Foreign Exchanges

Note: This covers both Chapters 16 & 17 of Pugel's 

Overview

The purpose of chapter 16 is to present the foreign exchange market and exchange rates, with an emphasis on spot exchange rates. Foreign exchange is the act of trading different countries' moneys. An exchange rate is the price of one money in terms of another. The spot exchange rate is the price for "immediate" exchange. The forward exchange rate is the price agreed to today for exchanges that will take place in the future.

An exchange rate is confusing because there is no natural way to quote the price. The text adopts the convention of quoting the rate as the price of foreign currency-units of the home currency per unit of foreign currency. (The currency that is being priced by the rate is in the denominator.)

At the center of the foreign exchange market are a group of banks that use telecommunications and computers to conduct trades with their customers (the retail part of the market) and with each other (the interbank part of the market). Most foreign exchange trades are conducted by exchanging ownership of demand deposits denominated in different currencies.

We can picture the foreign exchange market by using demand and supply curves. Exports of goods and services and capital outflows (as well as income payments to foreigners) create a demand for foreign currency, as payments for these items typically require that at some point in the payment process the home currency is exchanged for the foreign currency to pay for the items that the home residents are buying. Imports of goods and services and capital inflows (as well as income received from foreign sources) create a supply of foreign currency, as payments for these items typically require that at some point in the payment process the foreign currency is exchanged for the home currency to pay for the items that the foreign residents are buying.

The text explains the downward slope of the demand curve for foreign currency through changes in the dollar price of products that the home country might buy from the foreign country, as the going spot exchange rate changes. (The text assumes that the supply curve slopes upward, without much discussion at this point. The details of how values of exports and imports respond to changes in the exchange rate are deferred until the end of Chapter 22.)

In a floating exchange rate system without intervention by monetary authorities, the equilibrium is at the intersection of the demand and supply curves, where the curves show all private (or nonofficial) demand and supply. The floating exchange rate changes as demand and supply curves shift over time.

In a fixed exchange rate system, government officials declare that the exchange rate should be a certain level, usually within a small band around a par value. We can still use demand and supply to analyze this system. If the equilibrium rate that the market would set on its own (shown by the intersection of the private or nonofficial demand and supply curves) is outside of this band, then the officials must do something to prevent the actual rate from moving outside of the band. We focus on defense through official intervention-the officials must buy or sell foreign currency (in exchange for domestic currency) to keep the exchange rate within (or at the edge) of the band. This can be pictured as filling the gap between nonofficial supply and demand at the support-point exchange rate. (The intervention could also be pictured as shifting the overall supply or demand curve-each overall curve would include both nonofficial and official supply or demand-so that the new intersection occurs at the support point.)

Chapter 16 concludes by introducing the two different kinds of arbitrage that can occur using the spot foreign exchange market. The simpler form is arbitrage of the same exchange rate between two locations. This arbitrage assures that, at a particular time, the same exchange rate is essentially the same value in different locations (at least within a small range that reflects transactions costs). The more complicated form is triangular arbitrage -- profiting from misalignments among two exchange rates against a common currency (usually the dollar, which is the vehicle currency in the market) and the cross-rate between the other two currencies (for instance, pounds and Swiss francs). This type of arbitrage assures that the cross-rate essentially equals the ratio of the other two exchange rates.

Chapter 17 -- Forward exchange

This chapter is intended to present the uses of forward foreign exchange rates and the returns and risks of international financial investments, both covered and uncovered.

It begins by noting that in many situations people or organizations are exposed to exchange rate risk, because the value of the individual's income, wealth, or net worth changes when exchange rates change unexpectedly in the future. A net asset position in the foreign currency is called a long position; a net liability position is called a short position. Some individuals want to reduce their risk exposure by hedging -- an action to reduce a net asset or net liability position in a foreign currency. Other individuals may actually want to take on risk exposure in order to profit from exchange rate changes, by speculating -- an action to take on a net asset or net liability position in a foreign currency.

A forward foreign exchange contract is an agreement to exchange a certain amount of one currency for a certain amount of another currency on some date in the future, with the amounts based on the price (forward exchange rate) set when the contract is entered. Because the forward exchange contract establishes a position in foreign currency, it can be used to hedge or to speculate.

A key conclusion from the use of forward foreign exchange contracts to speculate is that the pressures on the supply and demand of forward foreign exchange should drive the forward exchange rate to equal the average expected value of the future spot exchange rate. (Also, a forward foreign exchange contract is a kind of derivative contract based on exchange rates. A box in the text discusses other foreign-exchange contracts currency futures, options, and swaps.)

International financial investment has grown rapidly in recent decades. Decisions about international investments depend on both returns and risks. The text focuses on calculating returns. It also discusses risks, including mention of risk as a portfolio issue (although a full treatment of international portfolio diversification is not provided).

An investor who calculates her wealth and returns in her home currency can easily calculate returns on investments denominated in her own currency. Investments in foreign currency-denominated assets are a bit more complicated. She must first convert her own currency into the foreign currency at the spot exchange rate. Then she uses this foreign currency to buy the foreign asset, and earns returns in foreign currency. Then, she must convert this foreign currency in the future back into her own currency (either actually or simply to determine the value of her wealth). She could contract now for the future currency conversion using a forward exchange contract, in which case she has a covered international investment, and she is hedged against exchange rate risk. Or, she can wait until the future and convert currencies at the spot exchange rate that exists at that date in the future, in which case she has an uncovered international investment, and she is exposed to exchange rate risk.

An investor can compare the return on a covered international investment to the return on a home investment using the covered interest differential (CD). The exact expression is CD = (I + if)-rf/rs  - (1 + i), where the i's are the foreign (subscript f) and domestic interest rates and the r's are the forward (subscript f) and spot (subscript s) exchange rates. A useful approximation is CD = F + (if - i), where F is the forward premium (discount if negative) on the foreign currency. 

If CD is not zero (or within a small range close to zero, determined by transactions costs), then international investors can engage in covered interest arbitrage -- buying a country's currency spot and selling it forward, while making a net profit from the combination of the interest rate difference and the forward premium or discount. Because covered interest arbitrage is essentially riskless (as long as there is no threat of exchange controls or similar government impediments), this arbitrage should drive the covered differential to be essentially zero -- covered interest parity. Covered interest parity links four current market rates together − the forward exchange rate, the spot exchange rate, and the interest rates in the two countries. If one of these rates changes, then at least one other also must change to reestablish covered interest parity.

At the time that an investor makes the investment, he can calculate the return expected on an uncovered international investment using the spot exchange rate that he expects to exist in the future. He can compare this expected return to the return on a home investment using the expected uncovered interest differential (EUD). The exact expression is EUD = (1 + if).rse/rs - (1 + i), where rse is the expected future spot exchange rate. A useful approximation is that EUD equals the expected rate of appreciation (depreciation if negative) of the foreign currency plus the interest differential (if - i). .

An uncovered international investment is exposed to exchange rate risk. Nonetheless, the investor may still undertake the uncovered investment, because the expected return is high enough to compensate for the risk, or, more subtly, because the uncovered investment may actually reduce the risk of the investor's overall portfolio because of the benefits of diversification of investments. If risk considerations are small, then investors will shift toward investments with higher (expected) returns. Demand-supply pressures on market rates will drive rates to eliminate the return differential, so that the uncovered interest differential is essentially zero-uncovered interest parity.

The final section of the chapter presents some evidence on whether the various parity conditions actually hold. Covered interest parity holds well between currencies of countries whose governments permit free movements of international capital. It is more difficult to test uncovered interest parity, because we cannot observe the expected future spot exchange rate in the market. (If we use the forward rate as an indicator of the expected future spot exchange rate, then we are really just testing covered interest parity.) Indirect tests of covered interest parity suggest that it does not hold as tightly as covered interest parity. While divergences from uncovered interest parity could simply indicate risk premiums to compensate for exposure to exchange rate risk, some studies suggest that the deviations are larger than seem necessary to compensate for such risk. Instead, expectations of future spot exchange rates seem to be biased. Such an apparent bias would not be troubling if market participants are correctly anticipating the probability of a large shift in the exchange rate at some time in the future (even if the rate does not actually change). The apparent bias is troubling if it reflects consistent errors, implying inefficiency in the foreign exchange market.

Key Terms

Appreciation/depreciation An increase (decrease) in the market price of a currency under a floating exchange rate system.
Clearing Permitting payments to be made between entities who want to hold or use different currencies.
Covered interest arbitrage Buying a country's currency spot and selling it forward to make a net profit off the combination of higher interest rates in the country and any forward premium on its currency.
Covered interest parity  The condition where the forward rate on a currency exceeds the spot rate by the percentage that its interest rate is lower than the other country's interest rate.
Covered international investment When the exchange rate at which anticipated foreign investment returns will be redeemed is determined in the present through a forward contract. The agent is protected from exchange rate risk when "covered."
Currency futures Contracts to buy or sell a foreign currency on a specific date in the future at a price set today. In this sense, futures are exactly like forward exchange contracts. The difference lies in their form. While forward contracts are tailored to the needs of the customer in terms of amount of funds, due date of contract, and so on, futures contracts have standardized denominations and due dates. As a consequence they can be traded in organized markets such as the Chicago Mercantile Exchange. Almost anyone with some up-front funds can enter into a futures contract; only very large firms get forward contracts from their banks.
Currency options A currency options contract gives parties the right (but not the requirement) to buy/sell foreign exchange in the future at a price set today. If someone purchases a call option she buys the right to obtain the currency at the strike price at a given date in the future. A person purchasing a put option buys the right to sell the currency at the strike price. A person expecting foreign currency to become pricier in the future might buy a call option; a person expecting the currency to fall in value might buy a put option.
Currency swaps A contract to buy/sell a currency now with a provision that the currency will be resold (or brought back) later. Often used by large corporations in financing debt.
Exchange rate risk When the value of an economic agents' income, wealth, or net worth changes as exchange rates change unpredictably in the future.
Fixed exchange rate A rate whose officially declared value is maintained by central bank intervention. (Also referred to as a pegged exchange rate.)
Floating exchange rate A rate whose value is determined purely by the market forces of supply and demand, with no direct intervention of the central bank. (Also referred to as a flexible exchange rate.)
Foreign exchange market A computerized communications network embracing all the major financial centers in the globe, where sellers and buyers of any national money can quickly and efficiently carry out any desired currency exchange.
Foreign exchange market intervention The act or policy of buying and selling foreign exchange on the  part of the central bank in order to manipulate or peg the exchange rate.
(Foreign) exchange rate The price of one country's currency expressed in terms of another country's currency. (Note that in this text, the exchange rate is expressed in terms of domestic currency units required to purchase one unit of a foreign currency.)
Forward exchange contract  An agreement to buy/sell a foreign currency for future delivery at a price set now (the "forward exchange rate").
Forward exchange rate: The exchange rate applicable to foreign exchange transactions agreed upon today for later delivery (usually in 30, 90, or 180 days).
Future spot rate The spot exchange rate that will end up prevailing at some date in the future.
Hedging The act of exactly matching assets and liabilities, such as foreign currencies, so as to avoid exchange rate risk.
Long position A net asset position (e.g., owning a foreign currency).
Revaluation (devaluation) An official increase (decrease) in the par value of a currency under a fixed exchange rate system.
Short position A net liability position (e.g., owing a foreign currency).
Speculation Deliberately assuming a net asset (long) position or net liability (short) position in an asset, such as a foreign currency, in the hope of profiting from price changes.
Spot exchange rate The (past, current, or future) rate applicable to foreign exchange transactions requiring contemporaneous delivery.
Uncovered interest parity When the expected rate of appreciation of a currency equals the percentage point amount by which its interest rate is lower than the other country's interest rate.
Uncovered international investment When the exchange rate at which anticipated foreign investment returns will be redeemed is not determined until the trade occurs at the future spot rate. The agent is exposed to exchange rate risk when "uncovered."
Vehicle currency A currency used to accomplish an indirect trade between two other currencies. The U.S. dollar is often used as a vehicle currency.

 True or False? Explain

1. T / F An increase in U.S. imports from France will give rise to a supply of francs in exchange for dollars.

2. T / F Central bank intervention is more prevalent under the floating exchange rate system than under a pegged exchange rate system.

3. T / F If Americans suddenly refuse to lend money to Mexico, we would expect the dollar to appreciate relative to the peso.

4. T / F Art appreciation courses have nothing to do with exchange rates.

5. T / F If a currency is undervalued in a fixed exchange rate system, officials from that country's central bank will have to sell their currency to keep it pegged.

ANSWER: False (to purchase the imports, we supply dollars in exchnage for francs), False ( intervention is more prevalent under pegged rate), True, True (unless you are Swiss and are bidding at Sotheby's), True.

True or False? Explain

1. T / F The forward exchange rate is the same as the future spot rate.

2. T / F Speculating means taking only a short position, not a long position.

3. T / F If German interest rates are higher than American interest rates, we would expect the DM to be at a forward discount relative to the dollar.

4. T / F Hedgehogs are afraid of risk.

5. T / F If a speculator believes that the future spot rate on the British pound will be higher than the current forward rate, the speculator will buy the pound forward.

ANSWER: False (the forward rate may approximate what investors think the future spot rate will be, but the actual future spot rate will be what it will be); False (speculation may occur through both short and long positions); True; False (at least in so far as you can see many flattened hedgehogs along the roads in England); True.

Multiple Choice

1. If the exchange rate between the Canadian dollar (C$) and the American dollar (U$) changes from C$1.340/U$ to C$1.325/U$, but the Canadian government wants to maintain a fixed exchange rate of C$1.340/U$. What should the Bank of Canada do?

A. Stop trading with the U.S. so that fewer U.S. dollars will flow into Canada.
B. Sell U.S. dollars (buy Canadian dollars).
C. Sell Canadian dollars (buy U.S. dollars).
D. Purchase British pounds and sell French francs.

2. If a dollar equals 400 Mexican pesos in the foreign exchange market, what is the value of one peso?

A. $250
B. $0.0025
C. $0.04
D. $1.25
E. None of the above.

3. Which of the following statements is false?

A. British imports of Florida oranges will create a demand for U.S. dollars.
B. If all Americans buy German cars the dollar will appreciate relative to the mark.
C. The American dollar is often used as a vehicle currency.
D. Australia, Canada, New Zealand and Taiwan all use currencies called "dollars."

4. When American residents buy bonds from Her Majesty's Treasury in London, in the foreign exchange market it leads to:

A. A demand for American dollars.
B. A supply of British pounds.
C. A supply of American dollars.
D. Another Boston Tea Party.

5. The demand curve for foreign currency slopes downward because:

A. At lower exchange rates foreign goods look cheaper to home country residents.
B. At higher exchange rates the home currency can buy more foreign goods.
C. The quantity supplied of the foreign currency rises as the exchange rate falls.
D. Marginal utility theory says that individuals substitute into any commodity whose price has fallen.

 

ANSWER: C, B, B, C, A

Multiple Choice  on Forward:

1. Suppose an American speculator anticipates the spot rate on the yen in 180 days will be higher than today's 180-day forward rate on yen ($0.0072). Which of these investments is best if she is right?

A. Sell one million yen today in the forward market for delivery in 180 days.
B. Buy one million yen today in the forward market for delivery in 180 days.
C. Buy dollars today in the spot market.
D. Buy dollars today in the forward market for delivery in 180 days.

2. Covered interest parity is a condition where:

A. The forward value of a currency will tend to exceed its spot value by the same percentage as its interest rates are lower than foreign interest rates.
B. The spot value will tend to exceed its forward value by the same percentage as its interest rates are lower than foreign interest rates.
C. The domestic and foreign interest rates are equalized.
D. The spot and forward rates are equalized.

3. Suppose you are an established speculator with an excellent reputation, but currently without liquid funds. You believe the dollar is going to rise again. What would you do?

A. Borrow dollars in the U.S. and sell the dollars in the spot exchange market.
B. Buy foreign (nondollar) currencies forward.
C. Sell foreign (nondollar) currencies forward.
D. Borrow yen in Japan and sell them on the spot market.

4. If today's spot rate on the British pound is $2 and the one-month forward rate on the pound is $2.10 (ignoring any interest earnings or costs), then a speculator who:

A. Purchased 100 British pounds forward today will make $10 profit in one month.
B. Purchased 100 British pounds spot today will make $10 profit one month from now.
C. Sold 100 British pounds forward today will make £10 profit one month from now.
D. Sold 100 British pounds spot today will make £10 profit one month from now.
E. None of the above.

5. Assume the interest rate in the U.S. exceeds Japan's by 4 percentage points on an annual basis. If you were a speculator, you would take a long; position in yen if:

A. The yen's value is expected to increase by two percentage points on an annual basis. 
B. The value of the yen is expected to fall by four percentage points.
C. The value of the yen is expected to fall by less than four percentage points.
D. The value of the dollar is expected to fall by more than four percentage points.

ANSWER: B, A, C, B, D.

Problems

Problem 1.

The currency of Leinster is the Leinster lira (LI); the currency of Saxony is the Saxon scudo (Ss). Consider the following diagram of the foreign exchange market in Saxony:

a. What is the equilibrium price of one Leinster lira in Saxony?
b. Can you also determine what the equilibrium price of the Saxon scudo is in Leinster?
c. Suppose a doctor in Leinster shows that eating Saxon bread can reduce the level of cholesterol in one's blood. What would you expect to happen to the exchange rate between lira and scudos in a floating exchange rate system?

d. If the Saxon finance minister had wanted to peg the exchange rate at the value you determined in (a), what must she do to counteract the impact on the exchange rate of the event described in (c)?

Problem 2. Suppose that the Saxon scudo appreciates relative to the Leinster lira. Determine whether the economic agents listed below would see that appreciation as a good or bad thing:

a. Someone who imports goods priced in scudos.
b. Someone who exports goods priced in scudos.
c. Someone who exports goods priced in lira.
d. Someone who has a retirement account denominated in scudos.
e. Someone who expected the lira to depreciate.

Problem 3.

For the most part, the exchange rate between U.S. dollars and the French franc is floating. What effect will each of the following events have on the $/F exchange rate?

a. The French government bans the import of American movies.
b. Americans learn drinking French red wine will prevent heart disease.
c. An American mutual fund purchases stock in Renault.
d. Parisian terrorists buy chemicals from a company in New Jersey.
e. New York foreign exchange speculators believe the French franc is going to depreciate in the next few hours.

Problem 4.

Assume that U.S. government officials are trying to keep the exchange rate between the dollar and the French franc pegged. For each of the events described in Problem 3, what actions must these officials take to return the exchange rate to its previous level?

Problem 5

You have been given one million yen to play with. Use the following exchange rates to show how you can make a riskless profit in terms of yen:

1 German mark = 70 yen in Munich
1 yen = 1 American penny in Tokyo
1 American dollar = 3 German marks in New York City.

Problems on Forward Exchanges:

Problem 1

Imagine you are a student who also works in your parents' bakery in Saxony. You have just shipped a load of bread to Leinster and are supposed to be paid LI 10,000 in 60 days. You observe the forward rate on the Leinster lira is Ss 95/Ll. You also guess that the spot rate may vary between Ss 85 / LI and Ss 105/LI over the next 60 days.

a. If you decide to lock in the exchange rate with a forward contract, how many Saxon scudos will you receive in 60 days?
b. If, instead, you decide to wait to sell the Leinster lira at the spot rate which will prevail in 60 days, how much could you gain compared to the assured return in (a)? How much could you lose compared to the assured return in (a)?
c. What will determine which option you choose?

Problem 2

(Sometime later ...) You have graduated to become a Saxon economist, and the finance minister of Saxony has asked you to consider the following information:

• The annual interest rate on 180-day government bonds in Saxony is 8 percent. The interest rate on similar bonds in Leinster is 6 percent.
• In today's exchange markets, the spot rate is Ss 100 / LI; the 180-day forward rate is Ss 110/Ll.

a. Will funds be more likely to flow from Saxony to Leinster or vice versa?
b. What will be the impact of these funds flows on the spot and forward exchange rates?
c. Assuming rigidity in the forward rate and in interest rates, at what spot exchange rate will investors be indifferent regarding whether they put their funds in Leinster or in Saxony?

Problem 3

(Much later ...) Despite the finance minister's protests you decide to become a foreign exchange speculator in your spare time. You observe that the 180-day forward rate on the Leinster lira is Ss 100/ LI. Based on all the information you have collected, you expect that in 180 days the lira will have appreciated to Ss 120/ LI.

a. Based on your expectations how would you use the forward foreign exchange market to try to earn a profit in Saxon scudos.
b. What will determine whether or not you actually make a profit?
c. If there are many speculators in Leinster and Saxony, all acting on their expectations, what does this tell you about the relationship between the forward rate and the future spot rate?

Problem 4

You have retired from government service in Saxony and now spend your time thinking deep economic thoughts for your own amusement. You notice the following information in the newspaper:

• Interest on one-year Saxon government bonds = 8 percent.
• Interest on one-year Leinster government bonds = 6 percent.
• Current spot rate on the Leinster lira = Ss 100/ LI. Furthermore, during your deep thinking you have formed the expectation that the spot rate on the Leinster lira is going to rise to 102 Ss/ LI by the end of the year.

a. Does uncovered interest parity hold?
b. If not, at what current spot rate would the expected uncovered differential be zero?
c. How might the current spot rate be driven to this new level?

Problem 5

Consider the following information from today's edition of the Greed Gazette (you may assume that all data is of the same periodicity):

• UK interest rate = 7 percent.
• U.S. interest rate = 4 percent.
• Spot exchange rate = $2 / £
• Forward exchange rate = $1.95 / £

a. If you have $100 to play with, explain how can you make the most money. In particular, should you invest in the U.S. or the U.K.?
b. At what forward rate do you earn zero profits and have no incentive to play this game?

 

Suggested answers to questions and problems (in the textbook)

2.

Exports of merchandise and services result in supply of foreign currency in the foreign exchange market. Domestic sellers often want to be paid using domestic currency, while the foreign buyers want to pay in their currency. In the process of paying for these exports, foreign currency is exchanged for domestic currency, creating supply of foreign currency. International capital inflows result in a supply of foreign currency in the foreign exchange market. In making investments in domestic financial assets, foreign investors often start with foreign currency and must exchange it for domestic currency before they can buy the domestic assets. The exchange creates a supply of foreign currency. Sales of foreign financial assets that the country's residents had previously acquired, and borrowing from foreigners by this country's residents are other forms of capital inflow that can create supply of foreign currency.

4.

The U.S. firm obtains a quotation from its bank on the spot exchange rate for buying yen with dollars. If the rate is acceptable, the firm instructs its bank that it wants to use dollars from its dollar checking account to buy 1 million yen at this spot exchange rate. It also instructs its bank to send the yen to the bank account of the Japanese firm. To carry out this instruction, the U.S. bank instructs its correspondent bank in Japan to take 1 million yen from its account at the correspondent bank and transfer the yen to the bank account of the Japanese firm. (The U.S. bank could also use yen at its own branch if it has a branch in Japan.)

6.

The trader would seek out the best quoted spot rate for buying euros with dollars, either through direct contact with traders at other banks or by using the services of a foreign exchange broker. The trader would use the best rate to buy euro spot. Sometime in the next hour or so (or, typically at least by the end of the day), the trader will enter the interbank market again, to obtain the best quoted spot rate for selling euros for dollars. The trader will use the best spot rate to sell her previously acquired euros. If the spot value of the euro has risen during this short time, the trader makes a profit.

8.

a. The cross rate between the yen and the krone is too high (the yen value of the krone is too high) relative to the dollar-foreign currency exchange rates. Thus, in a profitable triangular arbitrage, you want to sell kroner at the high cross rate. The arbitrage will be: Use dollars to buy kroner at $0.20/krone, use these kroner to buy yen at 25 yen/krone, and use the yen to buy dollars at $0.01/yen. For each dollar that you sell initially, you can obtain 5 kroner, these 5 kroner can obtain 125 yen, and the 125 yen can obtain $1.25. The arbitrage profit for each dollar is therefore 25 cents. b. Selling kroner to buy yen puts downward pressure on the cross rate (the yen price of krone). The value of the cross rate must fall to 20 (=0.20/0.01) yen/krone to eliminate the opportunity for triangular arbitrage.

10.

a. The increase in supply of Swiss francs puts downward pressure on the exchange-rate value ($/SFr) of the franc. The monetary authorities must intervene to defend the fixed exchange rate by buying SFr and selling dollars.

b. The increase in supply of francs puts downward pressure on the exchange-rate value ($/SFr) of the franc. The monetary authorities must intervene to defend the fixed exchange rate by buying SFr and selling dollars.

c. The increase in supply of francs puts downward pressure on the exchange-rate value ($/SFr) of the franc. The monetary authorities must intervene to defend the fixed exchange rate by buying SFr and selling dollars.

d. The decrease in demand for francs puts downward pressure on the exchange-rate value ($/SFr) of the franc. The monetary authorities must intervene to defend the fixed exchange rate by buying SFr and selling dollars.

Suggested answers to questions and problems (in the textbook) on FORWARD EXCHANGES

2.

You will need data on four market rates: The current interest rate (or yield) on bonds issued by the U.S. government that mature in one year, the current interest rate (or yield) on bonds issued by the British government that mature in one year, the current spot exchange rate between the dollar and pound, and the current one-year forward exchange rate between the dollar and pound. Do these rates result in a covered interest differential that is very close to zero?

4.

a. The U.S. firm has an asset position in yen-it has a long position in yen. To hedge its exposure to exchange rate risk, the firm should enter into a forward exchange contract now in which the firm commits to sell yen and receive dollars at the current forward rate. The contract amounts are to sell 1 million yen and receive $9,000, both in 60 days.

b. The student has an asset position in yen-a long position in yen. To hedge the exposure to exchange rate risk, the student should enter into a forward exchange contract now in which the student commits to sell yen and receive dollars at the current forward rate. The contract amounts are to sell 10 million yen and receive $90,000, both in 60 days.

c. The U.S. firm has an liability position in yen-a short position in yen. To hedge its exposure to exchange rate risk, the firm should enter into a forward exchange contract now in which the firm commits to sell dollars and receive yen at the current forward rate. The contract amounts are to sell $900,000 and receive 100 million yen, both in 60 days.

6.

Relative to your expected spot value of the euro in 90 days ($1.22/euro), the current forward rate of the euro ($1.18/euro) is low-the forward value of the euro is relatively low. Using the principle of "buy low, sell high," you can speculate by entering into a forward contract now to buy euros at $1.18/euro. If you are correct in your expectation, then in 90 days you will be able to immediately resell those euros for $1.22/euro, pocketing a profit of $0.04 for each euro that you bought forward. If many people speculate in this way, then massive purchases now of euros forward (increasing the demand for euros forward) will tend to drive up the forward value of the euro, toward a current forward rate of $1.22/euro.

8.

a. The Swiss franc is at a forward premium. Its current forward value ($0.505/SFr) is greater than its current spot value ($0.500/SFr).

b. The covered interest differential "in favor of Switzerland" is ((1 + 0.005).(0.505) / 0.500) - (1 + 0.01) = 0.005. (Note that the interest rate used must match the time period of the investment.) There is a covered interest differential of 0.5% for 30 days (6 percent at an annual rate). The U.S. investor can make a higher return, covered against exchange rate risk, by investing in SFr-denominated bonds, so presumably the investor should make this covered investment. Although the interest rate on SFr-denominated bonds is lower than the interest rate on dollar-denominated bonds, the forward premium on the franc is larger than this difference, so that the covered investment is a good idea.

c. The lack of demand for dollar-denominated bonds (or the supply of these bonds as investors sell them in order to shift into SFr-denominated bonds) puts downward pressure on the prices of U.S. bonds-upward pressure on U.S. interest rates. The extra demand for the franc in the spot exchange market (as investors buy SFr in order to buy SFr-denominated bonds) puts upward pressure on the spot exchange rate. The extra demand for SFr-denominated bonds puts upward pressure on the prices of Swiss bondsdownward pressure on Swiss interest rates. The extra supply of francs in the forward market (as U.S. investors cover their SFr investments back into dollars) puts downward pressure on the forward exchange rate. If the only rate that changes is the forward exchange rate, this rate must fall to about $0.5025/SFr. With this forward rate and the other initial rates, the covered interest differential is close to zero.

10.

In testing covered interest parity, all of the interest rates and exchange rates that are needed to calculate the covered interest differential are rates that can be observed in the bond and foreign exchange markets. Determining whether the covered interest differential is about zero (covered interest parity) is then straightforward (although some more subtle issues regarding timing of transactions may also need to be addressed). In order to test uncovered interest parity, we need to know not only three rates-two interest rates and the current spot exchange rate-that can be observed in the market, but also one rate-the expected future spot exchange rate-that is not observed in any market. The tester then needs a way to find out about investors' expectations. One way is to ask them, using a survey, but they may not say exactly what they really think. Another way is to examine the actual uncovered interest differential after we know what the future spot exchange rate actually turns out to be, and see whether the statistical characteristics 'of the actual uncovered differential are consistent with an expected uncovered differential of about zero (uncovered interest parity).