- The Changing Use of Derivatives: More Hedging, Less Speculation
- No room for speculation
- Chapter Foreign exchange risk
Why not share! Embed Size px. Start on. Show related SlideShares at end. WordPress Shortcode. Full Name Comment goes here. Are you sure you want to Yes No. No Downloads. Views Total views. Actions Shares. Embeds 0 No embeds. Some might get cold feet for being responsible for such immense piles of money. Hedging expertise brings bang for the buck Working in and between various currencies poses unpredictable risks to global businesses.
Swap deals are used to sell and buy a currency on different value dates. Forward deals are used to buy or sell a currency at a specified time in the future at a predetermined price, regardless of the actual market rate on the day of the payment. Leave a comment. They consist of: the spot market, which includes the retail market and the inter-bank market, the forward contract market including currency swaps , the futures market, the cash options market, the futures options market, and the market for exchange traded funds ETFs. The exchange rates that are used in such transactions are determined by an informal network of banks and other financial institutions known as the inter-bank market with settlement occurring in two business days.
The inter-bank market consists of large investment banking firms linked together with a computer network where members negotiate among themselves for large quantities of a given currency 24 hours a day five days a week. A forward contract is an agreement in which two parties negotiate the following terms: which currency is involved, the quantity to be exchanged, where and when the currency will be delivered, and the exchange rate. The forward contract market is for transactions with settlement beyond two days.
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Currency swaps are transactions in which two banks in the inter-bank market trade a quantity of currency with an agreement to reverse the transaction at a certain later time. The initial leg of the transaction can be either a spot transaction or a forward transaction with the closing leg being a forward transaction.
The Changing Use of Derivatives: More Hedging, Less Speculation
The futures markets have exchanges in which the terms of the contracts for the exchange of currencies are standardized by the exchanges, i. The only contract term remaining is the price, which is negotiated between the buyers and sellers. The cash options market trades calls and puts for the delivery of the cash currency. If you exercise a call, you receive the underlying currency for that call. If you exercise a put, you must deliver the underlying currency for that put. Exchange-traded cash options are traded at the Philadelphia Stock Exchange ; however, their settlement occurs in U.
The futures options markets usually coincide with the futures markets because the underlying asset for a futures option is a futures contract. In other words, if a futures option is exercised, the owner receives either a long or short futures position. By investing in the components of an index or in the commodity, the ETF makes available to small investors the opportunity to invest in the index or commodity.
Currency ETFs began trading in They are traded on the New York Stock Exchange. As international trade has grown, the sea of money has expanded. Of course, the bigger the bath tub, the easier it is to have waves and the more difficult it becomes to stop those waves. Thus, currency fluctuations have grown beyond the control of central banks and have spawned the need to protect oneself against the risk of price exchange rate change.
This risk can be transferred from those who want to avoid it to those who seek to profit from it in the FOREX markets. Consequently, two distinct groups of traders have arisen.
There are the hedgers , who want to reduce their risk of currency price fluctuations, and there are the speculators , who want to profit from the change in currency exchange rates. In the world of business, hedgers are entities individuals or businesses wanting to reduce their risk of loss from price changes.
No room for speculation
In broad terms, there are two types of hedgers: short hedgers and long hedgers; i. It could be a banker who wants to protect against a rise in interest rates and decline in bond prices , or it could be an exporter selling goods and being paid a fixed price in a currency with a declining price exchange rate.
A long hedger might be a farmer who fattens cattle and wants to protect against an increase in feed prices.
It could be an insurance company looking to purchase bonds in its portfolio when the cash becomes available down the road and wanting to protect against a decline in interest rates and an increase in bond prices. Or it could be a company planning to purchase goods in a country with an appreciating currency. Because hedgers have one foot in the cash market, they tie future prices to present prices. Thus, as we move into the future, future prices become present prices convergence.
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Between the time the invoice is issued and the time it is paid, the manufacturer withstands the risk of exchange rate loss. Specifically, if the price of the U.
Chapter Foreign exchange risk
This makes it more difficult to pay his employees and vendors in Europe. To hedge this risk in the futures markets , the German manufacturer buys Euro futures as a substitute purchase for the Euros he will be purchasing at a future time in the cash market. Fortunately, GAM reduced its currency risk exposure by hedging its position with futures. Way to go GAM!
I bet GAM will continue to hedge its currency exchange exposure in the futures. Because the various FOREX markets tend to move parallel to one another, it is possible to hedge currency risk. While there are both long and short hedgers providing liquidity to one another, hedging is also facilitated by speculators who provide the bulk of liquidity that makes for ease of entry and exit for hedgers.
Speculators assume risk in the pursuit of profits. Their risks are calculated to maximize profit potential. They might speculate that prices will rise, decline, go sideways or that price differentials will widen or narrow. Still others may prefer the to 1 leverage found in the currency spot market. Of course, the more leverage used, the faster one can be taken out of the markets for lack of adequate margin. If he were to liquidate his position at this point, he would have a As the price declines, our speculator must add additional money to his account to cover the daily losses and maintain his position.
Thus, his total return in the spot market is — Thus, his total return in the futures market is — This lower percentage loss is due to the higher margin requirement in the futures market.