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Mini-Case Mrs. Watanabe and the Japanese Yen Carry Trade

Mini-Case Mrs. Watanabe and the Japanese Yen Carry Trade

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PART 2   Foreign Exchange Theory and Markets



Exhibit A The Trending JPY and AUD Spot Rate

Japanese yen ‫ ؍‬1.00 Australian dollar (monthly)

110



100



90



80



70



60



Ja



n0

Ju 0

l-0

Ja 0

n0

Ju 1

l-0

Ja 1

n0

Ju 2

l-0

Ja 2

n0

Ju 3

l-0

Ja 3

n0

Ju 4

l-0

Ja 4

n0

Ju 5

l-0

Ja 5

n0

Ju 6

l-0

Ja 6

n0

Ju 7

l-0

Ja 7

n0

Ju 8

l-0

Ja 8

n0

Ju 9

l-0

Ja 9

n1

Ju 0

l-1

Ja 0

n1

Ju 1

l-1

Ja 1

n1

Ju 2

l-1

Ja 2

n1

Ju 3

l-1

3



50



¥50 million at 1.00% interest per annum for one year. She

could then exchange the ¥50 million yen for Australian

dollars at ¥60.91/A$, and then deposit the A$820,883 proceeds for one year at the Australian interest rate of 4.50%

per annum. The investor could even have rationalized that



even if the exchange rate did not change, she would earn a

3.50% per annum interest differential.

As it turned out, the spot exchange rate one year later, in

January 2010, saw a much weaker Japanese yen against the

Aussie dollar, ¥83.19/A$. The one-year Aussie-Yen carry



Exhibit B The Aussie-Yen Carry Trade

Start



End

JPY50,500,000

71,362,297

JPY20,862,297



JPY50,000,000



1.0100



JPY to = 1 AUD

60.91



360 Days



JPY to = 1 AUD

83.19



AUS820,883



1.0450



AUS857,823



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Chapter 6   International Parity Conditions



trade position would then have earned a very healthy profit

of ¥20,862,296.83 on a one-year investment of ¥50,000,000,

a 41.7% rate of return.

Post 2009 Financial Crisis

The global financial crisis of 2008–2009 has left a marketplace in which the U.S. Federal Reserve and the European

Central Bank have pursued easy money policies. Both central banks, in an effort to maintain high levels of liquidity and

to support fragile commercial banking systems, have kept

interest rates at near-zero levels. Now global investors who

see opportunities for profit in an anemic global economy

are using those same low-cost funds in the U.S. and Europe

to fund uncovered interest arbitrage activities. But what is

making this “emerging market carry trade” so unique is not

the interest rates, but the fact that investors are shorting two

of the world’s core currencies: the dollar and the euro.

Consider the strategy outlined in Exhibit B. An investor

borrows EUR 20 million at an incredibly low rate, say 1.00%

per annum or 0.50% for 180 days. The EUR 20 million are



Questions

1.Purchasing Power Parity. Define the following terms:



a. The law of one price



b. Absolute purchasing power parity



c. Relative purchasing power parity

2.Nominal Effective Exchange Rate Index. Explain how

a nominal effective exchange rate index is constructed.

3.Real Effective Exchange Rate Index. What formula

is used to convert a nominal effective exchange rate

index into a real effective exchange rate index?

4.Real Effective Exchange Rates: Japan and the

United States. Exhibit 6.3 compares the real effective

exchange rates for the United States and Japan. If the

comparative real effective exchange rate was the main

determinant, does the United States or Japan have a

competitive advantage in exporting? Which of the two

has an advantage in importing? Explain why.

5.Exchange Rate Pass-Through. Incomplete exchange

rate pass-through is one reason that a country’s real

effective exchange rate can deviate for lengthy periods from its purchasing power equilibrium level of 100.

What is meant by the term exchange rate pass-through?

6.The Fisher Effect. Define the Fisher effect. To what

extent do empirical tests confirm that the Fisher effect

exists in practice?

7.The International Fisher Effect. Define the international Fisher effect. To what extent do empirical tests

confirm that the international Fisher effect exists in

practice?



159



then exchanged for Indian rupees (INR), the current spot

rate being INR 60.4672 = EUR 1.00. The resulting INR

1,209,344,000 are put into an interest-bearing deposit with

any of a number of Indian banks attempting to attract capital. The rate of interest offered, 2.50%, is not particularly

high, but is greater than that available in the dollar, euro, or

even yen markets. But the critical component of the strategy is not to earn the higher rupee interest (although that

does help), it is the expectations of the investor regarding

the direction of the INR per EUR exchange rate.



Case Questions

1.Why are interest rates so low in the traditional core

markets of USD and EUR?

2.What makes this “emerging market carry trade” so

different from traditional forms of uncovered interest

arbitrage?

3.Why are many investors shorting the dollar and the

euro?



8.Interest Rate Parity. Define interest rate parity. What

is the relationship between interest rate parity and forward rates?

9.Covered Interest Arbitrage. Define the terms covered

interest arbitrage and uncovered interest arbitrage.

What is the difference between these two transactions?

10. Forward Rate as an Unbiased Predictor of the Future

Spot Rate. Some forecasters believe that foreign

exchange markets for the major floating currencies are

“efficient” and forward exchange rates are unbiased

predictors of future spot exchange rates. What is meant

by “unbiased predictor” in terms of how the forward

rate performs in estimating future spot exchange rates?



Problems

1.Pulau Penang Island Resort. Theresa Nunn is planning a 30-day vacation on Pulau Penang, Malaysia, one

year from now. The present charge for a luxury suite

plus meals in Malaysian ringgit (RM) is RM1,045/day.

The Malaysian ringgit presently trades at RM3.1350/$.

She determines that the dollar cost today for a 30-day

stay would be $10,000. The hotel informs her that any

increase in its room charges will be limited to any

increase in the Malaysian cost of living. Malaysian

inflation is expected to be 2.75% per annum, while

U.S. inflation is expected to be 1.25%.



a. How many dollars might Theresa expect to need

one year hence to pay for her 30-day vacation?



b. By what percent will the dollar cost have gone up?

Why?



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2.Crisis at the Heart of Carnaval. The Argentine peso

was fixed through a currency board at Ps1.00/$ throughout the 1990s. In January 2002, the Argentine peso was

floated. On January 29, 2003, it was trading at Ps3.20/$.

During that one-year period, Argentina’s inflation rate

was 20% on an annualized basis. Inflation in the United

States during that same period was 2.2% annualized.



a. What should have been the exchange rate in

January 2003 if PPP held?



b. By what percentage was the Argentine peso undervalued on an annualized basis?



c. What were the probable causes of undervaluation?

3.Japanese/United States Parity Conditions. Derek

Tosh is attempting to determine whether U.S./­

Japanese financial conditions are at parity. The current spot rate is a flat ¥89.00/$, while the 360-day

forward rate is ¥84.90/$. Forecast inflation is 1.100%

for Japan, and 5.900% for the United States. The 360day euroyen deposit rate is 4.700%, and the 360-day

eurodollar deposit rate is 9.500%.



a. Diagram and calculate whether international ­parity

conditions hold between Japan and the United

States.



b. Find the forecasted change in the Japanese yen/

U.S. dollar (¥/$) exchange rate one year from now.

4.Traveling Down Under. Terry Lamoreaux owns

homes in Sydney, Australia, and Phoenix, Arizona.

He travels between the two cities at least twice a year.

Because of his frequent trips, he wants to buy some

new high-quality luggage. He has done his research

and has decided to purchase a Briggs and Riley threepiece luggage set. There are retail stores in Phoenix

and Sydney. Terry was a finance major and wants to

use purchasing power parity to determine if he is paying the same price regardless of where he makes his

purchase.



a. If the price of the three-piece luggage set in Phoenix is $850 and the price of the same three-piece set

in Sydney is A$930, using purchasing power parity,

is the price of the luggage truly equal if the spot

rate is A$1.0941/$?



b. If the price of the luggage remains the same in

Phoenix one year from now, determine the price

of the luggage in Sydney in one year’s time if PPP

holds true. The U.S. inflation rate is 1.15% and the

Australian inflation rate is 3.13%.

5.Starbucks in Croatia. Starbucks opened its first store in

Zagreb, Croatia in October 2010. In Zagreb, the price

of a tall vanilla latte is 25.70kn. In New York City,

the price of a tall vanilla latte is $2.65. The exchange

rate between Croatian kunas (kn) and U.S. dollars is

kn5.6288/$. According to purchasing power parity, is

the Croatian kuna overvalued or undervalued?



6.Corolla Exports and Pass-Through. Assume that the

export price of a Toyota Corolla from Osaka, Japan is

¥2,150,000. The exchange rate is ¥87.60/$. The forecast

rate of inflation in the United States is 2.2% per year

and in Japan it is 0.0% per year. Use this data to answer

the following questions on exchange rate pass-through.



a. What was the export price for the Corolla at the

beginning of the year expressed in U.S. dollars?



b. Assuming purchasing power parity holds, what

should be the exchange rate at the end of the year?



c. Assuming 100% exchange rate pass-through, what will

be the dollar price of a Corolla at the end of the year?



d. Assuming 75% exchange rate pass-through, what

will be the dollar price of a Corolla at the end of

the year?

7.Takeshi Kamada—CIA Japan (A). Takeshi Kamada,

a foreign exchange trader at Credit Suisse (Tokyo), is

exploring covered interest arbitrage possibilities. He

wants to invest $5,000,000 or its yen equivalent, in a

covered interest arbitrage between U.S. dollars and

Japanese yen. He faced the following exchange rate and

interest rate quotes. Is CIA profit possible? If so, how?

  Arbitrage funds available



$5,000,000



  Spot rate (¥/$)



118.60



  180-day forward rate (¥/$)



117.80



  180-day U.S. dollar interest rate



4.800%



  180-day Japanese yen interest rate



3.400%



8.Takeshi Kamada—UIA Japan (B). Takeshi Kamada,

Credit Suisse (Tokyo), observes that the ¥/$ spot rate

has been holding steady, and that both dollar and

yen interest rates have remained relatively fixed over

the past week. Takeshi wonders if he should try an

uncovered interest arbitrage (UIA) and thereby save

the cost of forward cover. Many of Takeshi’s research

associates—and their computer models—are predicting the spot rate to remain close to ¥118.00/$ for the

coming 180 days. Using the same data as in Problem

7, analyze the UIA potential.

9.Copenhagen Covered (A). Heidi Høi Jensen, a foreign exchange trader at JPMorgan Chase, can invest

$5 million, or the foreign currency equivalent of the

bank’s short-term funds, in a covered interest arbitrage with Denmark. Using the following quotes, can

Heidi make a covered interest arbitrage (CIA) profit?

  Arbitrage funds available



$5,000,000



  Spot exchange rate (kr/$)



6.1720



  3-month forward rate (kr/$)



6.1980



  U.S. dollar 3-month interest rate



3.000%



  Danish kroner 3-month interest rate



5.000%



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Chapter 6   International Parity Conditions



10. Copenhagen Covered (B). Heidi Høi Jensen is now

evaluating the arbitrage profit potential in the same

market after interest rates change. (Note that any time

the difference in interest rates does not exactly equal

the forward premium, it must be possible to make a

CIA profit one way or another.)



  Arbitrage funds available



  Arbitrage funds available



$5,000,000



  Spot exchange rate (kr/$)



6.1720



15. Statoil of Norway’s Arbitrage. Statoil, the national oil

company of Norway, is a large, sophisticated, and active

participant in both the currency and petrochemical markets. Although it is a Norwegian company, because it

operates within the global oil market, it considers the

U.S. dollar, rather than the Norwegian krone, as its

functional currency. Ari Karlsen is a currency trader

for Statoil and has immediate use of either $3 million

(or the Norwegian krone equivalent). He is faced with

the following market rates and wonders whether he can

make some arbitrage profits in the coming 90 days.



  3-month forward rate (kr/$)



6.1980



  U.S. dollar 3-month interest rate



4.000%



  Danish kroner 3-month interest rate



5.000%



11. Copenhagen Covered (C). Heidi Høi Jensen is again

evaluating the arbitrage profit potential in the same

market after another change in interest rates. (Remember that any time the difference in interest rates does

not exactly equal the forward premium, it must be possible to make a CIA profit one way or another.)

  Arbitrage funds available



$5,000,000



  Spot exchange rate (kr/$)



6.1720



  3-month forward rate (kr/$)



6.1980



  U.S. dollar 3-month interest rate



3.000%



  Danish kroner 3-month interest rate



6.000%



12. Casper Landsten—CIA (A). Casper Landsten is a foreign exchange trader for a bank in New York. He has

$1 million (or its Swiss franc equivalent) for a shortterm money market investment and wonders whether

he should invest in U.S. dollars for three months or

make a CIA investment in the Swiss franc. He faces

the following quotes:

  Arbitrage funds available

  Spot exchange rate (SFr/$)

  3-month forward rate (SFr/$)



1.2740



  Swiss franc 3-month interest rate



3.200%



13. Casper Landsten—UIA (B). Casper Landsten, using

the same values and assumptions as in Problem 12,

decides to seek the full 4.800% return available in U.S.

dollars by not covering his forward dollar receipts—

an uncovered interest arbitrage (UIA) transaction.

Assess this decision.

14. Casper Landsten—Thirty Days Later. One month

after the events described in Problems 12 and 13,

Casper Landsten once again has $1 million (or its

Swiss franc equivalent) to invest for three months. He

now faces the following rates. Should he again enter

into a covered interest arbitrage (CIA) investment?



1.3286



  U.S. dollar 3-month interest rate



4.750%



  Swiss franc 3-month interest rate



3.625%



Arbitrage funds available



$3,000,000



Spot exchange rate (Nok/$)



6.0312



3-month forward rate (Nok/$)



6.0186



U.S. dollar 3-month interest rate



5.000%



Norwegian krone 3-month interest rate



4.450%



16. Separated by the Atlantic. Separated by more than

3,000 nautical miles and five time zones, money and

foreign exchange markets in both London and New

York are very efficient. The following information has

been collected from the respective areas:



1.2810

4.800%



1.3392



  3-month forward rate (SFr/$)



$1,000,000



  U.S. dollar 3-month interest rate



$1,000,000



  Spot exchange rate (SFr/$)









Assumptions



London



New York



Spot exchange rate ($/€)



1.3264



1.3264



1-year Treasury bill rate



3.900%



4.500%



Expected inflation rate



Unknown



1.250%



a. What do the financial markets suggest for inflation

in Europe next year?

b. Estimate today’s 1-year forward exchange rate

between the dollar and the euro?



17. Chamonix Chateau Rentals. You are planning a ski

vacation to Mt. Blanc in Chamonix, France, one

year from now. You are negotiating the rental of a

chateau. The chateau’s owner wishes to preserve his

real income against both inflation and exchange rate

changes, and so the present weekly rent of €9,800

(Christmas season) will be adjusted upward or downward for any change in the French cost of living

between now and then. You are basing your budgeting on purchasing power parity (PPP). French inflation is expected to average 3.5% for the coming year,

while U.S. dollar inflation is expected to be 2.5%.



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PART 2   Foreign Exchange Theory and Markets



The current spot rate is $1.3620/€. What should you

budget as the U.S. dollar cost of the 1-week rental?



U.S. dollar, would he be better off receiving Maltese

lira in one year (assuming purchasing power parity)

or receiving a guaranteed dollar payment (assuming a

  Spot exchange rate ($/€)$1.3620

gold price of $420 per ounce one year from now).

  Expected U.S. inflation for coming year



2.500%



  Expected French inflation for coming year



3.500%



20. Malaysian Risk. Clayton Moore is the manager of an

international money market fund managed out of

­London. Unlike many money funds that guarantee their

  Current chateau nominal weekly rent (€)9,800.00

investors a near risk-free investment with variable interest earnings, Clayton Moore’s fund is a very aggressive

18. East Asiatic Company—Thailand. The East Asiatic

fund that searches out relatively high interest earnings

Company (EAC), a Danish company with subsidiararound the globe, but at some risk. The fund is poundies throughout Asia, has been funding its Bangkok

denominated. Clayton is currently evaluating a rather

subsidiary primarily with U.S. dollar debt because of

interesting opportunity in Malaysia. Since the Asian

the cost and availability of dollar capital as opposed

Crisis of 1997, the Malaysian government enforced a

to Thai baht-denominated (B) debt. The treasurer of

number of currency and capital restrictions to protect

EAC-Thailand is considering a 1-year bank loan for

and preserve the value of the Malaysian ringgit. The

$250,000. The current spot rate is B32.06/$, and the

ringgit was fixed to the U.S. dollar at RM3.80/$ for seven

dollar-based interest is 6.75% for the 1-year period.

years. In 2005, the Malaysian government allowed the

1-year loans are 12.00% in baht.

currency to float against several major currencies. The



a. Assuming expected inflation rates for the comcurrent spot rate today is RM3.13485/$. Local currency

ing year of 4.3% and 1.25% in Thailand and the

time deposits of 180-day maturities are earning 8.900%

United States, respectively, according to purchase

per annum. The London eurocurrency market for

power parity, what would be the effective cost of

pounds is yielding 4.200% per annum on similar 180-day

funds in Thai baht terms?

maturities. The current spot rate on the British pound is

b.If EAC’s foreign exchange advisers believe

$1.5820/£, and the 180-day forward rate is $1.5561/£.

strongly that the Thai government wants to push







the value of the baht down against the dollar by

5% over the coming year (to promote its export

competitiveness in dollar markets), what might be

the effective cost of funds in baht terms?

c. If EAC could borrow Thai baht at 13% per annum,

would this be cheaper than either part (a) or part (b)?



19. Maltese Falcon. Imagine that the mythical solid gold

falcon, initially intended as a tribute by the Knights of

Malta to the King of Spain in appreciation for his gift

of the island of Malta to the order in 1530, has recently

been recovered. The falcon is 14 inches high and solid

gold, weighing approximately 48 pounds. Assume that

gold prices have risen to $440/ounce, primarily as a

result of increasing political tensions. The falcon is

currently held by a private investor in Istanbul, who is

actively negotiating with the Maltese government on

its purchase and prospective return to its island home.

The sale and payment are to take place one year from

now, and the parties are negotiating over the price and

currency of payment. The investor has decided, in a

show of goodwill, to base the sales price only on the

falcon’s specie value—its gold value.

The current spot exchange rate is 0.39 Maltese lira (ML)

per 1.00 U.S. dollar. Maltese inflation is expected to be

about 8.5% for the coming year, while U.S. inflation,

on the heels of a double-dip recession, is expected to

come in at only 1.5%. If the investor bases value in the



21. The Beer Standard. In 1999, The Economist reported

the creation of an index, or standard, for the evaluation of African currency values using the local prices

of beer. Beer, instead of Big Macs, was chosen as the

product for comparison because McDonald’s had not

penetrated the African continent beyond South Africa,

and beer met most of the same product and market

characteristics required for the construction of a proper

currency index. Investec, a South African investment

banking firm, has replicated the process of creating a

measure of purchasing power parity (PPP) like that of

the Big Mac Index of The Economist, for Africa.



The index compares the cost of a 375 milliliter bottle

of clear lager beer across Sub-Saharan Africa. As a

measure of PPP, the beer needs to be relatively homogeneous in quality across countries, and must possess

substantial elements of local manufacturing, inputs,

distribution, and service in order to actually provide a

measure of relative purchasing power. The beer is first

priced in local currency (purchased in the taverns of the

locals, and not in the high-priced tourist centers). The

price is then converted to South African rand and the

rand-price compared to the local currency price as one

measure of whether the local currency is undervalued or

overvalued versus the South African rand. Use the data

in the table and complete the calculation of whether the

individual currencies are undervalued or overvalued.



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Chapter 6   International Parity Conditions



163



Beer Prices

Country



Beer



Local

Currency



Price in

Currency



Price in

Rand



Implied

PPP Rate



Spot Rate



South Africa



Castle



Rand



2.30















Botswana



Castle



Pula



2.20



2.94



0.96



0.75



Ghana



Star



Kenya



Tusker



Malawi



Carlsberg



Mauritius



Phoenix



Namibia



Windhoek



Zambia



Castle



Zimbabwe



Castle



Z$



Cedi



1,200.00



3.17



521.74



379.10



Shilling



41.25



4.02



17.93



10.27



Kwacha



18.50



2.66



8.04



6.96



Rupee



15.00



3.72



6.52



4.03



N$



2.50



2.50



1.09



1.00



Kwacha



1,200.00



3.52



521.74



340.68



9.00



1.46



3.91



6.15



Internet Exercises



Data Listed by the Financial Times:









International money rates (bank call rates for

major currency deposits)











Money rates (LIBOR and CD rates, etc.)











10-year spreads (individual country spreads versus

the euro and U.S. 10-year treasuries). Note: Which

countries actually have lower 10-year government

bond rates than the United States and the euro?

Probably Switzerland and Japan. Check.



The Economistwww.economist.com/markets-data











2.Purchasing Power Parity Statistics. The Organization for Economic Cooperation and Development

(OECD) publishes detailed measures of prices and

purchasing power for its member countries. Go to the

OECD’s Web site and download the spreadsheet file

with the historical data for purchasing power for the

member countries.



Benchmark government bonds (sampling of representative government issuances by major countries

and recent price movements). Note which countries are showing longer maturity benchmark rates.











Emerging market bonds (government issuances,

Brady bonds, etc.)











Eurozone rates (miscellaneous bond rates for

assorted European-based companies; includes

debt ratings by Moodys and S&P)



1.Big Mac Index Updated. Use The Economist’s Web

site to find the latest edition of the Big Mac Index

of currency overvaluation and undervaluation. (You

will need to do a search for “Big Mac Currencies.”)

Create a worksheet to compare how the British

pound, the euro, the Swiss franc, and the Canadian

dollar have changed from the version presented in

this chapter.



OECDwww.oecd.org/std/prices-ppp/



3.International Interest Rates. A number of Web sites

publish current interest rates by currency and maturity. Use the Financial Times Web site listed here to

isolate the interest rate differentials between the U.S.

dollar, the British pound, and the euro for all maturities up to and including one year.

Financial Timesmarkets.ft.com/RESEARCH/

Markets/Interest-Rates



4.World Bank’s International Comparison Program. The

World Bank has an ongoing research program that

focuses on the relative purchasing power of 107 different

economies globally, specifically in terms of household consumption. Download the latest data tables and highlight

which economies seem to be showing the greatest growth

in recent years in relative purchasing power. Search the

Internet for the World Bank’s ICP program site.



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CHAPTER 6 APPENDIX



An Algebraic Primer to International

Parity Conditions



The following is a purely algebraic presentation of the parity conditions explained in this

chapter. It is offered to provide those students who desire additional theoretical detail and

definition ready access to the step-by-step derivation of the various conditions.



The Law of One Price

The law of one price refers to the state in which—in the presence of free trade, perfect substitutability of goods, and costless transactions—the equilibrium exchange rate between two

currencies is determined by the ratio of the price of any commodity i denominated in two

different currencies. For example,

St =



P$i,t

PSF

i,t



where P$i and PSF

i refer to the prices of the same commodity i, at time t, denominated in U.S.

dollars and Swiss francs, respectively. The spot exchange rate, St, is simply the ratio of the

two currency prices.



Purchasing Power Parity

The more general form in which the exchange rate is determined by the ratio of two price

indexes is termed the absolute version of purchasing power parity (PPP). Each price index

reflects the currency cost of the identical “basket” of goods across countries. The exchange

rate that equates purchasing power for the identical collection of goods is then stated as

follows:

St =



P$t

PSF

t



where P$t and PSF

t are the price index values in U.S. dollars and Swiss francs at time t, respectively. If p$ and pSF represent the rates of inflation in each currency respectively, then the

spot exchange rate at time t + 1 would be

St + 1 =



164



P$t (1 + p$)

SF

PSF

t (1 + p )



= St J



(1 + p$)

(1 + pSF)



R



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APPENDIX   An Algebraic Primer to International Parity Conditions



165



The change from period t to t + 1 is then

P$t (1 + p$)



St J



SF

PSF

St + 1

t (1 + p )

=

=

St

P$t



(1 + p$)

(1 + pSF)

St



R

=



(1 + p$)

(1 + pSF)



PSF

t

Isolating the percentage change in the spot exchange rate between periods t and t + 1 is then

St + 1 - St

=

St



St J



(1 + p$)

(1 + pSF)

St



R - St

=



(1 + p$) - (1 + pSF)

(1 + pSF)



This equation is often approximated by dropping the denominator of the right-hand side if it

is considered to be relatively small. It is then stated as

St + 1 - St

= (1 + p$) - (1 + pSF) = p$ - pSF

St



Forward Rates

The forward exchange rate is the contractual rate that is available to private agents through

banking institutions and other financial intermediaries who deal in foreign currencies and debt

instruments. The annualized percentage difference between the forward rate and the spot rate

is termed the forward premium,

f SF = J



Ft, t + 1 - St

St



R * J



360

R

nt,t + 1



where f SF is the forward premium on the Swiss franc, Ft, t + 1 is the forward rate contracted at

time t for delivery at time t + 1, St is the current spot rate, and nt, t + 1 is the number of days

between the contract date (t) and the delivery date (t + 1).



Covered Interest Arbitrage (CIA)

and Interest Rate Parity (IRP)

The process of covered interest arbitrage is when an investor exchanges domestic currency for

foreign currency in the spot market, invests that currency in an interest-bearing instrument,

and signs a forward contract to “lock in” a future exchange rate at which to convert the foreign

currency proceeds (gross) back to domestic currency. The net return on CIA is

Net Return = J



(1 + iSF)Ft,t + 1

St



R - (1 + i$)



where St and Ft, t + 1 are the spot and forward rates ($/SF), iSF is the nominal interest rate (or

yield) on a Swiss franc-denominated monetary instrument, and i$ is the nominal return on a

similar dollar-denominated instrument.



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166



APPENDIX   An Algebraic Primer to International Parity Conditions



If they possess exactly equal rates of return—that is, if CIA results in zero riskless profit—

interest rate parity (IRP) holds, and appears as

(1 + i$) = J



(1 + iSF)Ft,t + 1

St



R



or alternatively as

(1 + i$)

SF



(1 + i )



=



Ft,t + 1

St



If the percent difference of both sides of this equation is found (the percentage difference

between the spot and forward rate is the forward premium), then the relationship between the

forward premium and relative interest rate differentials is

Ft, t + 1 - St

St



= f SF =



i$ - iSF

1 + iSF



If these values are not equal (thus, the markets are not in equilibrium), there exists a

potential for riskless profit. The market will then be driven back to equilibrium through

CIA by agents attempting to exploit such arbitrage potential—until CIA yields no positive return.



Fisher Effect

The Fisher effect states that all nominal interest rates can be decomposed into an implied real

rate of interest (return) and an expected rate of inflation:

i$ = [(1 + r $)(1 + p$)] - 1

where r $ is the real rate of return and p$ is the expected rate of inflation for dollar-denominated

assets. The subcomponents are then identifiable:

i $ = r $ + p $ + r $p $

As with PPP, there is an approximation of this function that has gained wide acceptance. The

cross-product term of r $p$ is often very small and therefore dropped altogether:

i $ = r $ + p$



International Fisher Effect

The international Fisher effect is the extension of this domestic interest rate relationship to

the international currency markets. If capital, by way of covered interest arbitrage (CIA),

attempts to find higher rates of return internationally resulting from current interest rate

­differentials, the real rates of return between currencies are equalized (e.g., r $ = r SF):

(1 + i$) - (1 + iSF)

St + 1 - St

i$ - iSF

=

=

St

(1 + iSF)

(1 + iSF)



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APPENDIX   An Algebraic Primer to International Parity Conditions



167



If the nominal interest rates are then decomposed into their respective real and expected

inflation components, the percentage change in the spot exchange rate is

(r $ + p$ + r $p$) - (r SF + pSF + r SFpSF)

St + 1 - St

=

St

1 + r SF + pSF + r SFpSF

The international Fisher effect has a number of additional implications if the following requirements are met: (1) capital markets can be freely entered and exited; (2) capital markets possess

investment opportunities that are acceptable substitutes; and (3) market agents have complete

and equal information regarding these possibilities.

Given these conditions, international arbitragers are capable of exploiting all potential

riskless profit opportunities until real rates of return between markets are equalized (r $ = r SF).

Thus, the expected rate of change in the spot exchange rate reduces to the differential in the

expected rates of inflation:

St + 1 - St

p$ + r $p$ - pSF - r SFpSF

=

St

1 + r SF + pSF + r SFpSF

If the approximation forms are combined (through the elimination of the denominator

and the elimination of the interactive terms of r and p), the change in the spot rate is simply

St + 1 - St

= p$ - pSF

St

Note the similarity (identical in equation form) of the approximate form of the international Fisher effect to purchasing power parity discussed previously—the only potential

­difference is that between ex post and ex ante (expected) inflation.



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CHAPTER



7



Foreign Currency

Derivatives

and Swaps

Unless derivatives contracts are collateralized or guaranteed, their ultimate value also depends on the creditworthiness of the counterparties to them. In the meantime,

though, before a contract is settled, the counterparties

record profits and losses—often huge in amount—in their

current earnings statements without so much as a penny

changing hands. The range of derivatives contracts is

­limited only by the imagination of man (or sometimes, so

it seems, madmen). 

—Warren Buffett, Berkshire Hathaway Annual Report, 2002.



Learning Objectives





Explain how foreign currency futures are quoted, valued, and used for speculation

purposes







Illustrate how foreign currency futures differ from forward contracts







Analyze how foreign currency options are quoted and used for speculation purposes







Consider the distinction between buying options and writing options in terms of

whether profits and losses are limited or unlimited







Explain how foreign currency options are valued







Define interest rate risk and demonstrate how it can be managed







Explain interest rate swaps and how they can be used to manage interest rate risk







Analyze how interest rate swaps and cross-currency swaps can be used to manage both

foreign exchange risk and interest rate risk simultaneously



Financial management of the multinational enterprise in the twenty-first century will certainly

include the use of financial derivatives. These derivatives, so named because their values are

derived from an underlying asset like a stock or a currency, are powerful tools used in business today for two very distinct management objectives, speculation and hedging. The financial manager of an MNE may purchase financial derivatives in order to take positions in the

expectation of profit—speculation—or may use these instruments to reduce the risks associated with the everyday management of corporate cash flow—hedging. Before these financial

instruments can be used effectively, however, the financial manager must understand certain

basics about their structure and pricing.

168



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