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17-1 currency management: an introduction (2 review of foreign exchange…
17-1 currency management: an introduction
2 review of foreign
exchange concepts
spot
markets
an exchange rate - P/B - price currency per base currency
priced out to four decimal places
the fourth decimal place - a pip
T+2 settlement
the bid price - price currency to buy one unit base currency
the offer price - price currency to sell one unit base currency
bid-offer spread - the market width
the party asking the dealer for a price should on the more expensive side of the market
forward
markets
forward exchange rates typicaly quoted in terms of points - difference between forward exchange rate quote and spot quote - points are adjustments to spot price of the base currency
a market-
to-market
judge effectiveness of a hedge based on forward contracts
measure the profitability of speculative currency positions at points before maturity
*valuation on a forward position before settlement date
process
1 create an equal and offsetting forward position to the original forward position
2 determine the appropriate all-in forward rate for new offsetting forward position
3 calculate the cash flow at settlement day
4 calculate PV of cash flow at future settlement date
for marking-to-market a forward position
the day-count convention - an actual/360 basis
FX swap
markets
consists of offsetting and simulaneous spot
and forward transactions
base currency being bought spot and sold forward
have no interim interest payments
matched swap - two legs equal size
mismatched - one larger than other
for managing currency risk -
used to roll forward contracts forward as mature
to adjust the size of the currency hedge -
forward leg can be of a different size
matched transaction - used mid-market spot exchange rate
mismatched - pricing need to reflect difference in trade sizes - in the spot rate quoted as the base for FX swap
currency
options
widely used for both risk management
and speculative purpose
vanilla options / exotic options
the risk management of flows
takes place in FX derivatives markets
3 currency risk and
portfolio return and risk
return
decom-
position
the domestic-curreny return on a foreign asset:
R_DC = (1 + R_FC) (1 + R_FX) – 1
R_FX= %∆S_P/B : percentage change
in foreign currency against domestic
would need a market opinion for expected price movement R_A,i and exchange rates R_FX,i
typically correlations between all of these variables
volatility
decom-
position
σ^2(R_DC) ≈ σ^2(R_FC) + σ^2(R_FX) + 2σ(R_FC)σ(R_FX)ρ(R_FC,R_FX)
adding exchange rate risk exposure usually adds to domestic-currency return variance
σ(RDC) will depend on:
the variance of each of foreign-currency returns R_FC
and exchange rate movemens R_FX
alos on interacts with each others
for two with strong positive returen correlation
short selling can create considerable diversificaition
historical risk patterns may not repeat going forward
7 currency management
for merging market currencies
special
conside-
rations
two most
important
considerations
higher trading costs
especially for crosser in currency pairs
increasing
likelihood
especially important when get crowded
fatter tails and pronounce negaitive skew
crises -
affect hedging strategies based on froward /
undermine hedgging strategies based on presumed diversification
*of extreme market event and severe illiquidity under stressed market conditions
government involvement
foreign exchange market intervention
capital controls
pegged exchange rates
*in managing emerging market currency exposures
non-deliverable
forwards
NDFs
where capital control exist and delivery in controlled currency limited
cash settled
the credit risk typically lower than for outright forward
arbitrage condition unerlying covered interest rate parity no longer functions consistently - NDF pricing reflect individual supply and demand conditions in offshore market
1 introduction
globalization
benefit - broader availability of higer-expected-return investment
benefit - portfolio diversification opportunities
a unique set of challenges - measuring and managing foreign exchange risk