USIU-A FIN 6030: International Financial Markets Summer Quarter 2001 Protus Sigei. Foreign Exchange Markets. A). Introduction. Foreign exchange markets facilitate international cross-currency investments. An exchange rate is simply the price of one currency in terms of another i.e the rate at which one currency exchanges for another. The spot foreign exchange rate (or simply the spot rate) is the rate at which a currency is traded for immediate delivery; and the market in which these transactions occur is known as spot market. In contrast, a forward rate is a rate that reflects the future value of a currency based on expectations; and this rate may be greater than the current spot rate (hence it is at a premium) or less than the current spot rate (i.e at a discount). Example: 5.32 Francs/$ is price of a dollar in terms of Francs; or, equivalently, 0.188 $/Franc is price of a Franc in terms of a dollar. Hence exchange rate is no different from any other price e.g sh.2/orange or ½ orange /sh. There are two ways of exchange rate quotations: i). ii). Direct terms or American terms, based on price of foreign currency (e.g $) in terms of home currency: Sh.80/$ European terms i.e price of home currency in terms of foreign currency: $.(1/80)/Sh. Since the exchange rate is a price, it must be determined like any other price, by buyers and sellers. The higher the price, the higher the supply (but the lower the demand); and vice versa. The exchange rate (i.e price of $) is determined where supply exactly meets demand. 1
Exchange rates are determined by the relative supply and demand for a particular currency. But buyers and sellers are interested in using currency to purchase something--- an asset or commodity. Thus the commodity prices and asset returns must affect supply and demand (for currency) as well. Consequently, exchange rates, interest rates and prices must be linked (the so-called International Parity Relations). Alternative Monetary and Exchange Rate Regimes. 1). Pure floating exchange rate regime (e.g Switzerland); in which there is no deliberate exchange rate policy. The exchange rate is left to freely drift to a value determined by the fundamental economics of the country together with its monetary policy. 2). Pure fixed exchange rate regime (e.g Hong Kong, Argentina etc), in which the exchange is completely and perfectly fixed. Intervention in currency markets does not occur. 3). A managed float (e.g Russia, Brazil, Japan etc). Central bank tries to keep price of local currency within a band: (i). crawling pegs: formal bands are defined (e.g Russia, Mexico, Brazil) (ii). dirty floats: discretionary interventions Central bank intervenes using interest rates and foreign exchange purchases and sales to keep the currency in the desired target zone. When the market exchange rate is within the desired band, central bank lets the rate float freely Unlike pure floating and fixed rates, pegged rates and managed floats require a monetary authority to manage both exchange rate and monetary policy. Inevitably, conflicts between the two policies occur. The present international monetary systems largely operate floating, as opposed to fixed, exchange rate regimes. Exchange rates are, therefore, determined by the aggregate demand for and supply of currency. However, the factors that tend to affect DD and SS of currencies may sometimes be speculative and based on subjective expectations of the market. Fluctuations of a currency value (both in the short run and long run) are also driven by fundamental factors such as: 1). Inflation: The rate of exchange between two currencies is established by a parity between the purchasing powers of the two currencies. For instance, suppose it takes $1 to buy three apples in California and Sh.60 to buy the same apples in Nairobi. Then the exchange rate between the $ and Sh. is Sh.60/$ or $0.0167/Sh. If prices of apples doubled in California while the prices in Nairobi remain the same, then the purchasing power of the $ in California will drop by 50%. Consequently, only Sh.30 will exchange for $1. Currency exchange rates, therefore, tend to vary inversely with their respective purchasing powers to maintain the same purchasing power in each country. This relationship is called the purchasing power parity theory(pppt); which suggests that 2
changes in the inflation rate differential between two countries induce an adjustment of the exchange rate to correspond to the relative purchasing powers of the countries. Note: PPPT is a long-run equilibrium condition. 2). Interest Rates: If investors can earn a higher interest rate (i.e return) in country X than in country Y, they will prefer to invest in country X, provided that inflation rate and risk are the same in both countries. Therefore, interest rates and exchange rates adjust until the foreign exchange market and the money market establish an equilibrium. This relationship between interest rate differentials and exchange rate is known as the interest rate parity theory. 3). Balance of Payments (BoP): BoP refers to a government statement that catalogs the flow of transactions between the residents of one country and the rest of the world. When a country sells (exports) more goods and services than it purchases (imports) from abroad, it will have a surplus in its balance of trade; and vice versa. A continuous surplus in the balance of trade increases the demand by foreigners of a country s currency and, hence, its value increases in foreign exchange markets. A continuous deficit in a country s balance of trade will, likewise, depress the value of that country s currency because the deficit increases the supply of currency relative to demand. 4). Government Policies (as to Exchange Rate Regime): Governments may set the exchange rate administratively or may, through its central bank, intervene in the foreign exchange market to support the value of its currency relative to others by buying and selling currencies accordingly. 5). Other Factors: political instability; a significant drop in a country s principal exports etc. B). Exchange Rates and International Parity Conditions/Relations. Buyers and sellers of foreign exchange are interested in using the foreign currency to purchase assets (that yield returns) and commodities (that yield utility). Thus commodity prices and asset returns must affect supply and demand for currency; and, by extension, currency exchange rates. International parity conditions 1 /relations give a link between exchange rates, interest rates and commodity prices: 1). International Fisher Relation ( Open Fisher) The Fisher effect is based on the notion that: e ) 1 International parity conditions hold if international financial markets are efficient; so that arbitrage opportunities do not exist. 3
where i = nominal interest rate; r = real exchange rate (which is the investor s required rate of return on investment since this represents the purchasing power of the return on e = the expected rate of inflation. The Fisher effect can be expressed as: 1 + r = 1 + i (1.0) e "!$# %&!(' e ) Eq.(1.0) shows that investors will always demand a nominal rate higher than the real rate to compensate them for the expected inflation that will erode the purchasing power of returns on investment. Where more than one currency is involved, the Fisher effect generalizes to the International Fisher Relation, which gives the ratio of nominal investment values in terms of relative real interest rates and expected inflation rates: ' (1 + i x ) = (1 + r x )(1 + ( 1 + i y ) ( 1 + r y!(' e x ) (2.0) e y ) where the subscripts x and y refer to countries () *+,-,./ *102. 3547698/;:=<>,. 3@?;.A*BC0 D;.1E FHG If expected real returns on identical assets were higher in one country than another, arbitrage would cause capital to flow from the country with a lower real return to the country with higher real return. Assuming perfect competitive markets (with free mobility of capital and negligible transactions costs etc), this arbitrage would continue until real returns become equal. Consequently, eq(2.0) becomes: e (1 + i x ) = (1 + I x ) (3.0) e ( 1 + i y 4 JLKM(I y ) 2). Interest Rate Parity Theory. Interest rate parity theory is based on the notion of covered interest arbitrage. Covered interest arbitrage involves borrowing in one currency, selling the borrowed currency on the spot market, investing the proceeds of the sale and simultaneously buying back the borrowed currency on the forward market. Consider borrowing sh.1 at interest rate i x, selling the sh.1 in order to buy $S yx (at the spot exchange rate of $S yx for sh.1); and investing the proceeds in a $-denominated asset. If i x and i y are the interest rates in Kenya and U.S respectively, then with the forward transaction, the shilling value of the investment will be: 4
S yx (1 + i y ) (4.0) F yx where F yx = forward exchange rate of $F yx for sh.1 The possibility of covered interest arbitrage disappears when the shilling cost of borrowing (in the illustration above) is just equal to the shilling gain from lending/investing in dollars. And if there is no possibility of covered interest arbitrage, expression (4.0) must be equal to (1 + ix) that must be paid on the shilling loan. This equality implies the interest rate parity relation: 1 + i y = F yx (5.0) 1 + i x S yx But F yx = 1 + f, S yx where f is the forward premium (discount) i.e the proportion by which a country s forward exchange rate exceeds (falls below) its spot rate. Thus eq. (5.0) becomes, 1 + i x = 1 + f 1 + i y 1 + i x = (1 + f)(1 + i y ) = 1 + i y + f + f.i y i x = i y + f (6.0) (since f.i y is typically negligible and can be ignored altogether) i x i y = f The interest rate parity relation states that in perfect money markets, the forward discount or premium on the FOREX market is equal to the relative difference between the two interest rates. 3). Purchasing Power Parity Theory (PPPT). PPPT, a theory linking inflation and exchange rate movements, is based on the notion of the law of one price. The law of one price states that identical commodities or goods must have the same price, quoted in one currency, in all markets; otherwise arbitrageurs would continuously exploit the price differentials until the prices in all markets are equalized, thereby eliminating the potential for profit. PPPT is defined as: 5
E(S yx ) = e y.syx ( 7.0) e x where E(S yx ) is the expected spot rate of currency Y for currency X in one period s time. Thus according to the PPPT, the expected spot rate in one period s time is equal to the current spot rate times a factor reflecting the relative expected rates of inflation in the two countries. If currency X has a lower expected rate of inflation compared to that of currency Y, then currency Y is expected to depreciate and vice versa. Since S yx is already known (hence given/constant), eq. (7.0) requires equality between expected changes in the relative prices of goods in currency Y and currency X ( as determined by their relative expected inflation rates), and expected changes in the spot exchange rates. PPPT also implies that there will be equality in the amount of real goods that equivalent amounts of different currencies in the FOREX market will buy. 4). Forward Rate Parity Theory. This theory is based on the notion of unbiasedness. Unbiasedness is said to obtain when the forward market is efficient and investors are risk-neutral, so that the forward rate is equal to the expected value of the spot rate at the time the contract matures. Thus, F yx = E(S yx ) (8.0) Equality (8) can also be stated in terms of a forward discount or premium relative to the current spot rate: F yx - S yx = E(S yx ) Syx (9.0) S yx S yx where L.H.S of eq.(9.0) is the forward discount or premium (given that S yx is current spot rate). If equality (8.0) failed to hold due to, say, F yx systematically exceeding E(S yx ), potential traders in the forward market would expect to be better off waiting until the end of the period to make their exchanges. Equalities (3.0) (8.0) together imply that in equilibrium in the FOREX markets for spot and future contracts, 1 + i x = 1 + e x ) = E(S yx ) = F yx 1 + i y e y ) S yx S yx which together imply that zero expected speculative gains from further arbitrage are possible. 6
Interest Parity Relations (Revisited). Having considered the international parity relations above, it s necessary to appreciate that interest rates and currency values are also inter-related through two central valuation relations called uncovered and covered interest parity. Let i t = home (Kenyan) interest rate at time t and i * t = foreign (say, U.S) interest rate at time t. Also let the spot exchange rate be sh.s t per U.S$ at time t (i.e the price of the foreign currency in terms of the home currency). Consider an investor who is faced with an opportunity of investing sh.1 either locally or abroad (U.S). The return after 1 year of investing either in Kenya or U.S will be: Kenya: Sh.1(1 + i t ) U.S : $ 1 (1 + i * t ) S t All the variables above are known to the investor except the exchange rate that will prevail at the end of the year. Let that exchange rate be E t S t+1 (i.e the spot rate at period t + 1 whose forecast or expected value we make in period t). Thus a dollar will buy sh. E t S t+1 at the end of the year. Therefore if the investor decides to invest abroad, his/her return of $ 1 (1 + i * t ) S t will, when converted back to the shilling, buy sh.1(1 + i * t).e t S t+1 S t In equilibrium (i.e when there is, on balance, no tendency for funds to move into or out of Kenya from the U.S, and vice versa), investing at home or abroad will have to yield exactly the same shilling return. Equilibrium requires that: (1 + i t ) = (1 + i * t ). E t S t+1 S t (10.0) Note: The ratio E t S t+1 S t will be >1 if the domestic currency i.e shilling will have depreciated ( or foreign currency appreciated) E t S t+1 = 1 + E t S t t (10.1) where E t t = expected rate of depreciation/appreciation of domestic currency. Subst. (10.1) into (10.0) yields, (1 + i t ) = (1 + i * t )(1 + E t t ) 7
1 + i t = 1 + i * t + E t t + i * t.e t t (1 + i t ) = (1 + i * t )+ E t t (10.2) (disregarding the typically negligible i * t.e t t ) Eq. (10.2) defines the uncovered interest parity (UIP) condition that: The domestic interest rate must be higher(lower) than the foreign interest rate by an amount equal to the expected depreciation (appreciation) rate of the domestic currency Note: There is no straight answer to the cause-effect relationship e.g whether increases in E t t cause i to increase or i * to decrease; or whether interest rate differentials (i * -i) cause expectations to change. If, instead of basing his/her decisions on expected rate of depreciation of domestic currency (E t S t+1 ), the investor locks in the end-of-period exchange rate via the forward market, the investor is insured against (hedged against) a lower dollar value than anticipated. The forward rate, F t+1, can be put in place of E t S t+1 in the UIP equation (10.0). Hence, (1 + i t ) = (1 + i * t ).F t+1 S t ( 10.3) But F t+1 = 1 + f, S t where f is the forward premium (discount) i.e the proportion by which a currency s forward exchange rate exceeds (fall below) its spot rate. Thus eq. (10.3) becomes: (1 + i t ) = (1 + i * t )(1 + f) = 1 + i * t + f + i * t.f = 1 + i * t + f (disregarding i * t.f as before) i t = i * t + f (10.4) Eq. (10.4) defines the covered interest parity (CIP) condition that: The domestic interest rates must be higher (lower) than the foreign interest rate by an amount equal to the forward discount (premium) on the domestic currency Covered interest parity gets its name from the fact that the forward contract provides a cover to the FOREX risk in the series of transactions. 8
Note: There are reasons why UIP may not hold exactly, and can even be expected to fail altogether: i). It only holds on average: the market s expectations (even rational ones!) do no prove correct. ii). Capital does not flow freely across borders (due to market imperfections) iii). PPP does not hold: a growing economy is experiencing improving productivity and an appreciation in prices. C). Foreign Exchange Risk. Foreign exchange risk facing an economic agent, especially a multi-national corporation (MNC), refers to (the magnitude of) the gain or loss that corresponds to a particular change in exchange rate i.e FOREX gain/loss = (S t+n S t )(Exposure), where exposure is expressed in units of the underlying foreign currency; the exchange rate (i.e S t+n, S t ) is the price of the foreign currency in units of home currency (e.g sh.80/$). This implies that the exchange rate gain/loss is in home currency units. There are three kinds of foreign exchange risks/exposures: 1). Translation exposure (or accounting exposure). Translation exposure is the degree to which a firm s foreign currency-denominated accounts on the balance sheet are affected by exchange rate changes. Accounting standards generally calls for the use of the current-rate method that involves all assets and liabilities being translated at the exchange rate prevailing at the date of the balance sheet. To determine the foreign exchange gain or loss, the net asset position (i.e assets minus liabilities) is used as the measure of exposure. 2). Transactions exposure. Transaction exposure is the degree to which cash and transactions denominated in a foreign currency and already entered into for settlement at a future date are affected by exchange rate changes. All contractual obligations that are not reported in the balance sheet are included are included in the measure. These off-balance sheet activities include leases, commodityindexed bonds etc. Note: The gains/losses associated with the transactions exposure are, in general, not posted to the firm s financial statements and reports but they only enable managers to gauge the effect of this exposure on firm value. 9
3). Economic exposure. Economic exposure is the extent to which the market value of a firm or subsidiary changes when exchange rates change. Note: (in retrospect) that translation exposure may not be a true reflection of reality since the value of a firm is equal to the present value of future cash flows. Economic exposure takes into account three aspects of exchange rate risk: i). Net worth exposure: the impact of exchange rate changes on the market values of fixed assets and inventory. ii). Cash flow exposure: the impact of exchange rate changes on the projected real inflows and real outflows denominated in different currencies. iii). Real exchange rate exposure: the accounting for exchange rate changes that result from differences in national inflation rates. A statistical measure of economic exposure can be obtained by applying linear regression analysis on real cash flows or real net asset values as follows: CF t t t, where CF t = cash flows in home currency units in period t S t = spot exchange rate (home currency units per unit of foreign currency, e.g sh.80/$)! #"$% &(')')!%(!*+),+-.(/103242+56&7 8:9 Cov(CF t, S t ) Var(S t ) which is a measure of the sensitivity of cash flows to the level of the exchange rate; which is precisely a definition of exposure denominated in the foreign currency units. Exchange rate times this exposure yields the foreign exchange rate gain/loss. Foreign Exchange Risk Management. 1). The Use of forward Currency markets. A firm investing or selling abroad in anticipation of future receipts of foreign currency in one period s time can insure (or hedge) against foreign exchange risks by selling the foreign currency, Y, (e.g U.S$) forward for the home currency X (e.g Ksh) at the known agreed forward rate F xy = 1/F yx that is known now, where F xy is the number of units of currency X (Ksh.) per unit of currency Y (U.S$) that are available from a forward contract for delivery in one period s time. 10
The present value (PV 1 ) of the cash received in currency X (Ksh) from hedging using the forward exchange rate is: PV 1 = F xy.v y /(1 + i x ) (1) where V y = cash generated by the project at the end of the period and i x is the interest rate in currency X. 2). Neutralizing Foreign Exchange Exposure. The firm (MNC) could make use of the financial markets internationally to neutralize its foreign exchange risk exposure. This exposure depends on the pattern of the flow of future receipts and payments under the project or overseas operation, together with the time profile of the firm s net monetary assets less liabilities. Note: Monetary assets include cash, debtors tax refunds receivable etc; while monetary liabilities include creditors due, tax due, bonds due etc. To neutralize its foreign exchange exposure, the firm can borrow against an excess of future receipts over future payments or its net positive monetary position if it fears a decline in the value of the foreign currency. The amount of borrowing, B y, in the foreign country that is required to neutralize the positive cash inflow of V y from the project at the end of the period is given by: B y.(1 + i y ) = V y (2) so that the total repayment and interest on the foreign borrowing is just equal to the cash coming in from the project at the end of the period, where i y is the interest rate in currency Y. Borrowing the amount B y in the foreign currency generates cash at the start of the period of an amount equal to: PV 2 = B y.s xy = V y.s xy /(1 + i y ) (3) using eq.(2), where S xy is the current spot rate of currency X for currency Y. If the interest rate parity theory holds, then 1 + ix = Syx (4) 1 + iy Fyx From eq. (4), we may show that PV 1 =PV 2 i.e the present value of the cash generated is the same, whether the firm hedges using the forward currency market or neutralizes its future overseas cash flows by borrowing in the foreign currency. 11
3). The use of Derivatives. The two risk management strategies mentioned above eliminate the risk of foreign exchange movements to the extent of ensuring a certain flow of currency X from the project, given a certain flow of currency Y from the project at the end of the period. However, this does not eliminate two remaining sources of risk: (i) (ii) the firm might have achieved a high cash flow in currency X through a better exchange rate from an appreciation in S xy by waiting to see what the spot rate actually is at the end of the period, rather than opting for certainty; and the cash flow from the overseas project in currency Y may be uncertain, causing potential financial embarrassment to the firm if it sells its expected cash flow forward on the forward currency market or has to repay overseas borrowing out of this uncertain future cash flow. The first source of risk (i) above involves the upside risk of a gain from the appreciation in S xy which would be beneficial to the firm. However, the firm still wishes to limit its exposure to the downside risk of S xy dropping in value. To still retain the benefits of the upside risk while limiting the downside risk, the firm can make use of currency options. The firm could buy from its bank (or elsewhere) a put option in currency Y with an exercise date at the end of the period and with an exercise price of P xy. If the actual spot rate, S xy, drops below P xy at the end of the period, the firm can exercise the put option (i.e sell its foreign exchange income of V y at the exercise price of P xy to avoid the fall in the spot rate). The converse is true. 4). Covered Interest Arbitrage (recall?) 5). Currency Swaps ( Homework: Read on this!) 12