Thomas A. Pugel： Understanding F

【Forward Exchange Inference】

文莱帝国酒店.jpg

Many international activities lead to money exchange of future, and it is true of many global economical activities, whose payments are not due until sometime in the usually near future. It examines future exchanges of moneys in exposure to the risks of uncertain future exchange rates.

• Exchange-Rate Risk

Exchange rates change over time. In a floating-rate system, spot exchange rates change from minute to minute because supply and demand are constantly in flux. In a fixed-rate system, spot exchange rates also can change from minute to minute, however a range of the rate is typically limited to a small band spinning the par value as long as the fixed rate is defended successfully by the government authorities.

A person is expressed to exchange-rate risk if the value of the person's income, wealth, or net worth changes when exchange rates change unpredictably in the future. If you take a vacation in Japan and take U.S. dollars along with you to convert into yen as needed to pay for your expenses and purchases, one is exposed to exchange-rate risk. The dollar value of the things that you buy and the number of things that you can afford to do will be affected by the dollar-yen exchange rates during your vacation. While you have some expectation of what exchange rates will be, actual rates will probably be different.

From your viewpoint, the risk is that the yen could appreciate substantially so that it would take more dollars to obtain same number of the yen. The dollar prices of the things that you want to do and buy will be higher, you will enjoy your vacation less. Of course, yen might instead depreciate, in this case you will be pleasantly surprised by the increased buying power in dollars. Very broadly, in your vacation you are exposed to an exchange-rate risk since you do not know what will happen to the yen during your vacation.

Some people do not want to gamble on what exchange rates will be in the future. They have acquired exposures to exchange-rate risk of course of their regular activities, but they seek to reduce or eliminate their risk exposure by hedging. Hedging a position exposed to rate risk, here exchange-rate risk, is acts of reducing or eliminating a net asset or net liability position in the foreign currency. Other people, thinking they have an idea of what will happen to exchange rates, are quite willing to gamble on what exchange rates will be in the future. They prefer to bet that the rates are going to move in their favor so that they make a profit.

Speculating is a choice of taking a net asset position or a net liability position of asset, here a foreign currency. As a matter of fact, you might choose to behave as a hedger in some situations and as a speculator in others.

• The Market Basics of Forward Foreign Exchange

For larger transactions involving international trade in goods and services, international financial investment, or speculation on future exchange-rate movements, forward foreign exchange and forward exchange rates are often useful. A forward foreign exchange contract is an agreement to exchange of currency for another on some date on future at a price set now the forward exchange rate. Banks acting as foreign exchange dealers could meet effective needs of their customers in specific size of the forward exchange contract and specific future date in exchange.

Common dates for future exchange are 30,90,and 180 days forward (one, three, and six months). Don’t confuse forward rate towards future spot rate, the spot rate that ends up with prevailing 90 days from now. The actual spot price of sterling that exists in 90 days could be above, below, or equal to their forward rate. In this respect, a forward exchange rate is like a commodity futures price or a hotel reservation.

-- Hedging using forward foreign exchange

Hedging involves acquiring an asset in a foreign currency to offset a net liability position already held of foreign currency, or acquiring a liability in a foreign currency to offset a net asset position already held. Hedgers in international dealings are persons who have a home currency and seek a balance between the liabilities and assets in foreign currencies.

In financial jargon, hedging means reducing both kinds of "open" positions in a foreign currency-both long positions holding net assets in the foreign currency and short positions owing more of the foreign currency than one holds.

An American who has completely hedged a position in € has ensured that the future of the exchange rate between dollars and euros will not affect his net worth. Hedging is perfectly normal kind of behavior, especially for people whose main business is not international finance. Simply avoiding any net commitments in a foreign currency saves of time and trouble of keeping abreast of fast-changing international currency conditions.

-- Speculating using forward foreign exchange

Speculating means committing oneself to an uncertain future value of one's net worth in terms of home currency. A rich imagery surrounds the term speculator. Speculators are usually portrayed as a class apart from the rest of humanity. These speculators are viewed as being excessively greedy-unlike us, of course. They are also viewed as exceptionally jittery and as adding an element of subversive chaos to the economic system. They come out in the middle of storms-we hear about them when the markets are veering out of control, and then it is their fault. Although speculation has played such a sinister role, it is an open empirical question whether it does so frequently.

More to the present point, we must recognize that the only concrete way of defining speculation is the broad way just offered. A speculator is anybody who is willing to take a net position in a foreign currency, whatever his expectations about the future of the exchange rate. There is nothing necessarily sinister about this. Still, banks and other international financial players often claim that they invest while others speculate, implying that the latter action is more risky and foolhardy. Yet there is no clear difference here. Any investment that is exposed to exchange-rate risk has speculative element to it.

The lake diagram of Currency.jpg

• International Financial Investment

Decisions about international investments are based on overall returns and risks of available investment alternatives. How do we calculate returns of assets denominated in other currencies? What are the sources of risk that apply specifically or especially to foreign investments? Can the investor hedge exposure to the exchange-rate risk?

Consider an investor who holds dollars now and plans to end up a year from now also holding dollars or, at least, who calculates her wealth and returns in dollars. There are two major points, and the correspond to our concepts of hedging and speculation. First, she can contract now for the exchange of pounds back into dollars at the one-year forward exchange rate using the forward exchange contract. Her pound liability in the forward contract matches her pound asset position, so she has hedged her exposure to exchange-rate risk. She has a hedged or covered international investment. Second, she might wait and convert back into dollars at the future spot exchange rate, the one that will exist a year from now. She does not know for sure what this future spot exchange rate will be, so her investment is exposed to the exchange-rate risk. This non-hedged investment has one speculative element to it, and it is called an uncovered side.

• International Investment with Cover

Studying how one gets from any corner to any other for any purpose, you will find that the choice of the more expressions. Suppose we want to convert present dollars into future dollars. We could route our money through Britain, buying pounds in the spot market, obtaining 1/e pounds for each dollar. We could then invest these pounds at interest and have (1+i_{UK})/e pounds at maturity for each initial dollar. At the time of the investment we also sell the upcoming pounds in the forward market at the rate of f to get an ensured number of dollars in the future. Overall, this yields (1+i_{UK}) * f/e future dollars for every dollar invested now. Or we could simply invest our money at interest in America, getting (1+i_{UK}) future dollars for every present dollar. Which road we should take depends on the sign of the difference between the two returns.

The difference is sometimes called the covered interest differential (CD): CD=(1+i_{UK}) * f/e - (1+i_{US}) .

If the covered interest differential is positive , one is better off investing in Britain. If it is negative, one should avoid investments in Britain, investing in America instead. Why is it called covered? Because the investor is fully hedged or covered against exchange-rate risk if he uses a foreign-currency investment to get from his own currency today to the same currency in the future. This is an approximation that provides insight into what the covered differential is actually comparing. Before we see this handy formula, we first need to define the forward premium (F) as the proportionate difference between the current forward exchange-rate value of the pound and its current spot value: F=(f-e)/e.

The forward premium converted into a percentage shows the rate at which the pound gains value between a current spot transaction to buy pounds and future selling of pounds at the forward rate that we can lock in today. The handy approximation is that the covered interest differential is approximately equal to the forward premium on the pound plus the interest rate differential: CD=F+(i_{UK}-i_{US}).

The formula shows that the net incentive to go in one particular direction around the lake depends on how the forward premium on the pound compares with the difference between interest rates. There is another way to interpret the approximation. The overall covered return in dollars to a U.S. investor from investing in Britain is approximately equal to the sum of two components: the gain or loss from the spot and forward currency exchanges the forward premium, F, on the pound plus the interest return on the pound investment itself (i_{UK}). The covered interest differential is then approximately equal to the difference between the overall covered return to investing in pound-denominated assets (F+i_{UK}) and the return to investing in dollar-denominated assets (i_{US}).

-- Covered Interest Arbitrage

Covered interest arbitrage is buying a countrys currency spot and selling that countrys currency forward, to make a net profit from the combination of the difference in interest rates between countries and the forward premium on that country`s currency. What happens if many people take advantage of an opportunity for interest arbitrage? Their activities will put pressures on the various rates. In the example in which. initially, the British interest rate is 4 percent, the U.S. interest rate is 3 percent, and both the spot and forward exchange rates are $2.00/￡.

i. As many arbitrageurs sell dollars and sell pounds for immediate delivery, the spot exchange rate tends to rise above $2.00/￡.

ii. As the arbitrageurs also buy dollars and sell pounds forward, the forward exchange rate tends to fall below $2.00/￡.

iii. As the arbitrageurs shift their funds from dollar-denominated investments to pound-denominated investments or borrow dollars to fund the pound investments, U.S. interest rates tend to rise and British interest rates tend to fall.

If one or more of the rates change in these ways, the size of the covered interest differential shrinks. Where is all this heading?

-- Covered Interest Parity

Covered interest parity links together four rates: the current forward exchange rate, the current spot exchange rate, and the current interest rates in the two countries. If one of these rates changes, then at least one of the other rates also must change to maintain covered interest parity.

John Maynard Keynes, himself an interest arbitrageur, argued that opportunities to make arbitrage profits would be self-eliminating because rates would adjust so that the covered interest differential were driven to zero. Since Keynes we have referred to the condition CD=0 as covered interest parity. Here are two equivalent ways to think of covered interest parity:

i. A currency is at a forward premium discount by as much as its interest rate is lower higher than the interest rate in the other country that is, F=i_{US}-i_{UK} .

ii. The overall covered return on a foreign-currency investment equals the return on a comparable domestic-currency investment (F+i_{UK}=i_{US}).

• International Investment without Cover

Global economy has grown rapidly recently. Investments of foreign-currency assets is more complicated than the domestic investment because of currency exchanges need, both to acquire foreign currency now and to convert back the foreign currency in the future. If the rate at which the future sale point of foreign currency will occur at a spot rate, we have an uncovered plan, one that is exposed to the exchange-rate risk and speculative.

Generally, the pressures on the rates will subside only when there is no further incentive for large shifts in investments. When the expected uncovered differential equals zero (EUD=0), at least for the average investor, we have a condition called uncovered interest parity. This parity is also called the "International Fisher Effect," named for Irving Fisher, the economist who first proposed it. Here are two ways to say it:

i. A currency is expected to appreciate (depreciate) by as much as its interest rate is lower (higher) than the interest rate in the other country for instance, expected appreciation of the pound=i_{US}-i_{UK}.

ii. The expected overall uncovered return on the foreign-currency investment equals the return on the domestic-currency investment (expected appreciation + i_{UK} = i_{US}).

If uncovered interest parity holds, then it links together four rates: the current spot exchange rate, the spot exchange rate that is currently expected to exist on average in the future, and the currency interest rates in the two countries. As with covered interest parity, if one of these four rates changes, then at least one of the other rates must change to maintain or reestablish uncovered interest parity.

A similar conclusion is that, empirically, the forward exchange rate is a rough but somewhat biased predictor of the future spot exchange rate.