Chapter 3: Forward Markets and
Transaction Exchange Risk
Power Points created by:
Joseph F. Greco Ph. D.
California State University, Fullerton
Mihaylo College of Business and Economics
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Chapter 3: Forward Markets and
Transaction Exchange Risk
3.1
Transaction Exchange Risk
3.2
Describing Uncertain Future Exchange Rates
3.3
Hedging Transaction Exchange Risk
3.4
The Forward Foreign Exchange Market
3.5
Forward Premiums and Discounts
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3.1 Transaction Exchange Risk
• Introduction: Uncertainty of future exchange rates
• Who incurs transaction exchange risk?
• Corporations
• Institutional investors
• individuals
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3.2 Describing Uncertain Future Exchange
Rates
Uncertain Future Exchange Rates: Overview
• Assessing Exchange Rate Uncertainty Using
Historical prices
• The Probability Distribution of Future Exchange
Rates
• Conditional Means and Volatilities
• Assessing the Likelihood of Particular Future
Exchange Rate Ranges
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3.2 Describing Uncertain Future Exchange
Rates
• Assessing Exchange Rate Uncertainty Using
Historical prices
• Mean and standard deviation
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Exhibit 3.1
Dollar-Pound Monthly Exchange Rate, 1975-2005
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Exhibit 3.2
Peso-Dollar Monthly Exchange Rate, 1994-2005
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3.2 Describing Uncertain Future Exchange
Rates
• The Probability Distribution of Future Exchange
Rates
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Exhibit 3.3
Probability Distribution of Future Exchange Rates
S(t+90)
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3.2 Describing Uncertain Future Exchange
Rates
• Conditional Means and Volatilities
• Conditional probability distribution
• Conditional Mean or Conditional Expectation
• Volatility
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3.2 Describing Uncertain Future Exchange
Rates
• Assessing the Likelihood of Particular Future
Exchange Rate Ranges
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3.3 Hedging Transaction Exchange Risk
• Forward Contracts and Hedging
• Exposure of Hedged Versus Unhedged Strategies
• The Cost and Benefits of a Forward Hedge
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3.3 Hedging Transaction Exchange Risk
• Forward Contracts and Hedging
• Forward rate
• Specified in a forward contract
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3.3 Hedging Transaction Exchange Risk
• Exposure of Hedged Versus Unhedged Strategies
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Exhibit 3.4 – Panel A
Gains and Losses Associated with Hedged Versus
Unhedged Contracts
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Exhibit 3.4 – Panel B
Gains and Losses Associated with Hedged Versus
Unhedged Contracts
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3.3 Hedging Transaction Exchange Risk
• The Cost and Benefits of a Forward Hedge
• What is the appropriate way to view the cost of a
forward hedge?
• Ex post
• Ex ante
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Exhibit 3.5
Costs and Benefits of Hedging
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3.4 The Forward Foreign Exchange Market
The Forward Market: Overview
• Market Organization
• Forward Contract Maturities and Value Dates
• Forward Market Bid-Ask Spreads
• Net Settlement
• The Foreign Exchange Swap Market
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3.4 The Forward Foreign Exchange Market
• Market Organization
• Outright forward contracts
• Swap
• More than 50% of forex transactions are
swaps
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3.4 The Forward Foreign Exchange Market
• Forward Contract Maturities and Value Dates
• Forward value or settlement date
• Most active dates are 30, 60, 90 days
• Exchange takes place on the forward value
date
• Rules for determining forward value dates
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Exhibit 3.6
Rules for Determining Forward Value Dates
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3.4 The Forward Foreign Exchange Market
• The Foreign Exchange Swap Market
• How swap prices are quoted
• Swap points
• A rule for using swap points
• Cash flows in a swap
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Exhibit 3.7 Risks in Forward Contracts
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3.4 The Forward Foreign Exchange Market
• Net Settlement
• Settling a contract by paying or receiving a net
settlement that depends of the value of the
contract
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Exhibit 3.8
Cash Flows in a Spot-Forward Swap
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3.5 Forward Premiums and Discounts
Forward Premiums and Discounts: Overview
•
Introduction
•
Size of Forward Premiums or Discounts
•
Forward Premiums and Swap Points
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3.5 Forward Premiums and Discounts
• Introduction
• Forward premium
• Occurs when the price of the currency
contract is higher then the spot rate
• Forward discount
• Occurs when the price of the currency
contract is lower then the spot rate
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Exhibit 3.9
Historical Means of Forward Premiums or Discounts
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3.5 Forward Premiums and Discounts
• Size of Forward Premiums or Discounts
• Size varies according to currencies
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3.5 Forward Premiums and Discounts
• Forward Premiums and Swap Points
• Because forward contracts typically trade as part
of a swap, the swap points indicate the premium
or discount for the denominator currency
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3.6 Changes in Exchange Rate
Volatility (Advanced)
• Volatility Clustering
• Other Volatility Models
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Volatility Clustering
• Volatility clustering
• GARCH model
– Developed by Tim Bollerslev (1986)
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Exhibit 3.10
Monthly Standard Deviations of Daily Rates of
Appreciation
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Other Volatility Models
• “Implied volatility”
• Models accommodating discrete shifts in
volatility
• Regime-switching models
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Exhibit 3A.1Euro/$ Data
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Exhibit 3A.2
Euro-Dollar Monthly Percentage Changes
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Exhibit 3A.3
Euro-Dollar Monthly Percentage Change Normal
Density, 2004-2005
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