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Lecture Derivatives: An introduction: Chapter 10 - Robert A. Strong

Chapter 10 - Foreign exchange futures. The main contents of the chapter consist of the following: Introduction, foreign exchange risk, forward rates, foreign currency futures, dealing with the exposure. | © 2004 South-Western Publishing Chapter 10 Foreign Exchange Futures Outline Introduction Foreign exchange risk Forward rates Foreign currency futures Dealing with the exposure Introduction The capital markets across the globe have become one giant playing field The U.S. share of market capitalization is steadily declining as foreign markets develop Foreign Exchange Risk Introduction FX risk and interest rates The concept of exposure FX risk from a business perspective FX risk from an investment perspective Introduction Overseas investments and international business involve foreign exchange risk A survey of corporate treasurers indicates that the primary corporate use of derivative assets is hedging foreign exchange exposure Introduction (cont’d) Foreign exchange risk is the risk of loss due to changes in the relative value of world currencies Modest changes in exchange rates can result in significant dollar differences FX Risk and Interest Rates Introduction The real rate of interest The inflation premium The risk premium Introduction Events in one industrial country affect the rest of the world Interest rates are often a good barometer of events like high unemployment, changes in economic policy, etc. The Real Rate of Interest The nominal interest rate (the stated rate) can be expressed as the sum of: The real rate An inflation premium and A risk premium The Real Rate of Interest (cont’d) The real rate reflects the rate of return investors demand for giving up the current use of funds Indicates people’s willingness to postpone spending their money Is not directly observable Hovers in the 3% to 4% range The Inflation Premium The inflation premium reflects how the general price level is changing Measures how rapidly the money standard is losing its purchasing power In the past 75 years, U.S. inflation has averaged about 3.2% annually The Risk Premium The risk premium is the component of interest rates that is most | © 2004 South-Western Publishing Chapter 10 Foreign Exchange Futures Outline Introduction Foreign exchange risk Forward rates Foreign currency futures Dealing with the exposure Introduction The capital markets across the globe have become one giant playing field The U.S. share of market capitalization is steadily declining as foreign markets develop Foreign Exchange Risk Introduction FX risk and interest rates The concept of exposure FX risk from a business perspective FX risk from an investment perspective Introduction Overseas investments and international business involve foreign exchange risk A survey of corporate treasurers indicates that the primary corporate use of derivative assets is hedging foreign exchange exposure Introduction (cont’d) Foreign exchange risk is the risk of loss due to changes in the relative value of world currencies Modest changes in exchange rates can result in significant dollar differences FX Risk and Interest Rates .