization also boosts the economic
growth of nations. Singapore is a good example of this.
Ques 2: What do you
mean by Balance of Payments?
The balance of payments, also known as balance of international payments
and abbreviated BoP or BP, of a
country is the record of all economic transactions between the residents of the
country and the rest of the world in a particular period (over a quarter of a
year or more commonly over a year).
According to the RBI, balance of payment is a
statistical statement that shows;
1. The transaction in goods, services and income between an economy and the
rest of the world,
2. Changes of ownership and other changes in that economy's monetary gold,
special drawing rights (SDRs), and financial claims on and liabilities to the
rest of the world, and
3. Unrequited transfers.
The
greatest importance of balance of payments lies in its serving as an indicator
of changing international economic position of a country. The balance of
payments is the economic barometer which can be used to appraise a nation’s
short-term international economic prospects, to evaluate the degree of its
international solvency, and to determine the appropriateness of the exchange
rate of country’s currency.
However, a country’s favorable balance of
payments cannot be taken as an indicator of economic prosperity nor the adverse
and even the unfavorable balance of payments is not a reflection of bankruptcy.
A balance of payments deficit per se is not
the proof of competitive weakness of a nation in foreign markets. However, the
longer the balance of payments deficit continues, the more it would imply some
fundamental problems in that economy.
Similarly, a favorable balance of payments
should not always make a country complacent. A poor country may have a
favorable balance of payments due to large inflow of foreign loans and equity
capital. A developed country may have adverse balance of payments due to
massive assistance given to developing countries.
Thus, a deficit or surplus of balance of
payments of a country per se should not be taken as an index of economic
bankruptcy or prosperity of the country. The balance of payments deals only
with the transactions of the period under review.
It does not provide data about assets and
liabilities that relate one country to others. However, despite all these short
comings, the significance of balance of payments lies in the fact that it
provides vital information to understand a country’s economic dealings with
other countries.
The balance of payments (BOP) is the method
countries use to monitor all international monetary transactions at a specific
period of time. Usually, the BOP is calculated every quarter and every calendar
year. All trades conducted by both the private and public sectors are accounted
for in the BOP in order to determine how much money is going in and out of a
country. If a country has received money, this is known as a credit, and if a
country has paid or given money, the transaction is counted as a debit.
Theoretically, the BOP should be zero, meaning that assets (credits) and
liabilities (debits) should balance, but in practice this is rarely the case.
Thus, the BOP can tell the observer if a country has a deficit or a surplus and
from which part of the economy the discrepancies are stemming.
As we shall see later, the BOP is divided
into three main categories: the current account, the capital account and the
financial account. Within these three categories are sub-divisions, each of
which accounts for a different type of international monetary transaction.
Explain its components and their significance for an
economy.
The balance of payments is made up of these
key parts
- i)
The current account
- ii)
The capital account
- iii)
Official financing account
Within any country, the BOP record comprises
three "accounts": the current account, which includes
primarily trade in goods and services (often referred to as the balance of
trade), along with earnings on investments; the capital account,
including transfers of non-financial capital such as debt forgiveness, gifts
and inheritances; and the financial account, essentially trade in such
assets as currencies, stocks, bonds, real estate, and gold, among others.
The current
account is used to mark the inflow and outflow of goods and services into a
country. Earnings on investments, both public and private, are also put into
the current account.
Within the current account are credits and
debits on the trade of merchandise, which includes goods such as raw materials
and manufactured goods that are bought, sold or given away (possibly in the
form of aid). Services refer to receipts from tourism, transportation (like the
levy that must be paid in Egypt when a ship passes through the Suez Canal),
engineering, business service fees (from lawyers or management consulting, for
example) and royalties from patents and copyrights. When combined, goods and
services together make up a country's balance of trade (BOT). The BOT is
typically the biggest bulk of a country's balance of payments as it makes up total
imports and exports. If a country has a balance of trade deficit, it imports
more than it exports, and if it has a balance of trade surplus, it exports more
than it imports.
Receipts from income-generating assets such
as stocks (in the form of dividends) are also recorded in the current account.
The last component of the current account is unilateral transfers. These are
credits that are mostly worker's remittances, which are salaries sent back into
the home country of a national working abroad, as well as foreign aid that is
directly received.
The current
account is affected by several factors. It will post a surplus, or the deficit
will shrink, if there is an increase in competitiveness (measured by
productivity and relative prices, based on the exchange rate) or if economic
growth is less vigorous than in other countries, which would lead to lower
import growth. Conversely, an economic decline in foreign countries will
negatively affect a country’s current account balance, as the market for the
country’s goods and services shrinks.
The capital account is made up of capital transfers, (e.g.
migrants’ assets, public service superannuation benefits, debt forgiveness and
inheritance funds), and intangible assets (intellectual property rights, such
as patents).
The capital account is where all
international capital transfers are recorded. This refers to the acquisition or
disposal of non-financial assets (for example, a physical asset such as land)
and non-produced assets, which are needed for production but have not been
produced, like a mine used for the extraction of diamonds.
The capital account is broken down into the
monetary flows branching from debt forgiveness, the transfer of goods, and
financial assets by migrants leaving or entering a country, the transfer of
ownership on fixed assets (assets such as equipment used in the production
process to generate income), the transfer of funds received to the sale or
acquisition of fixed assets, gift and inheritance taxes, death levies and,
finally, uninsured damage to fixed assets.
In the financial account, if foreign
ownership of domestic financial assets has increased more quickly than domestic
ownership of foreign assets in a given year, then the domestic country has a financial
account surplus. On the other hand, if domestic ownership of foreign
financial assets has increased more quickly than foreign ownership of domestic
assets, then the domestic country has a financial account deficit. The
United States persistently has the largest capital (and financial) surplus in
the world, but as of 2006 had a large account deficit. To a significant extent,
this reflects that the United States imports far more than it exports.
Taken together, the capital and financial
accounts consist of "capital transfers, direct investments [in which the
investor has a permanent interest], portfolio investments [stocks, bonds, notes
and the like] and other forms of investment [financial derivatives, loans,
etc.]."
The example below refers to a hypothetical
country, data is in $ billion
|
Item of the BoP
|
Net Balance $ billion
|
Comment
|
|
Current Account
|
|
|
|
(1) Balance of trade in goods
|
-25
|
A trade deficit
|
|
(2) Balance of trade in services
|
10
|
A trade surplus
|
|
(3) Net investment income
|
-12
|
Net outflow of income i.e. due
to profits of transnational corporations
|
|
(4) Net overseas transfers
|
8
|
Net inflow of transfers perhaps
from remittance payments from migrants
|
|
Sum of 1+2+3+4 = Current account
balance
|
-19
|
Overall – this country runs a
current account deficit
|
|
Financial Account
|
|
|
|
Net balance of foreign direct
investment flows
|
5
|
Positive net inflow of FDI
|
|
Net balance of portfolio
investment flows
|
6
|
Positive net inflow into equity
markets, property etc.
|
|
Net balance of short term
banking flows
|
-2
|
Small net outflow of currency
from country's banking system
|
|
Balancing item
|
2
|
There to reflect errors and
omissions in data calculations
|
|
Changes to reserves of gold and
foreign currency
|
8
|
+8 means that this country's
gold and foreign currency reserves have been reduced
|
|
Overall balance of payments
|
0
|
|
The status of a current account of a country
has some significance. For example, a current account deficit, which usually
reflects an imbalance between imports and exports, may suggest a policy
"directed to increase competitiveness in the global market for local
products and/or develop new industries that will produce import
substitutes," or a policy focused on currency exchange rates, such as
devaluation.
Likewise, a steep current account deficit can
lead policy makers to impose tariffs, which effectively slow imports, or lower
interest rates, which enable domestic manufacturers to lower their own prices,
thereby better competing with demand for imports. Other measures suggested by
payments imbalances might include restrictive monetary and fiscal policies, or
increasing borrowing.
A
current account surplus can help to boost domestic employment of a country. If
a country’s exports are competitive, it will be able to sell a lot of exports
and this can lead to higher domestic employment in the exporting sector.
Without the strong export demand, a country’s economy can be weak and it can be
liable to have higher unemployment.
Like the current account, the capital account
is important because it's a component of the balance of payments. Combined with
the financial account, it represents the transfer of capital to help pay for
the current account, which includes the trade of goods and services. The
capital account is usually somehow small but its combination with the financial
account can result into enough surplus to take care of a trade deficit. But
this means that the country in question is selling off its assets, whether
tangible or intangible, to purchase foreign goods and services.
Ques 3: THE FOLLOWING
RATES ARE GIVEN
•
SPOT(RS/EURO)—57.90 58.10
•
I MTH FWD 57.50 57.80
•
FIND WHETEHER EURO IS PREMIUM/DISC
•
CALCULATE ANNUALISED PREMIUM/DISC
•
INTERPRETATION TO THIS FIGURE?
•
AVG(MID RATE)FOR 3M,6M,12M FWD CONTRACTS ASSUMING
SPREADS RS 0.50,0.80,1.00
Euro is a discount because 1
month forward rate of 57.80 Euros are less than the existing spot rate of 58.10
Euros.
To calculate the discount for
the Euro, we first want to calculate the forward and spot rates for the Euro in
terms of Rupees per Euro. Those numbers would be (1/57.80 = 0.01730) and
(1/58.10 = 0.01721), respectively.
So
the annualized forward discount for the Euro, in terms of Indian Rupees, would
be:
((0.01730 - 0.01721) ÷ 0.01721) × 1 × 100% = -0.009%
The
implication of these answers is that an investor who buys this future contract now
stands to be earning an amount less than what the actual future amount (without
discount) would have given him or her at the end of the future contract period.
The opposite is the case with the seller of this future contract.
CASE
STUDY
What do you mean by the term ‘Arbitrage’?
Arbitrage is basically buying in one market
and simultaneously selling in another, profiting from a temporary difference.
This is considered riskless profit for the investor/trader.
Here is an example of an arbitrage opportunity.
Let's say you are able to buy a toy doll for $15 in Tallahassee, Florida, but
in Seattle, Washington, the doll is selling for $25. If you are able to buy the
doll in Florida and sell it in the Seattle market, you can profit from the
difference without any risk because the higher price of the doll in Seattle is
guaranteed.
In the context of the stock market, traders
often try to exploit arbitrage opportunities. For example, a trader may buy a
stock on a foreign exchange where the price has not yet adjusted for the
constantly fluctuating exchange rate. The price of the stock on the foreign
exchange is therefore undervalued compared to the price on the local exchange,
and the trader makes a profit from this difference.
If all markets were perfectly efficient,
there would never be any arbitrage opportunities - but markets seldom remain
perfect. It is important to note that even when markets have a discrepancy in
pricing between two equal goods, there is not always an arbitrage opportunity.
Transaction costs can turn a possible arbitrage situation into one that has no
benefit to the potential arbitrager. Consider the scenario with the toy dolls
above. It would cost you a certain amount per doll to get the dolls from
Florida to Seattle. If it costs $11 per doll, the arbitrage opportunity has
been erased.
Arbitrage only takes place when one of the three following conditions are
satisfied:
The same financial instrument is not traded
at equal prices in every market. This condition is known as the law of one
price.
Two financial instruments that have similar cash flows are not traded at equal
price.
A commodity, which has a fixed price in the future, is not traded at the
present time at a risk free interest rate and future discounted price. Here the
commodity has no insignificant storage expenditure. This condition is mostly
applicable for food grains; however, it is not applicable for securities or
stocks.
The different types of arbitrage can be categorized into the following:
Exchange-traded fund
arbitrage
Merger arbitrage or risk arbitrage
Convertible bond arbitrage
Municipal bond arbitrage
Regulatory arbitrage
Depository receipts
Triangle arbitrage
Telecom arbitrage
Statistical arbitrage
Discuss its significance.
Why
is Arbitrage so important or significant?
True arbitrage opportunities are rare. When
they are discovered, they do not last long. So why is it important to explore
arbitrage in detail? Does the benefit justify the cost of such analysis? There
are compelling reasons for going to the trouble.
Investors are interested in whether a
financial asset’s price is correct or "fair." They search for
attractive conditions or characteristics in an asset associated with
misvaluation. For example, evidence exists that some low price/earnings (P/E)
stocks are perennial bargains, so investors look carefully for this
characteristic along with other signals of value. Yet the absence of
an arbitrage opportunity is at least as important as its presence! While the presence
of an arbitrage opportunity implies that a riskless strategy can be designed to
generate a return in excess of the risk-free rate, its absence
indicates that an asset’s price is at rest. Of course, just because an asset’s
price is at rest does not necessarily mean that it is "correct."
Resting and correct prices can differ for economically meaningful reasons, such
as transactions costs. For example, a $1.00 difference between correct and
resting prices cannot be profitably exploited if it costs $1.25 to execute the
needed transactions. Furthermore, sometimes many market participants believe
that prices are wrong, trade under that perception, and thereby influence
prices. Yet there may not be an arbitrage opportunity in the true sense of a
riskless profit in the absence of an initial required investment. Thus, it is
important to carefully relate price discrepancies to the concept of arbitrage
because one size does not fit all.
Another significant role is that arbitrage
activities will quickly eliminate arbitrage opportunities available in the
market, thereby promoting market efficiency.
Yet again, arbitrage facilities price determination
by rapid price adjustment that eliminate any arbitrage opportunities.
Arbitrage-free prices act as a benchmark that
structures asset prices. Indeed, understanding arbitrage has practical
significance. First, the no-arbitrage principle can help in pricing new
financial products for which no market prices yet exist. Second, arbitrage can
be used to estimate the prices for illiquid assets held in a portfolio for
which there are no recent trades. Finally, no-arbitrage prices can be used as
benchmark prices against which market prices can be compared in seeking
misvalued assets.
Following are the rates of $/ Euro applicable in one
country
BUY SELL
•
BANK A $/EURO 1.3160 1.3260
•
BANK B 1.3280 1.3380
While the rates in banks of US and Germany are the
following:
BUY SELL
•
US BANK ($/EURO)
1.3160 1.3260
•
GERMANY(EURO/$) 0.7475
0.7525
a)
Is their any arbitrage opportunity within the country?
Yes
there is arbitrage opportunity within the country because one can buy from bank
A at $1.3260 and sell it to bank B at $1.3280 therefore making a profit of
$1.3280 - $1.3260 = $0.002. Note that our understanding of the word arbitrage
opportunity shows buying an item at a lower price and selling the same at a
higher price.
b)
Does arbitrage opportunity exist between US and
GERMANY?
Yes,
arbitrage opportunity exist between US and Germany because if you buy in
Germany at the rate of EUR0.7525 to US$1.00 and sell it in US 1EURO for
US$1.3160. A difference of US$0.31
Assignment ‘C’
Objective Questions
1. Find the forward rate of foreign currency Y if the
spot rate is $4.50, the domestic interest rate is 6 percent, the foreign
interest rate is 7 percent, and the forward contract is for nine months.
a) $5.104
b) none are correct
c) $4.458
d) $4.532
e)
e. $4.468
2. Margin in a futures transaction differs from margin in
a stock transaction because
a) stock transactions are much smaller
b) delivery occurs immediately in a stock transaction
c)
no money is borrowed in a futures transaction
d) futures are much more volatile
3. Most futures contracts are closed by
a) exercise
b)
offset
c) default
d) none are correct
e) delivery
4. Which of the following is not a forward contract?
a) an automobile lease non-cancelable for three years
b)
none are correct
c) a signed contract to buy a house in six months
d) a long-term employment contract at a fixed salary
e) a rain check
5. One of the advantages of forward markets is
a) none are correct
b)
the contracts are private and customized
c) trading is conducted in the evening over computers
d) performance is guaranteed by the G-30
e) trading is less costly and governed by more rules
6. Suppose you
sell a three-month forward contract at $35. One month later, new forward
contracts are selling for $30. The risk-free rate is 10 percent. What is the
value of your contract?
a) $4.55
b) $4.96
c) $4.92
d)
$5
e) none are correct
7. Futures prices differ from spot prices by which one of
the following factors?
a) the systematic risk
b) the risk premium
c) the spread
d) none are correct
e)
the cost of carry
8. An option which gives the holder the right to sell a
stock at a specified price at some time in the future is called a(n)
a. Call option.
b. Put option.
c. Out-of-the-money
option.
d. Naked option.
e. Covered
option.
9. There are call options on the common stock of XYZ
Corporation. Which of the following best
describes the factors affecting the value of these call options?
a. The price of
the call options is likely to rise if XYZ’s stock price rises.
b. The higher
the strike price on the call option, the higher the call option price.
c. Assuming the
same strike price, a call option which expires in one month will sell for a
higher price than a call option which expires in three months.
d. All of the
answers above are correct.
e. None of the answers above is correct.
10.
Which of the
following statements is correct?
a. Put options
give investors the right to buy a stock at a certain exercise price before a
specified date.
b. Call options
give investors the right to sell a stock at a certain exercise price before a
specified date.
c. Options
typically sell for less than their exercise value.
d. LEAPS are
very short-term options which have begun trading on the exchanges in recent
years.
e. Option
holders are not entitled to receive dividends unless they choose to exercise
their option.
11.
An investor who
writes call options against stock held in his or her portfolio is said to be
selling ___________ options.
a. in-the-money
b. put
c. naked
d. covered
e. out-of-the-money
12.
A commercial bank
estimates that its net income suffers whenever interest rates increase. The bank is looking to use derivatives to
reduce its interest rate risk. Which of
the following strategies best protects the bank against rising interest rates?
a. Buying
inverse floaters.
b. Entering into
an interest rate swap where the bank receives a fixed payment stream, and in
return agrees to make payments that float with market interest rates.
c. Purchase
principal only (PO) strips that decline in value whenever interest rates rise.
d. Enter into a short hedge where the bank agrees
to sell interest rate futures.
e. Sell some of
the banks floating rate loans and use the proceeds to make fixed rate loans.
13.
Company A can
issue floating rate debt at LIBOR + 1 percent and can issue fixed rate debt at
9 percent. Company B can issue floating
rate debt at LIBOR + 1.4 percent and can issue fixed rate debt at 9.4 percent. Suppose A issues floating rate debt and B
issues fixed rate debt. They engage in
the following swap: A will make a fixed 7.95 percent payment to B, and B will
make a floating rate payment equal to LIBOR to A. What are the resulting net payments of A and B?
a. A pays a
fixed rate of 9 percent, B pays LIBOR + 1.5 percent.
b. A pays a fixed rate of 8.95 percent, B
pays LIBOR + 1.45 percent.
c. A pays LIBOR
plus 1 percent, B pays a fixed rate of 9.4 percent.
d. A pays a
fixed rate of 7.95 percent, B pays LIBOR.
e. None of the
answers above is correct.
14.
Which of the
following are not ways in which risk management can increase the value of a
company?
a. Risk
management can increase debt capacity.
b. Risk
management can help a firm maintain its optimal capital budget.
c. Risk
management can reduce the expected costs of financial distress.
d. Risk management can help firms minimize taxes.
e. Risk
management can allow managers to maximize their bonuses.
15.
Which of the
following statements is most correct?
a. One advantage
of forward contracts is that they are default free.
b. Futures contracts generally trade on an
organized exchange and are marked to market daily.
c. Goods are
never delivered under forward contracts, but are almost always delivered under
futures contracts.
d. Answers a and
c are correct.
e. None of the
answers above is correct.
16.
Multinational
financial management requires that
a. The effects
of changing currency values be included in financial analyses.
b. Legal and
economic differences be considered in financial decisions.
c. Political risk
be excluded from multinational corporate financial analyses.
d. All of the
above.
e. Only a and b above.
17. If the inflation rate in the United States is
greater than the inflation rate in Sweden, other things held constant, the
Swedish currency will
a. Appreciate against the U.S. dollar.
b. Depreciate
against the U.S. dollar.
c. Remain
unchanged against the U.S. dollar.
d. Appreciate
against other major currencies.
e. Appreciate
against the dollar and other major currencies.
18.
If one Swiss
franc can purchase $0.71 U.S. dollars, how many Swiss francs can one U.S.
dollar buy?
a. 0.71
b. 1.41
c. 1.00
d. 2.81
e. 0.50
19.
If the spot rate
of the French franc is 5.51 francs per dollar and the 180-day forward rate is
5.97 francs per dollar, then the forward rate for the French franc is selling
at a ________________ to the spot rate.
a. premium of 8%
b. premium of
18%
c. discount of
18%
d. discount of 8%
e. premium of
16%
20.
Hockey skates
sell in Canada for 105 Canadian dollars.
Currently, 1 Canadian dollar equals 0.71 U.S. dollars. If purchasing power parity (PPP) holds, what
is the price of hockey skates in the United States?
a. $ 14.79
b. $ 71.00
c. $ 74.55
d. $ 85.88
e. $147.88
21.
The relationship
between the exchange rate and the prices of tradable goods is known as the:
a)
Purchasing-power-parity theory
b) Asset-markets theory
c) Monetary theory
d) Balance-of-payments theory
22.
If wheat costs $4
per bushel in the United States and 2 pounds per bushel in Great Britain, then
in the presence of purchasing-power parity the exchange rate should be:
a) $.50 per pound
b) $1.00 per pound
c)
$2.00 per pound
d) $8.00 per pound
23.
A primary reason
that explains the appreciation in the value of the U.S. dollar in the
1980s is:
a) Large trade surpluses for the United States
b) High inflation rates in the United States
c) Lack of investor confidence in the U.S. monetary
policy
d)
High interest rates in the United States
24.
When the price of
foreign currency (i.e., the exchange rate) is above the equilibrium
level:
a) An excess
supply of that currency exists in the foreign exchange market
b) An excess demand for that currency exists in the
foreign exchange market
c) The supply of foreign exchange shifts outward to the
right
d) The supply of foreign exchange shifts backward to the
left
25.
The international
exchange value of the U.S. dollar is determined by:
a) The rate of inflation in the United States
b) The number of dollars printed by the U.S. government
c)
The international demand and supply for dollars
d) The monetary value of gold held at Fort Knox, Kentucky
26.
Which
of the following is an example of foreign exchange?
a) Exchange of cash issued by a foreign
central bank.
b) Exchange of claims denominated in another
currency.
c)
Exchange
of bank deposits.
d) All
of the above.
27.
Which
of the following are usual suppliers of Euros?
a) US foreign investors remitting profits.
b) European direct investors.
c) US exporters.
d)
All of the above.
28.
The
vast majority of large-scale foreign exchange transactions in the US are:
a) done through foreign exchange brokers.
b) done through Morgan-Chase and Deutsche Bank
of America.
c)
done through Interbank.
d) done through the Chicago Mercantile
Exchange
29.
If a
company contracts today for some future date of actual currency exchange, they
will be making use of a:
a) stock rate.
b) variable rate.
c) futures rate.
d)
forward rate.
30.
Which
of the following might affect the cost of a trip to Japan by a resident of
Britain?
a) The depreciation of the Euro.
b) The
time at which the British resident purchases Yen.
c) The depreciation of the US dollar.
d) All of the above.
31.
A
company that functions to unite sellers and buyers of foreign
currency-denominated bank deposits is called:
a)
a broker.
b) an investor.
c) a wholesaler.
d) a bank
32.
_____________
contracts are more widely accessible to firms and individuals than ____________
contracts.
a)
Futures; forward
b) Forward; futures
c) Forward; arbitrageur
d) Arbitrageur; forward
33.
If
the euro dollar deposit rate is 3% per year and the euro-euro rate is 6% per
year, by how much will the euro be expected to devalue in the coming year?
a) 0.3%
b) 2.0%
c)
2.9%
d) 3.0%
34.
According
to which theory will differences in nominal interest rates be eliminated in the
exchange rate?
a) The PPP.
b)
The Fisher effect.
c) The Leontief paradox.
d) The combined equilibrium theory.
35.
If
inflation goes up in the US relative to other countries, it is expected that
the price of the US dollar will:
a) increase.
b) remain the same.
c)
fall.
d) may increase or decrease.
36.
Which
of the following is an exchange risk management technique through which the
firm contracts with a third party to pass exchange risk onto that party, via
instruments such as forward contracts, futures, and options?
a) Diversification.
b) Risk avoidance.
c) Risk
transfer.
d) Risk adaptation.
37.
What
is the base interest rate paid on deposits among banks in the eurocurrency
market called?
a) INEC.
b) EUIN.
c) LIBOR.
d) INEU.
38.
Which of the
following contract terms is not set by the futures exchange?
a) the price
b) the
deliverable commodities
c) the dates on which delivery can occur
d) d. the size of the contract
e) e. the expiration months
39.
Which one is the
best derivative instrument according to you?
a) Forwards
b) Futures
c)
Options
d) Swap
40.
What does premium
mean?
a) Reduction in the contract value
b)
Increase in the contract value
c) Constant value of the contract price
d) None of these.
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