b821 block4unit8 foreign exchange and contingent risk

7/28/2019 b821 Block4unit8 Foreign Exchange and Contingent Risk

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B821 FinancialStrategylock 4 Financial Risk ManagemeB nt

Unit 8ForeignExchangeandContingentRiskPreparedbytheCourseTeam

Masters


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Thispublication formspartofanOpenUniversity courseB821,FinancialStrategy.Detailsof this andotherOpenUniversitycourses canbeobtained from theStudentRegistration andEnquiryService,TheOpenUniversity,POBox625,MiltonKeynes,MK76YG,UnitedKingdom:tel. +44 (0)1908653231,[email protected],youmayvisit theOpenUniversitywebsite athttp://www.open.ac.ukwhereyoucan learnmore about thewide rangeofcoursesandpacksoffered at all levelsbyTheOpenUniversity.Topurchasea selectionofOpenUniversitycoursematerialsvisithttp://www.ouw.co.uk,orcontactOpenUniversityWorldwide,MichaelYoungBuilding,WaltonHall,MiltonKeynesMK76AA,UnitedKingdom forabrochure. tel. +44 (0)1908858785; fax+44 (0)1908 858787;[email protected]

TheOpenUniversityWaltonHall,MiltonKeynesMK76AAFirstpublished 1998.Secondedition1999.Third edition2000.Fourthedition2003.Fifthedition2006. Sixth edition2006.Reprinted2007.Copyright#1998,1999, 2000, 2003,2006,2007TheOpenUniversityAll rights reserved.Nopartof thispublicationmaybe reproduced, stored ina retrieval system, transmittedorutilised inany formorbyanymeans, electronic,mechanical,photocopying, recordingorotherwise,withoutwrittenpermission from thepublisherora licence from theCopyrightLicensingAgencyLtd.Detailsof such licences (for reprographic reproduction)maybeobtained from theCopyright LicensingAgencyLtdof90TottenhamCourtRoad,LondonW1T4LP.OpenUniversitycoursematerialsmay alsobemadeavailable in electronic formats foruseby studentsof theUniversity.All rights,includingcopyrightand related rightsanddatabase rights, in electroniccoursematerials and their contents areownedbyor licensed toTheOpenUniversity,orotherwiseusedbyTheOpenUniversity aspermittedby applicable law.Inusingelectronic coursematerialsand theircontentsyouagree thatyourusewillbe solely for thepurposesof followinganOpenUniversitycourseof studyorotherwiseas licensedbyTheOpenUniversityor its assigns.Except aspermittedaboveyouundertakenot tocopy, store inanymedium (includingelectronic storageoruse inawebsite),distribute,transmitor retransmit,broadcast,modifyor show inpublic suchelectronicmaterials inwholeor inpartwithout thepriorwritten consentofTheOpenUniversityor inaccordancewith theCopyright,DesignsandPatentsAct1988.Edited anddesignedbyTheOpenUniversity.Typeset in IndiabyAldenPrepressServices,Chennai.Printed andbound in theUnitedKingdombyHobbs thePrintersLimited,BrunelRoad,Totton,Hampshire,SO40 3WX.ISBN 9780 7492239466.2
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C O N T E N T S 1 Introduction 52 What is foreign exchange risk? 7

2.1 The nature of foreign exchange exposure 72.2 Transaction exposure 72.3 Translation exposure 82.4 Economic exposure 102.5 Measurement of foreign exchange exposure 13

Summary 163 The market for foreign exchange 17

3.1 What and where is the foreign exchange market? 173.2 The size of the worlds currency markets 183.3 Why and for whom does the foreign exchange

market exist? 18Summary 21

4 The mechanics of foreign exchange 234.1 Spot rates 234.2 Cross rates 274.3 Forward exchange rates 284.4 The advantages and disadvantages of using forward

contracts 33Summary 35

5 Forecasting foreign exchange rates 375.1 Fundamental approaches to forecasting

exchange rates 375.2 Technical analysis 455.3 Currency histograms 46

Summary 486 Techniques for exposure management 49

6.1 Internal techniques 516.2 External techniques 546.3 Arguments for not hedging 596.4 The solution of currency unions 60

Summary 65


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7 Contingent risk 678 Options 69

8.1 Options where did they come from? 698.2 Options on shares 708.3 Pay-off diagrams 748.4 Currency options 818.5 Interest-rate options 848.6 Options pricing 88

Summary 89Summary and conclusions 90Appendix 1 Proofs of propositions concerning

optionvaluation 92Appendix 2 Valuing share and currency options 97Answers to exercises 105References and further reading 112Acknowledgements 113


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1 I N TR OD U C TI ON 1 INTRODUCTION

In thismiddleunitof theblockonFinancialRiskManagementwelookat twokeyelementsof financialrisk:namely, foreignexchangeriskandcontingentrisk.

Youwill study foreign exchange risk firstwhat it consists of, howto measure it and manage it; this is covered in Sections 2 to 6. Thediscussion also covers the main financial instruments used inforeign exchange management.The unit then moves on to consider contingent risk. This is the risktowhichyou become exposed if a particular event occurs

whether the risk materialises depends (or is contingent) on such aparticular event happening. Sections 7 and 8 examine the types ofcontingent risks organisations can be exposed to and then explorethe means of managing these risks. Managing risk brings us intotheworld of financial options instruments that are, in effect,insurance policieswhichyou can buy to protectyourself against ariskwhich may materialise. Entering theworld of financial options

with its complex mathematics, jargon and complicated diagramsmay appear daunting. Please relax though!Youwill not beexpected to delve into the intricacies of options models. Rather, touse a motoring analogy,youwill be opening the bonnet to see thatthere is an engine, a radiator, a starter motor and an alternatoramong other things, butyouwill not be dismantling the constituentpieces, simply investigatingwhy they are there.Learning outcomes By the end of this unit,you should be able to:l explain the differences between transaction, translation and

economicforeign

exchange

exposure;

l understand spot and forward exchange rates;l describe the linkage between forward exchange rates and

interest rates;l describe some of the determinants of exchange-ratevariability;l design a hedging strategy to manage foreign exchange risk;l understand the rationale for establishing a common currency

such as the euro across a number of nation states;l understand contingent risk;

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UNIT 8 FOREIGN EXCHANGE AND CONTINGENT RISK

l describe the main elements of financial options contracts andtheir use;

l describe the key factors involved in thevaluation of financialoptions;

l make use of computer software forvaluing options.



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2 WHAT IS FOREIGN EXCHANGE RISK?

2W H AT I S FOR EI GN EX C H A N GE R I SK ? Irrespectiveof thenatureof theiractivities,organisations need tounderstandand,wherenecessary, control the degreeof foreignexchangevariability towhich they areexposed. In order to do this,every organisation must find answers to the following key questions:l What is the nature of our foreign exchange exposure?l How can this risk be measured?l Does our organisation need to hedge this risk ...l ...and,ifso,whattechniquesareavailabletohedgeourexposure?

Anexchange rate issimply thepriceofacurrencyexpressedasavalueofanothercurrency.

2 . 1 T H E N AT UR E O F F O R E I G N E X C H AN G E E X P O S UR E

What is meant by foreign exchange (or FXor forex) risk? It is therisk of financial loss caused byvariations in exchange rates thataffect an organisations business. Sometimes the change isrepresented by an actual cash-flow difference; sometimes it isreflected in a change in recordedvalue, although no funds move.This is a broad-brush definition andwe need to refine it. It is usualto divide FX risk into three categories of exposure:l transaction exposure;l translation exposure;l economic exposure.Let us look at each of these.

Foreignexchange,FXand forex. In thisunit,weuseall theseterms interchangeablybecause that iswhathappens in the financialmarkets.

ACTIVITY 2.1Before

reading

further,

list

the

ways

in

which

you

believe

the

organisationyouwork for is exposed to FX risk. Notewhichcurrencies are involved. Keep this list for a further reviewlater on in this unit.

T R AN S AC T I O N E X P O S UR E 2 . 2 This is the exposure that most peoplewould normally associate

withmovements

in

exchange

rates.

Transaction

exposure

is

the

cash-flow consequence that changes in foreign exchange rates haveon existing contractual obligations. For example, a US companymakes a sale, denominated in euros, to an Italian company. Until

FX transactions involvetheexchangeofonecurrency foranother;whensellingoneyoumustbuy theother.



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the Italian company pays for the sale, there is a risk thatfluctuations in the USD/EUR exchange ratewill affect the finalamount the US company receives. Other typical types of transactionexposure are the repayments on loans denominated in overseascurrencies, purchases from overseas companies and dividends fromoverseas subsidiaries.Transaction exposure occurswhenever foreign-currency cash flowsare agreed. Even before formal contracts are made (for example,

when a price is quoted, but before an order is confirmed) potentialexposure may arise. Table 2.1 shows an example of actual andpotential transaction exposure.

Table2.1 An exampleof wheretransaction exposure existsCompanycreatesnewproduct

Buildsupstocks

Fixes foreignprice forproduct

Receivesorder Invoicedate Receiptofforeign

fundsConversion intodomestic currency

: :Potentialtransactionexposure

Actual transactionexposure Gainor lossduetoexchange-ratemovementcrystallised

An organisation designs a product for export. It builds up stocks,fixes the products prices, receives an order, sends an invoice andis eventually paid.After fixing the product price, but before actuallyreceiving payment and converting into its domestic currency, theorganisation is subject to transaction exposure, potential at first,then actual once the order is received.Transaction exposure therefore involves precisely identified cashflows and results in realised gains and losses thatwill affect theprofit and loss account (or income statement under IFRS). Thus,transaction exposure is likely to have a tax effect,with realisedgains being taxable and losses deductible.

T R AN S L AT I O N E X P O S UR E 2 . 3 Translation exposure (also called accounting exposure) arises fromthe need to translate the foreign-currency financial statements ofoverseas subsidiaries into the home currency in order to prepare aset of financial statements for the group in the home currency.Anexamplewould be a US companywith a Spanish subsidiary. Toprepare the full accounts for the US company, the accounts of theSpanish subsidiarywould need to be translated into USD andadded to the results of the US company. Every time the Spanishaccounts are translated into USD, a uniform USD/EUR exchangeratewould be used, usually the financialyear-end rate.Even if therewere no activity in the Spanish subsidiary over ayear,changes in the USD/EUR exchange ratewould mean that, over

In thisunitweuseSWIFTcodes forcurrencies.ForexampleUSD forUSdollars,orEUR for theeuro.Aguide to thesecodescanbe found intheGlossary.SWIFT isaco-operativeownedbythe financial industryandsuppliesstandardisedmessagingservices toinstitutions.SWIFTstandsforSociety forWorldwideInterbankFinancialTelecommunication.



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time, the US translated accounts for the Spanish subsidiary couldshow different resultswhen looked at in terms of the USDequivalent. Indeed, it is not uncommonwith translation exposurefor there to be no associated cash flows in a reporting period

when the relevant assets and liabilities have been in the subsidiaryfrom earlieryears. Should the organisation sell its foreign assets andrepatriate the proceeds (or repay its foreign liabilities) therewould,of course, be actual cash flows and hence transaction exposures.Note that it does not require the presence of an overseas subsidiaryfor translation exposure to exist. Exposure can even arisewhere acompany simply has overseas assets that need to be translated tothe reporting currency on the balance sheet date.Different approaches to dealingwith translation exposure may leadto two organisations,with identical overseas subsidiaries, presentingdifferent group balance sheets. This arises in particular from thechoice of exchange rates to use for translation.Thereisanaccountingstandardinmostcountriesonforeign-currencytranslationthatprescribeswhichexchangeratestouseand

when.IntheEuropeanUnionfrom2005thisisInternationalAccountingStandard(IAS)21.ThisstandardhasbeenadoptedwithintheInternationalFinancialReportingStandards(FRS23).Generally,thisprescribesthatforeign-currencymonetaryassetsandliabilitiesarisingfromoverseasoperationsshouldbereflectedattherateapplyingattheendofthefinancialyear(theclosingrate).Bycontrast,non-monetaryitems(suchassharesinacompany)maybemeasuredateitherhistoricalcostormarket(fair)value:intheformercase,translationisattheexchangerateatthedateofthetransaction;inthelattercase,attheratethemarketvaluewaslastestablished.Exchangedifferencesarisingwhentranslatingmonetaryitemsatratesdifferent from those applying initially are, in most cases, recognisedin the consolidated profit and loss account and are subject to taxat this point. The treatment of non-monetary items is that any gainsor losses on translation are reflected in the parent companysbalance-sheet reserves and are not recognised in the profit and lossaccount (and subject to tax) until the items are disposed of.Examples of translation accounting policy are shown in Box 2.1.

BOX 2.1ACCOUNTING POLICIES AlliedDomecq,12months to31August2004ForeigncurrenciesMonetaryassetsand liabilities from transactions in foreigncurrenciesare translatedat the rateofexchangeprevailingat thedateof transaction.Subsequentmovements inexchange rates



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are included in thegroupprofitand lossaccount.The resultsoftheundertakingsoutside theUnitedKingdomare translatedatweightedaverageexchange rateseachmonth.The closingbalance sheetsofundertakingsoutside theUnitedKingdomaretranslatedat yearend rates.Exchange ratedifferencesarising fromthe translationof foreign currencydenominatedbalance sheets toclosing ratesaredealtwith through reserves.(AlliedDomecqplc,ReportandAccounts2004)Boots,12months to31March2005Foreign currenciesThe resultsand cash flowsofoverseassubsidiariesand the resultsofjointventuresare translated into sterlingonanaverageexchange ratebasis,weightedby theactual resultsofeachmonth.Assetsand liabilities includingcurrencyswapsare translated intosterlingat the ratesofexchange rulingat thebalancesheetdate.Exchangedifferencesarising from the translationof the resultsandnetassetsofoverseassubsidiaries, lessoffsettingexchangedifferenceson foreign currencyborrowingsand currencyswapshedging thoseassets (netofany related taxeffects)aredealtwiththrough reserves.Where foreign currency hedges are taken out for committed futureforeign currency purchases, the fair value of those hedges are notincluded in the profit and loss account and balance sheet. Allother exchange differences are dealtwith in the profit and lossaccount.The costof the company investment inshares inoverseassubsidiaries is statedat the rateofexchange in forceat thedateeach investmentwasmade,exceptwherehedgeaccountingapplies inwhich case the yearend rate isused.(BootsGroupplc,AnnualReportandAccounts2005)

It is important to emphasise that translation exposure does not havea cash-flow impact on the organisation, but it does affect the totalbalance sheet and the profit and loss figures shown in theaccounts. This may therefore affect how outsiders perceive theorganisation.

E C O N O M I C E X P O S UR E 2 . 4 Economic exposure (sometimes called operating exposure orstrategic exposure) measures the change in the presentvalue ofthe firm resulting from any change in the future operating cash

10 OU BUSINESS SCHOOL


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flows of the firm caused by an unexpected change in exchangerates. The change invalue depends on the effect of the exchangerate change on future salesvolume, prices or costs (Eitemanetal.,2003).Economic exposure can be thought of as encompassing transactionexposure,

but

generally

takes

a

broader

perspective,

in

that

it

looks at thewhole operation of an organisation and how cost andprice competitiveness could be affected by movements inexchange rates. It also encompasses the impact on an organisationof the effect that FX movements have on the cash flows of itscompetitors.

Away to see the difference between them is that transactionexposure only refers to that associatedwith cash flows that havealready been contracted (for example, sales invoiced), butwhichhave notyet taken place. By contrast, economic exposure is much

wider, covering certain cash flows (that is, cash flows contractedfor) and those that are likely to arise in the future as theorganisation goes about its business.For example, a company manufacturing luxury cars in Germanyfor sale to the USwill be exposed to transaction risk on all sales tothe US denominated in USD. The German companywill, however,also be economically exposed. Over time, the German company

will be exposed to shifts in the USD/EUR exchange rate. If thecompetitors of the German-based manufacturer are all based in theUS, any increase of the USD/EUR exchange rate (that is, anappreciation of thevalue of the EUR)will increase its sales pricesin the US,which may mean a loss of market share to thoseUS competitors.

EXERCISE 2.1Aprs GmbH is a German company selling skiing holidays inSwitzerland to German customers.Aprs GmbH faceseconomic and transaction exposure since it sells Swissholidays to German customers. Its future profitabilitywilldepend on the EUR/CHF rate. If the CHF strengthens againstthe EUR,Aprss costswill increase. Unless itcan pass on theprice increases, itwill generate less profit. If it does pass onthe price increases, it may lose market share to thosecompanies not exposed to the EUR/CHF rate for example,companies selling skiing holidays in France to Germancustomers.Whatwill determinewhetherAprs GmbH can pass on to itscustomers cost increases due to movements in foreignexchange?



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BOX 2.2DOLLAR WOESIn2003and2004 theUSDollarweakened sharplywith theUSD/GBP ratemoving from$1.60 to$1.90.Theeconomic impactof

this

was

reported

in

the

Sunday

Times

in

the

United

Kingdom.

ThechiefexecutiveofaUnitedKingdombasedmanufacturerofhigh-techsimulatorsobserved: The realhit tous from the[fall in the]dollar isnotjust the fact thatallourcompetitorsareAmerican. It is thatwearecompeting in thirdmarketssuchastheMiddleEastagainst[US]dollarpricedcompetitors.ThechairmanofafirmexportingspecialistcleaningmaterialstotheUSechoedthissentiment:WereonlyjustbreakingevenonourexportstotheStatesasitis,andwearenotlookingfornewbusiness.Clearlywith suchahugechange in thevalueof theworldsmajorcurrency itwas inevitable that the vulnerabilityoforganisationsworldwide toFXeconomicexposurewouldsurface.

(SundayTimes,21November2004)

As Exercise 2.1 and Box 2.2 have shown, identifying economicexposure to movements in exchange rates isvery difficult. It is, forexample, easy to understand that a German organisation,with aproduction base in Germany, is exposed to changes in the USD/EUR, as sales in its industry may be denominated in USD. Furtheranalysis may highlight that some of its competitors are based in

Japan and, even though sales may be in USD, there may be anindirect exposure to the USD/JPYexchange rate and, byimplication, the EUR/JPYexchange rate, since thesewill affect theability of the German company to competewith itsJapanesecompetitors. Onceyou look at the range of exchange rates thataffect the marketyou trade in as awhole, rather than just thoseexchange rates that apply toyour direct business in that market,

you start to understand just how complex it is to quantifyeconomic exposure.Asyou can see, economic exposure is animportant strategic risk for organisations.Whilewe have focused onthe nature of FX risk on the sales activities of organisations, notethat FX exposure also has an impact on the purchases made by anorganisation.

ACTIVITY 2.2Revisit the notesyou made aboutyour organisations FX exposure and considerwhetheryou can now refineyour list.How easywould it be foryou to quantify these exposures?



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BOX 2.3WHERE DID YOU GET THAT HAT?Inan interviewonBBCRadio4sTodayprogramme,whenquestionedabout the impactof the strongGBPonhisexports, theownerofa smallmanufacturerof chef'shatssaidhehaddealtwitha strongGBPbyproducinghats inGermany, towhichmuchofhisexports from theUnitedKingdomhadbeengoing.This isoneexampleofhow todealwitheconomicexposurebutnotethatbyestablishingaGerman subsidiary thecompanyopeneditselfup to translationexposure.

ACTIVITY 2.3Read the article from the Course Reader, Operating Exposureby Lessard and Lightstone.Throughout the article, inyour mind, please replace their termoperating by economicwhen talking about exposure. Bothwords can be used, so itwas felt inappropriate to change theauthors preferred term, although economic is more commonin Europe (which iswhywe use it).Note how this article highlights the complexity of economic,or operating, exposure.Although many organisations mightdecide that there isvery little that they can do abouteconomic exposure in the short term, it is an area that has tobe managed over the long term.

M E AS UR E M E N T OF F O R E I G N E X C H AN G E E X P O S UR E

2 . 5 How doyou measure the amount of the FX exposureyourorganisation has?



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Ta

ble

2.2

(a)

Measuremen

to

ftr

ansac

tionexposure

.Source:

Buc

kley

(1996)

Compa

ny

USSubInc.

Country

USA

Currency

Forecastperiod

6month

sto30.6.06

Preparedby

AB

Dateprepared

24.12.05

Rate:$v.as

at24.12.05

Spot:1.72001

mth1.7300

3

mths1.7500

Jan

Feb

Mar

Apr

May

June

Beyond

June

RECEIPTS

Thirdp

arty

Inter-co

mpanySwedishsub

2000

3000

2000

1000

1000

1000

DueSept

06

TOTAL

RECEIPTS

2000

5000

1000

1000

1000

PAYME

NTS

Thirdp

arty

Inter-co

mpanyGermansub

3000

3000

2000

2000

DueOct

06

TOTAL

PAYMENTS

3000

3000

2000

2000

NETRECEIPTS/(PAYMENTS)

COVER

AGAINSTRECEIPTS

COVER

AGAINSTPAYMENTS

(1000)

1000

2000

1000

(1000)

1000

1000

1000

(2000)

2000

Sept

06

Oct

06

NETEXPOSURE

1000

1000

1000

DETAILSOFFORWARDCOVER*

(specifycontractdate;settlementdate;rate;

amount)

1.8.05

Jan1.7530

1000

1.9.05

Feb1.7450

1000

30.9.05

Mar

1.7550

1000

16.10.05

Oct

1.7580

2000

*Details

offorward

coverfrequently

appearon

a

se

parate

schedule.

Note

thatthe

details

offorward

foreign

exchange

willbe

covered

laterin

this

unit.



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Table2.2(b)Jan Feb Mar Apr May June Beyond

JuneCurrencieswitha forwardmarketEcountrieswherewedobusiness

BelgiumHollandFranceGermanyItalyOtherEuroamounts

TotalECanadian$JapaneseyenSwedishkronaSwiss francUS$Others (specify)TotalNo forwardmarketArgentinianpesoBrazilian cruzeiroOthers (specify)TotalSource: adapted fromMultinational Finance,A.Buckley (1996)

Transaction exposure could be measured in the format shown inTable 2.2(a) and Table 2.2(b). These show the currency flowsemanating from a companys business and the net foreignexchange exposure that results.A decision has to be taken,however, on how many months of sales or purchases should beincluded in the transaction-exposure position. Thisvaries betweencompanies, depending on each companys pricing flexibility andhow fast it can increase selling prices to offset the effect of acurrency change.Economic exposure is more difficult to pin down. It is necessary toinclude both certain, quantifiable exposures (transaction exposure)and thosewhere risk is less clearly defined (situations such as

Aprs GmbH in Exercise 2.1). Organisations usually need a systemOU BUSINESS SCHOOL 15


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that can handle both hard quantifiable data and less preciseinformation.To achieve thisyou could produce a strategic DCF model for the

whole organisation. This might highlight the direct effects ofexchange rate movements, but also the indirect effects, through theinfluence

on

competitors,

customers

and

suppliers.

In

essence,

you

would be performing scenario analysis based on, for example,Porters five forces.Measuring economic exposurewould involve the followingconsiderations.l Strategic consideration of expected future cash inflows and

outflowswhichwould require discussionswith the sales andmarketing arms of the organisation.

l Interrogation of the model by testing itwith what ifscenarios perhaps based on Porters five forces.

l Establishing the key currencies relevant to the organisation.l Assessingwhatwould happen if a relevant currency changed

by, say, 10% or 20%. This could feed into different possiblestrategies: the short term (six months), medium term (one totwoyears) and long term (say, more than twoyears).

l Evaluating the likelihood of the different scenarios occurring: forexample, how likely is it that the USD/EUR ratewill be, say,USD1.50/EUR1 in oneyear from now?

S UM M AR Y FX exposure concerns the risk that thevalue of assets, liabilities,profits, losses or cash flows might changewith changes in FX rates.In this sectionyou have looked at the three different types of FXexposure that may arise as currency movements alter homecurrencyvalues: transaction, translation and economic exposure.Wenow move on to examine the FX markets,what determines the

values of currencies andwhy thesevalues change over time.



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3 T H E M A R K ET FO RFOR EI GN EX C H A N GE 3 TH E MARKET FO R FOREIGN EXCHANGE

Whenwe take holidays overseas, buy goods from abroad orworkin organisationswhere some purchases or sales are in foreigncurrencies,we are affected by movements in FX rates. For examplethe USD fell substantially against the GBP and EUR in 2003 and2004, losing approximately 15% and 25% ofitsvalue respectively. Changes in FX ratescan, therefore, have a dramatic impact onthe revenues of any organisation that deals

with selling its services and productsoverseas for example, The OpenUniversity!We need to understandwhatmakes exchange rates move andwhatwecan do to minimise our exposure (or,perhaps, to take advantage of thesemovements).Let us beginwith the foreign exchangemarket, how itworks and the meanings ofsome terms. One small point: as exchangerates can change so rapidly, the ratesweuse in this text may seem out of date bythe timeyou actually read them. Themechanics, however,will be the same. London thecapitalof foreignexchange

WH AT AND W HE RE I S T HE F O R E I G N E X C H AN G E M AR K E T ?

3 . 1 The foreign exchange market is the framework that permitsindividuals, companies, banks and brokers to buy and sell foreigncurrencies. The market for any one currency such asJapanese

yen (JPY) consists of all the locations such as London, NewYork,Frankfurt and Tokyowhere theJPY is bought and sold for othercurrencies. The market consists of the interbank (wholesale)market and the client (retail) market. Transactions in the interbankmarket are for large amounts of currency (for example, severalmillion USD). Transactions in the retail market are usually forsmaller amounts.

Where doyou findwholesale transactions in foreign exchange?Transactions take place in the capital of a country or in its mainfinancial centre. The major market for any single currency is itshome country and, especially, the city inwhich most foreign trade



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takes place. For example, Prague, Madrid and Mexico City arenational financial centres. There are also a few centres that are trulyinternational markets for foreign exchange business, principallyNewYork, London and Tokyo.Onecantradeanytimeofdayornightintheglobalforeignexchangemarkets.

This

is

because

FX

dealers

use

an

electronically

linked

network,connectingthemtothosewhowishtotradecurrencies.The continuous overlap of foreign exchange trading in differentcentres is illustrated in Figure 3.1. Banks inAsia Pacific begintrading in Hong Kong, Singapore and Tokyo at about the time mosttraders in San Francisco are finishing.AsAsia Pacific closes, tradingin the Middle Eastern financial centres has been going on for twohours and the trading day in Europe is just beginning. Owing tothe United Kingdoms geographical location, banks in London candealwithAsia Pacific, the Middle East and the USA, aswell aswiththe rest of Europe, during aworking day. This has helped Londonto maintain a pre-eminent position in the foreign exchange market.

T H E S I Z E O F T H E WOR LD SC UR R E N C Y M AR K E T S

3 . 2 InApril2004,theestimatedglobalnetturnoverintheworldsforeignexchange marketswas USD1,900 billion perworking day. This hadgrown by 60% from 1995. These data, produced by the Bank forInternational Settlements (BIS), showed that the US dollarwas the

worlds dominant currency, being involved in 89% ofall currencytrades. In contrast, the eurowas involved in 37% of trades,Japanese

yen in 20% and the GB pound in 17%. The BIS report showed theglobal market being dominated by London, NewYork and Tokyo,

with London retaining its position as theworlds FX capital.


Globalnet turnoverofFX transactionsmeansthe totalvalue inUSDofallspot,outright forward,swap, futuresandoptionstransactions.

Sinceeachcurrencytransaction involves twocurrencies, theaggregateparticipationofsinglecurrencies inFXtransactionsamounts to200%of the tradevolume.

3 . 3 W HYAND FO RWH OM D O E S TH E F O R E I G N E X C H AN G E M AR K E T E X I S T ?

Theworlds economic system is based upon a large number ofdifferent currencies, many ofwhich are freely convertible intoother currencies.The economic system does not require all currencies to be freelyconvertible, only that a medium of exchange is available.Whengovernment controls impede the convertibility of currencies anillegal free market (or black market) may develop.

For the latestdataon theFXmarketandFXactivity,visit thewebsitesof theBankofEnglandwww.bankofengland.co.ukand theBISwww.bis.org



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BOX 3.1THE MARKET FOR FOREIGN EXCHANGE My research indicates that,at the timeofwriting, thereare167currencies in theworldalthough there isadebateabout thisnumber largelyasa consequenceof the statusofveryminorcurrenciessuchas the Jerseypound.Thismeans thatanyonecurrencycouldbepriced166 timesorhave166markets inwhichtobuyor sell thehomecurrency.Thereare, therefore,potentially167currencies6166=27,722exchange rates.Theactualnumber,however, is lowerbecausesomecountries,suchasNorthKorea,donotengage in international trade. Inaddition,notall currencies in theworldare convertible.Non-convertibilitymeans thateither thegovernmenthas imposedexchangecontrolsor that the foreign tradeof the country isrelatively smalland, consequently, thecountrys currencywillnotbeexchanged (andhencepriced) inall currencymarkets.Nonetheless, thenumberofexchange rates tobepriced is stillconsiderableand theactualnumberchangeseach yearasa resultof international trade flows.(Adapted fromWoodandBtiz-Lazo,1995)

The participants in the foreign currency market include:l organisations (for example, importers and exporters, often

multinational companies);l investors;l recipients and payers of dividends, interest, profits, royalties

and loans;l speculators;l arbitrageurs;l central banks.

A speculators purpose is not to hedge, but to take risks on marketprices for profit.An arbitrageur seeks to obtain risk-free profits bytaking advantage of temporary pricing differences for the sameproduct in different markets.An arbitrageur gains the benefits ofthe price differences (arbitrages away) by buying and selling thesame product at different prices in different markets. Banks areacting in the interbank market on their own behalf and on behalfof their customers. The customers comprise central banks, foreignbanks, governments, companies and individualswhowish todispose of or acquire a particular currency. Note, however, thatindividuals and most firms do not engage in buying and sellingforeign currency directly. Rather, theywork through their bank or aforeign exchange broker.Only a fraction of the totalvolume of daily business in currencyis on behalf of customerswishing to finance their trading andcapital flows; thevast bulk of currency business is between banks,



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3 TH E MARKET FO R FOREIGN EXCHANGE

trading for their own accounts. But it is the market liquiditygenerated by the banks own account trading that ensures retailcustomers can obtain a fair FX quotewhenever they need it.

S UM M AR Y In this sectionwe have looked at the who, where and why oftheworlds trading in foreign currencies. The foreign exchangemarket consists of two levels: the wholesale and the retail level,and the main difference between the two is the size of thetransactions. The foreign exchange market is not a physical place,but an electronically linked network of institutions predominantlybanks. The market is extremely large and exists to provide currencyconvertibility to support international trade.A great proportion offoreign exchange transactions, however, are for speculation andarbitrage. In the next sectionwe shall look more closely at themechanics of trading in the foreign exchange markets.

Theconceptofarbitragewillbeparticularlyimportant forunderstandingpartsofSection4.



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TH E MECHANICS OF FOREIGN EXCHANGE

4 T H E M EC H A N I C S OF FOR EI GN EX C H A N GE 4

In this sectionwe look first at spot rates,which are deals donefor settlement now.You have been advised (in Unit 7) that spotinterest rates differ from spot exchange rates. In this unitwe aretalking about foreign exchangewheneverwe use the termspot rate.

We then discuss cross rateswhich are neededwheneverwewantto deal currencyA against currency B, butwhere each is quotedonly against currency C. In otherwords,we have a rate forAagainst C and B against C, butwe need to calculateA against B.The third topic for this section is forward exchange rates. Theseare spot rates adjusted to reflect the fact that delivery is deferreduntil some future date. In particular,we shall see that a forwardexchange rate isnot a forecast of a future exchange rate.

We concludewith a crucial subject: how to use the foreignexchange markets, be it for spot or forward transactions. This topic

will be continued in later sections.

A forwardexchangecontract isanagreementtopurchase foreignexchangeataspecifieddate in the futureatanagreedexchange rate.The rate is fixedwhen thecontract is takenoutsothat theparticipantsknowhowmuch theywillreceiveofonecurrencyandpayof theother.The

agreement

is

an

over-the-counter (OTC)dealbetween thecounterparties.


4 . 1 S P O T R AT E S In the spot market, currencies are bought or sold for immediatedelivery,which in practice means settlement in one or twoworkingdays. The rate for such a deal is called the spot exchange rate orspot rate.

BOX 4.1SPOT SETTLEMENTAsalreadynoted, ina currencydealmade for forwarddelivery,currenciesareboughtorsoldnow for futuredelivery.Though theexchange rate isagreedupon today,payment isatanagreed timein the future.This contrastswithadealdone for spotdelivery,where thecurrenciesare typically receivedandpaid in twoworkingdaysa time interval toallow forall theback-roomproceduresneeded toallow thesettlement tohappenandwhich isgenerallythoughtofas now.Why twoworkingdays?Consideradealer inTokyo talking tooneinSanFrancisco.Given time zonesand the InternationalDateLine, if it isafternoonofDay t inSanFrancisco, it isalready the


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morningofDay (t+1) inTokyo.Sinceboth sides reallyneedatleastoneday toensure thatallprocessesarecompletedsatisfactorily, thepractical intervalwhich shouldallowall situationstobe catered for is twoworkingdays.So spot is typically in twodays time.Thisdoesnotmean that it is impossible togetanearlierdelivery (tomorrowor today) inmanycircumstances forexample,betweencountrieswithinEuropebut the internationalstandard fordelivery is spot.

A foreign exchange rate is the price of one currency in terms ofanother. There are twoways of quoting these rates: the direct quoteand the indirect quote.The direct quote gives the quotation in terms of the number ofunits of home currency needed to buy one unit of foreigncurrency. The following are examples of direct quotes,written asifwewere in NewYork:

GBP1 = USD1.7294EUR1 = USD1.2013CHF1 = USD0.7686

The indirect quote gives the quotation in terms of the number ofunits of foreign currency boughtwith one unit of home currency.Examples of indirect quotes in London are as follows:

GBP1 = USD1.7294GBP1 = EUR1.4396GBP1 = CHF2.2502

Whetherdirectorindirect,itiseasytofindtheotherwayofquotingratessinceoneisthereciprocal(1/x)oftheother.Ifanindirectquotationisgiven(GBP1=USD2)thereciprocalofthisisUSD1=GBP0.50,adirectquotation.Donotbetooconcernedaboutdirectorindirect,butalwaysknowwhatisbeingquotedforwhat.Thisiseasierthanitsounds.Activity4.1clarifieswhatismeant.


Fordiscussionofreciprocals,seeVitalStatistics,Section1.2.5.


ACTIVITY 4.1Ifyou asked a foreign exchange dealer for a GBP/EURquotation andyou heard 1.44,whatwouldyou thinkwasmeant?Fromreadinganewspaperoranyothergeneralnewssource,youwouldknow that the ratewasaboutEUR1.50perpoundrather thanGBP1.50pereuro.Soyouwouldautomaticallyunderstandwhat thequotedpricemeant.Incidentally,

this

exercise

also

shows

why

reliance

on

the

terms

directandindirectisnotreallymeaningful.Assumethat
http:///reader/full/GBP0.50http:///reader/full/GBP0.50


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4 TH E MECHANICS OF FOREIGN EXCHANGE

youwere inLondonandcalledadealer inFrankfurt.IsEUR1.44/GBP1adirectoran indirectquotation?It isbothorneither.TheFrankfurtdealersees itasdirect,youregard itas indirect,but theactualquotation isunaffectedby thegeographicallybased terminology.

Table 4.1 shows a selection of spot and forward exchange ratesagainst the United Kingdom pound (GBP). The data relate totrading on 20July 2005 andwere published in theFinancialTimesthe following day.All the exchange rates shown use the indirectmethod.Table4.1 Spotandforwardratesagainst theGBP,20 July2005

Currency

abbreviation Closing mid-point Change onday 1 monthforward 3 monthsforward 1 yearforwardEuropeDenmark DKK 10.7431 -0.0688 10.7203 10.6766 10.5204Norway NOK 11.4660 -0.1435 11.4408 11.3952 11.2574Switzerland CHF 2.2502 -0.0169 2.2426 2.2280 2.1726Eurozone EUR 1.4396 -0.0093 1.4365 1.4306 1.4094AmericasArgentina ARS 4.9440 -0.0270Brazil BRL 4.0770 +0.0116Canada CAD 2.1136 -0.0032 2.1098 2.1036 2.0878Mexico MXN 18.4143 -0.0424 18.4986 18.6706 19.4237UnitedStates USD 1.7294 -0.0079 1.7276 1.7253 1.7252PacificAustralia AUD 2.2952 -0.0215 2.2971 2.3258HongKong HKD 13.4523 -0.0600 13.4368 13.4134 13.3691NewZealand NZD 2.5693 -0.0094 2.5745 2.6361Source:Financial Times, 21 July 2005

Two columns in Table 4.1 are labelled Closing mid-point andChange on day. Closing mid-point is the mid-point between thebuying rate and the selling rate at the close of trading business(20July 2005 in this case). Change on day is simply the movementfrom the previous days closing price.



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BOX 4.2BID-TO-OFFER SPREADSThe ratesshown inTable4.1are themid-pointsof thespreadbetween theexchange rateatwhich the currenciesareboughtandsold.Thedifferencebetween these two reflects themargin thebanksFXdealersseek toextract from their transactions.Thesizeof thisbid-to-offerspreadvariesaccording to thedepthofthemarket (or thevolumeof transactions)and themarketsvolatilityat the time.Aquote fromadealer inLondonofUSD1.72851.7295showsaspreadofUSD0.0010: this is ten points.Apoint isaunitofdecimal,usually the fourthplace to the rightof thedecimalpoint(0.0001).Apip isusually the fifthplace to theright (0.00001).TheFXdealer is the marketmaker thepersonquoting therates; the marketuser is theperson (perhaps yourself)who takesthe ratesasgiven.This is truewhether thequotation isdirectorindirect.Whenyouwant tobuy currency, theFXdealer is thenselling that currency toyouandvice versa.Forexample, ifFXdealersarequoting youabid-to-offer spreadforAUDagainstGBPofAUD2.28522.2872 itmeans theyarewilling to:sellAUD to youatAUD2.2852 foreachGBP1 theybuy;buyAUD from youatAUD2.2872 foreachGBP1 theysell.

Thereforeyoumustestablishwhat rate (the buy rateor the sellrate) thedealer isquotingeach time you transact.Youexperience thesebid-to-offer spreadsyourselfwhenyoubuycurrencies to takeonholidayand (on theassumptionyouhavesome left)sell someof itbackon your return.The sizeof thebid-to-offerspread facingan individual is large relative to thosefacedby institutions in thewholesalemarkets.Thebid-to-offerspreadmeans that,assumingexchange ratesarestable, theFXdealers (and theirbank)alwayswin.This isbecause the lower limitof thespread (bidprice) is the rateatwhich thebankwillbuy from youwhile theupper limitof thespread (offerprice) is the rateatwhich thebankwillsell to you.

EXERCISE 4.1Using Table 4.1, identify the closing spot exchange rates forGBP against:(a) NOK spot(b)HKD spot(c)EUR spot(d)USD spot.



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C R O S S R AT E S 4 . 2 So farwe have seen how spot rates are normally quoted. That isfine ifwewant, for example, a USD/CHF exchange rate, becausesuch rates are quoted explicitly.What ifwe needed to sell Swissfrancs against New Zealand dollars?Wewould require a CHF/NZDexchange rate. If only USD/CHF and USD/NZD rates areimmediately available,wewould need to be able to calculate therequired cross rate from the set of standard quotations (usuallyagainst the USD) that are readily available. The procedure isverystraightforward:we compute the required rates as ifwe had boughtand sold the intermediate currency. So in our CHF/NZD example,given thatwe know the CHF/USD and NZD/USD spot rates,weshould first buy USDwith our CHF (using the CHF/USD rate), andthen sell those notional dollars for NZD at the NZD/USD rate.Some actual figureswill show how to do the computation, ignoringbid

askspreads

for

simplicity.

Let

us

use

the

exchange

rates

applying on 20July 2005 of CHF1.3011/USD1 and NZD1.4857/USD1.If the initial amountwere CHF2,000,000, then after Stage 1weshould have

USD(2,000,000/1.3011) = USD1,537,160.86After Stage 2,we should have

NZD(1,537,160.8661.4857) = NZD2,283,759.89We have therefore exchanged CHF2,000,000 for NZD2,283,759.89.This

gives

us

an

effective

NZD/CHF

exchange

rate

of

2,283,759.89/2,000,000 = 1.1419NZD/CHF

EXERCISE 4.2Ifwe require a rate to buy CHFwithArgentinean pesos (ARS),how shouldwecalculate the right rate?AssumeCHF1.3011/USD1andARS2.8588/USD1.

We can generalise the system to say:Multiply or divide the known rates so that the unwanted middlecurrency can be cancelled out.

In our examplewe had exchange rates for CHF/USD andNZD/USD.We therefore had to divide the second exchange rateby the first exchange rate to get the NZD/CHF exchange rate:

NZD/USD NZD USD NZD= =

CHF/USD USD CHF CHF

http:///reader/full/NZD2,283,759.89http:///reader/full/NZD2,283,759.89


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ThusNZD/USD

=1.4857

= 1.1419 NZD/CHFCHF/USD 1.3011

giving us the same result aswe calculated above.In

Exercise

4.2

you

had

the

exchange

rates

for

CHF/USD

and

ARS/USD, so to be able to cancel out the USDyou shouldmultiply the rates, since

ARS USD ARS =

USD CHF CHF

These procedures alwayswork, regardless ofwhether the rates arespots or forwards.

F O R W AR D E X C H AN G E R AT E S 4 . 3 A forward exchange contract is an agreement to deliver a specifiedamount of one currency for a specified amount of another currencyat some agreed future date. For example, ifyou as a Hong Kongcompany know thatyouwill be receiving GBP500,000 in sixmonths time,your company mightwellwant to know exactly howmany HKD theywill receive for those GBP. It is possible to obtaina quote for a forward exchange rate, or forward rate, in six monthsfor the GBP/HKD and, by booking a six-month forward contract atthis rate for the sale of these GBP,your companywill know nowexactly how many HKD itwill receive in six months time. Ofcourse, the forward agreement is a binding contract and must becompleted on the due date.Beforewe go on to see how forward contract rates are quoted and

what determines them,we should look at a few terms that areoften heard.If a currency is trading at a discount this means that the currency is

weaker in the forward market than in the spot market. If a currencyis trading at a premium this means that the currency is stronger inthe forward market. The impact of this on forwardversus spot ratescan be shownwith an example.If the spot USD/GBP rate is quoted in London as USD1.8000 =GBP1 and the forward rate for three months time is quoted asUSD1.8400 = GBP1 thenwe can say that the USD is currentlytrading at a discount to the GBP. That is, GBP1will buy more USDfor delivery in three months time than now. By implication,therefore, the GBP is trading at a premium to the USD.

Alternatively, if the spot rate for GBP/CHF is CHF2.4500 = GBP1and the six-month forward rate is CHF2.3900 = GBP1 then GBP1

will buy fewer CHF for delivery in six months time and the CHF istrading at a premium to the GBP. This premium or discountrepresents the difference between the forward rate and the spotrate for the currencies.



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EXERCISE 4.3What is the difference between saying sterling is trading at adiscountwith respect to the Swiss franc and saying the Swissfranc is trading at a premiumwith respect to sterling?

TheFXmarket isanover-the-counter (OTC)marketwhere there isnocentralmarketplaceorexchangeandeachtransaction takesplacedirectlybetween thecounterpartiesconcerned.Forward rates can be quoted in twoways, either as a forward

outright rate or as a forward margin. The forward outright rate isthe complete rate thatyouwould apply to calculate how much ofcurrencyAwas equal to currency B in the forward deal. Theforward margin is the difference, measured in points (see Box 4.2regarding points), between the forward outright rate and the spotrate: that is

Forward outright = Spot + Forward marginWhy make this peculiar division? Because, aswe shall see, theforward margin depends primarily on the interest differentialbetween the two currencies. It is therefore more stable than thespot rate, because interest rates are normally lessvolatile than FXrates.As a result, it is more practical to show thevolatile part (thespot rate) and the stable part (the forward margin) separately,bearing in mind that banks have to display (through Reuters andother market information systems) continually updated rates.Remember at the beginning of Section 4we said that the forwardratewas just the spot rate adjusted for a delay in settlement. Thisdelay

results

in

the

difference

between

the

spot

and

forward

rates

being determined provided the market isworking efficiently bythe interest-rate differential between the two currencies. Thefollowing example illustrates this.

Assume that an investor has GBP100,000which shewants to investfor ayear and she can invest in either GBP or USD.At the end ofthe period shewants to end upwith USD (perhaps she hascontracted to buy some US asset in oneyears time). The currentspot rate for USD/GBP is USD1.60 = GBP1. The forward rate forexchanging USD into GBP is USD1.57 = GBP1.Annual interest ratesin the USA and the United Kingdom for similar risk-free securitiesare 5% and 7% respectively. The investor has to decidewhether sheshould put her GBP100,000 into USD now and invest in dollars, orinvest it in the United Kingdom and book a forward exchange dealto provide the dollarswhen required.

EXERCISE 4.4Given the interest rates noted here,wouldyou expect theGBP to purchase more USD in oneyears time or fewer?

What should our investor do? It is easiest to show the decision in adiagram (see Figure 4.1).



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BuyUSD

spotat1

.60

GBP

USD

BuyUSD

forw

ardat1.57

Invest in GBP for period at 7%

Invest in USD for period at 5%

Time

Figure4.1 The rectanglemodel

Itis

very

important

to

realise

that

all

transactions

are

booked

at

the

start of the deal,whichever route is chosen. Thus buy USDforward is shown at the end of the rectangle because that iswhensettlement takes place. The rate, however, is locked in right at thebeginning of the period, as are also the spot rate and the twocurrencies interest rates.

Asyou can see from Figure 4.1, the investor should be indifferentas towhether she invests in USD or in GBP because she is justchoosing between alternative routes around the rectangle. Let us

work out the numbers and see if they are actually equivalent.Route 1 Invest in GBP and book forward exchangeThiswill involve investing at the sterling interest rate of 7% for one

year and exchanging the funds at 1.57, the forward exchange rate.As mentioned before, the forward ratewill have been booked atthe start of the deal and it is only the settlementwhich is delayedby oneyear.Thus the end result of taking Route 1would be:

Investment GBP100,00061.07 = GBP107,000Exchange GBP107,00061.57USD/GBP = USD167,990

Route 2 Buy USD spot and invest in USDThis choicewould give figures of:

Exchange GBP100,00061.60USD/GBP = USD160,000Investment USD160,00061.05 = USD168,000

Thevery small difference of USD10 is caused by rounding errorsdue to only quoting the exchange rates to two decimal places. Inpractice, rateswould usually be specified to four decimal places.Thus the two routes can legitimately be seen as equal.



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This is an example ofwhat is known as interest rate parity. Theforward rate for GBP against the USD reflects the differencebetween the interest rate on GBP and the interest rate on USD. If itdid not, opportunities for risk-free gains, or arbitrage,would arise;price movements in the marketswould then rapidly ensure thatthe two routes returned to equivalence.

ACTIVITY 4.2Workoutwhatwould happen if the interest rateswere thesame as in the preceding example, but a trader quoted theforward rate at the same level as the spot rate.Whattransactionswouldyou do to make a profitoutof the trader?If the investorstays inGBPshewillgetGBP107,000at theendof theyear.Ifshemoves intoUSD immediatelyandconvertsback intoGBPat theendof theyearshewillonlygetGBP105,000.Tomakeaprofitoutof the trader, the investorshouldborrowUSD,convert it intoGBPat the1.60 rateandputtheGBPondeposit.The investorshouldalso takeoutaforwardcontract tobuyUSD inoneyears time topayoffthe initialUSD loan.Sucharbitrageopportunitiesevenofmuchsmallersizeareveryquicklyeliminatedbymovements inexchangeratesand interest rates.

You have now learnt how it is possible to calculate the forwardexchange rate ifyou are given the spot rate and relevant interestrates. For everyday use it is better, however, to encapsulateavailable information in an equationwhich can be applied directlyand quickly. The formula below is used to calculate the forwardmargin rather than the forward outright rate itself, for the reasonpreviously discussed about relative stability of exchange andinterest rates. Thus the equation for the forward margin (FM) is

Period in days Spot rate i i(L)][ (F)FM =

360 + [Period in days i(L)]

where i(F) and i(L) are the interest rate per annum on the foreigncurrency, F, and the local currency, L, respectively, bothwritten asdecimals not percentages (i.e. 0.07 not 7%).Also, the currencies Fand L are connected by the spot rate, S, such that: F = S6 L. Inotherwords, thespot rate isdefinedas thenumberofunitsofcurrency Fperunitof currency L (it isvery important to get thisthe rightway round).The figure 360 in the equation is a market convention, meant torepresent the number of days in theyear. Box 4.3 explainswhy.



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Remember that thesterlingLIBORmarket,whichyouencountered inUnit7,uses365daysperyear.

BOX 4.3TRADE CALCULATIONS WITHOUT CALCULATORSWhydoes the internationalbankingmarket seem to think that theworldgoes round thesunonceevery360days rather than themore

common

notion

that

ittakes

about

365.25

days?

This isa continuationofahabitdevelopedby themedievalancestorsof todaysbankers.Whenallowing credit for tradegoods,typicallyevidencedbyaBillofExchange, themerchantswouldusuallygive the customer30,60,90or180daysbeforepaymentbecamedue.Before theadventofelectroniccalculators (oreventheolder,mechanicalsort) toworkout the interestpayable itwasmucheasier todivideby360 rather than365.The typicalperiodscould thenbederivedbydividingby12,6,4or2 corresponding to30,60,90or180days.Thispractice survives to thisday.Italsomeant that theactual interest ratebeing chargedwasa tinybithigher,bya factorof365/360,but youraveragemedievalcustomerwasnothighly trained in thedevilryofarithmeticandthemerchantswerentgoing to tell them!

You do not need to be able to prove the formula, just be able touse it and to understand the principle of the round the rectanglearbitrage relationship it comes from.Let us apply the forward margin equation to our round therectangle

example. Ifwe take GBP as our local currency, L, andUSD as our foreign currency, F, and use the rates from ourprevious example then

360 1.60 (0.05 0.07)FM =

360 + (360 0.07)= 0 03 .

The forward outright rate for USD/GBP is given byForward outright = Spot + Forward margin

= 1.60 0.03 = 1.57 USD/GBPThe forward outright rate of 1.57 is thus the same as in our originalcomputation.In the foreign exchange market, then, dealers calculate the forwardmargin for the forward rate for currency exchange by reference tothe difference in interest rates between the two currencies. Dealersdo not, as many of the public believe, simply guesswhere theexchange ratewill be. There is no guesswork in calculating forwardexchange rates.

Organisationsuse forwardexchangeagreements tosecure thevalueof futurecash flows.



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ACTIVITY 4.3From a recent edition of a financial newspaper (such as theFinancialTimes or theWallStreetJournal) pick an exchangerate that is particularly important foryour industry, an industryyou are familiarwith or for the countrywhereyou live.Identify the interest rates for the relevant forward period forthe two countries concerned such interest rates are shown,for example, in the Market Data page of theFinancialTimesin the Companies and Markets section. Then use the equationfor the forward margin to calculatewhether the exchange rateis trading at a premium or at a discount.

TH E AD V ANT AG E S AND D I S AD V AN T AG E S OF US I N G F O R W AR D C O N T R AC T S

4 . 4

By entering into a forward foreign exchange contract UnitedKingdom importers or exporters can:l fix at the time of the contract a price for the purchase or sale

of a fixed amount of foreign currency at a specified future time;l eliminate their exchange risk due to future fluctuations in

foreign exchange rates;l

calculate the exactvalue in their domestic currency (GBP) of aninternational commercial contract despite the fact that paymentis to be made in the future in a foreign currency.

If the foreign currency is trading at a premium it shows that thecurrency is stronger than GBP in the forward market. This meansthatwhen entering into a forward contract:l a United Kingdom exporterwill receive more GBP for the

proceeds of the foreign currency export at the future date thanat the spot rate current at the time the contract is taken out;

l a United Kingdom importerwill have to pay more GBP to settleits foreign-currency debts at the future date than at the spot ratecurrent at the time the contract is taken out.

If the foreign currency is trading at a discount it shows that thecurrency is weaker than GBP in the forward market. This meansthatwhen entering into a forward contract:l a United Kingdom exporterwill receive fewer GBP for the

proceeds of the foreign currency export at the future date thanat the spot rate current at the time the contract is taken out

l a United Kingdom importerwill have to pay fewer GBP tosettle its foreign-currency debts at the future date than at thespot rate current at the time the contract is taken out.



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In decidingwhether to use the forward market, an organisationwillbe led by its policy towards risk, but it should in any case make anassessment ofwhat the future spot rate is likely to be.

Assume that a company has a one-month forward payment of USDto make: that is, itwants to sell forward GBP. The organisation hasthree

choices:

first,

it

can

sell

GBP

forward

now;

secondly,

it

can

sell GBP spot for USD, put the USD on deposit for one month andpay outwhen the deposit matures. The third option is towait forone month and then sell GBP spot.

EXERCISE 4.5Are there really three independentoptions?

Thenext

step

is

to

calculate

the

forward

outright

rate

that

is,

the

spot rate plus the forward margin.

Assume the rates are as follows: spot exchange rate, USD1.8060;one-month interest rates, USD 2% p.a. and GBP 6% p.a. (You mayignore bidoffer spreads.)Taking theperiod as thirtydays,we canuse the rectanglediagramapproachwe looked at in thepreceding sub-section (seeFigure 4.2).

Invest in GBP at 6%

BuyUSDspot

GBP

USD

BuyUSD

forward

Invest in USD at 2%

30 days

Value in 30 days= 1.0049

Spot rate= 1.8060

Forward rate= 1.8090/1.0049

= 1.8002

Value in 30 days= 1.8090

Figure4.2For thesterling interestcalculation, remember tousea365-dayyear.FortheUSdollar interestcalculation,usea360-dayear.

To clarify the numbers in the diagram, if the importer invests insterling for thirty days at 6% per annum, GBP1would grow toGBP1.0049. Similarly, if it invests in dollars at 2%, USD1.8060 (thatis, GBP16 spot rate)would grow to USD1.8090. Thus the forwardratewill be 1.8090/1.0049 = 1.8002.If the importer thinks that the spot dollar rate for the poundwillactually be USD1.81/GBP1 in a months time,what should it do?

y



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This decision involves individual judgement, but look at the risks asopposed to the benefits. If the importers estimate (guess) is correctand it backs its opinion (by not covering forward) itwill havewon comparedwith the safe strategy. Butwhat if the GBP has abad month? The importer could lose far more. In general, it can besaid that the importer should normally lock in the rate by using theforward market, unless there is avery clear reason for not doingso. If the importer chooses not to hedge because it believes thespot ratewill be USD1.81/GBP1, it is effectively saying it knowsbetter than the market. Even by doing nothing, the importer is ineffect speculating against the market. The importerwould dowellto remember that the market comprises a lot of peoplewho makean excellent living by taking bets from corporate treasurydepartments.

We can see from the above that forward cover can be a cost or abenefit, but that the removal of uncertainty allowing for moreaccurate budgeting is often of prime importance. Companiesoperating on high turnover and small profit margins are usuallyadvised to take out forward cover, since the uncertainty involved innot hedging may cause fluctuations in the eventual net proceedsthat are greater than the firms overall margin.To put it anotherway, considering that currency fluctuations areoften of the order of 1015% ayear, an exporting or importingbusiness that trades on gross margins of the same orderwould bediversifying 50% of its activity (in profit terms) into currencyspeculation. If its management feels they are not in the business ofcurrency

speculation,

they

should

really

have

a

policy

for

hedging

foreign currency cash flows.

S UM M AR Y In this sectionwe have covered a lot of ground, startingwith thebasic FX market conventions of direct and indirect quotationsdiscussed in the context of the spot market. Thatwas followed bya demonstration of theway to calculate cross rates.

We then moved on to the forward market, discussing the termspremium and discount, forward outright and forward margin.This led to avery important result: the forward margin equals thedifference in interest rates between the two currencies involved.The lastpartof thesection lookedattheprosandconsof takingouta forwardcontract.Weshallreturn tothis in latersections.Indeed,ouranalysisofcontingentrisk later inthisunitwill introduceyoutoa furtherwayofhedgingFXriskthrough thepurchaseofFXoptions.Beforewedoso,weneed toconsideranother importantaspect involvedwithmanagingFXexposureforecastingforeignexchangerates.



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5 FOR EC A STI N G FOR EI GN EX C H A N GE R A TES 5 FORECASTING FOREIGN EXCHANGE RATES

Once its total FX exposure is defined, as discussed in Section 2, anorganisation can then decide, given the costs of hedging policiesand its attitude to risk, the degree towhich it should hedge orremain exposed.Unless itwishes to hedge all its currency transactions, itwill haveto consider likely future exchange rates. The organisation canemploy in-house personnel to forecast exchange rates, as is donein the largest companies, such as General Motors, or it may useexchange rate forecasts from banks or forecasting specialists.There are generally two types of approach to forecasting exchangerates: fundamental approaches and technical approaches.We shalldiscuss both types in this section. Major examples of fundamentalapproaches are the four-way equivalence model, the balance-ofpayments approach and the monetarist approach.An example ofthe technical approach is chartist analysis.

F UN D AM E N T AL AP P ROAC H E S T O F O R E C AS T I N G E X C H AN G E R AT E S

5 . 1

Four-way equivalence model or parity conditions Four concepts are thought to explain foreign exchange rates:purchasing-power parity, the Fisher effect, interest-rate parityand expectations theory. These four concepts form the four-wayequivalence model (see Figure 5.1 overleaf).Purchasing-powerpari ty (PPP) Purchasing-power parity, or PPP, is based on the common senseidea that something should cost essentially the same anywherein theworld, otherwise peoplewould try to buy the product inthe cheaper market and sell it in the more expensive market(arbitrage).Prices,when converted to a common currency, should be thesame everywhere: price rises due to inflation in one country arecompensated by a change in the exchange rate, so that the realcost of products remains the same.When one country has a higherinflation rate than others, its exchange ratewill adjust downwardsso that the real cost of products remains the same between thecountries. Therefore, if the inflation rate in the United Kingdom is3% and that in the USA is 1% and the spot rate is USD1.8 = GBP1,



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Fisher effect

Purch

asing

ate

parity

-

r-

Interest

powerparitytheory

Expectations theory

Inf Inf

1 + Inf

S S

S

F S

S

=

= =

=

Key

S0= Spot now

i= Interest (annual %)

iF iL F = ForeignF L1 + iL L F0 = Forward now

St= Spot at time t

Inf = InflationInternationalFisher L = Localeffect

0 0 t 0

0 0

Figure5.1 The four-wayequivalencemodelwe should expect the GBP to deteriorate against the USD by, onaverage, 2% ayear. In ayears timeyou might expect the exchangerate to have fallen to USD1.764/GBP1.Though PPP does not hold in the short term, as there are so manymarket imperfections (taxes, problems of information, quotas), thereis evidence to suggest that PPP does hold, on average, in the longterm. It therefore should be of interest to thosewhowish toforecast future exchange rates, as these should move in linewithpredicted future inflation differentials. This is particularly useful if

you need to predict over a long span of time for example, ifyouare thinking of building a new factory in a foreign location.The Fisher effect The Fisher effect states that the nominal interest rate is made up oftwo components: a required real rate of return and an inflationpremium equal to the expected rate of inflation. Thus

(1 + Nominal rate) = (1 + Real rate)(1 + Expected inflation rate)Aswith PPP theory above, the Fisher effect relies on the activitiesof arbitrageurs,whowill move capital from countrieswith low ratesof return to countrieswith high rates of return. If real rates ofinterest are thought to be the sameworldwide, the difference innominal interest rates between countries should be due todifferences in inflation rates.The Fisher effect and purchasing-power parity together make upthe international Fisher effect,which holds that interest ratedifferentials between countries should be reflected in theexpectation of the future spot rate of exchange. PPP states that arise in the home countrys inflation ratewill also be accompaniedby a devaluation of the home countrys currency. However, the


VitalStatistics,Section4.4.2,discusses theFishereffect ingreaterdetail.


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5 FORECASTING FOREIGN EXCHANGE RATES

international Fisher effect states that the increase in inflation meansthat an increase in the home countrys interest rate relative toforeign interest rateswill also take place.In teres t - rate pari ty The theory of interest-rate parity (IRP) states that the difference inthe national interest rates for securities of similar risk and maturityshould be equal to the difference between forward and spot ratesof exchange (ignoring transaction costs). That is, the forwardpremium or discount is equal to the interest differential. The key tothis parity condition is the arbitrage mechanism discussed in theSection 4when dealingwith forward rates: if the forward premiumor discount is not equal to the interest differential, there areopportunities for risk-free arbitrage. In effect, this parity conditionmeans that a countrywith a lower interest rate than anotherwillfind thevalue of its forward currency at a premium in terms of theother countrys currency.

EXERCISE 5.1If the annual interest rate in the United Kingdom is 5%, that inthe USA 2% and the current spot rate between the twocountries is USD1.50 = GBP1, assuming interest rate parityholds,what is the one-year forward rate of exchange?

Expectat ions theoryExpectations theory is the last parity condition. Central to thistheory is the efficient markets hypothesis that states that all relevantinformation should be reflected rapidly and accurately in themarket rates. For example, changes in expectations about inflationand interest rates are rapidly incorporated into spot and forwardexchange rates. Expectations theory also leads to the conclusionthat the forward rate of exchange reflectswhat people expect thefuture spot rate to be on average in the long term. The forwardrate is an unbiased estimate of the future spot rate in the longterm.Any changes in expectations are therefore likely to causeupward or downward movements of the rates. However, given thatthis is a long-term average, the forward ratewill not always reflectthe actual future spot rate, as shown in Box 5.1.The above collective theory of exchange-rate determination iscalled the four-way equivalence model. The crucial part of thismodel is that all the parity conditions arrive, eventually, at the sameconclusion: namely, that the difference between spot and forwardrates is just the interest differential between two currencies. Forexample, IRP shows it directly as an arbitrage condition,whereasPPP ends up at the same position from the standpoint of the long-term economic equivalence ofvalues.

Ifyouwould like torefreshyourmemoryontheefficientmarketshypothesis,seeUnit1.



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BOX 5.1ESTIMATION AND PREDICTION IN THE FOUR-WAY EQUIVALENCE MODELThere isevidence thatpartsof thismodelmayhold in the longterm,but in theshort term theremaybemanymarketimperfections thatmean itdoesnotallhold.Note though that IRPalwaysholds,except for veryshortperiods (measured inminutesrather thandays,before the imbalance isarbitragedaway).Is the forward rateagoodestimatorof the futurespot rate?Yes,inaway. Inastatisticalsense, it is the bestestimatewecanachieve in that it isanunbiasedprojectionof the trend.Is itagoodpredictorof the future spot rate?Empiricalevidencesays, no, resoundingly.How cansomethingbeagoodestimate,butapoorprediction? Itis thedifferencebetweenbeing rightonaverageandbeing rightona specificday.Even if the trend inspot-ratemovement isconsistentand followsPPP, the fluctuationsaround the trend linearesosevere thedataareso noisy that it isseldommuchusewhen trying topredict theactualspot rate foraspecificdateweeks,monthsor years in the future.This isassuming the trend,which itself isbasedonexpected inflation rates (whichcanchange), remainsunaltered.Figure5.2shouldgivea feel for theproblemof noisydataarounda trend line.

Actual spotrate

Trend line

Time

Value

Figure5.2 Trendwith noisydata

To complete this part of our review of theory, let us look at anamusing butworthwhile use of the PPP conceptwith apologiesto ourvegetarian (and gourmet) students!EveryyearTheEconomist produces its so-called Big Mac Index.To decidewhether currencies are relatively overvalued orundervalued, it looks at an item standardised (more or less) around



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the globe the McDonalds Big Mac hamburger. Box 5.2 providesthe text of their 2005 survey.

BOX 5.2FAST FOOD AND STRONG CURRENCIESHowmuchburgerdo youget for youreuro, yuanorSwiss franc?Italians like theircoffee strongand their currenciesweak.That,atleast, is theconclusionone candraw from their latest roundofgrumblesaboutEuropes singlecurrency.Butare the Italians righttomoan? Is theeuroovervalued?OurannualBigMac index [seeTable5.1]suggests theyhaveacase: theeuro isovervaluedby17%against thedollar.Howcome?Theeuro isworthabout$1.22on the foreignexchangemarkets.ABigMaccostsE2.92,onaverage, in theeuro zoneand$3.06 in theUnitedStates.The rateneeded toequalise theburgersprice in the two regionsisjust$1.05.TopatronsofMcDonalds,at least, thesinglecurrency isoverpriced.TheBigMac Index,whichwehave compiled since1986, isbasedon thenotion thatacurrency'sprice should reflect itspurchasingpower.According to the late,greateconomistRudigerDornbusch, thisideacanbe tracedback to theSalamancaschool in16th-centurySpain.Since then,hewrote, thedoctrineofpurchasing-powerparity (PPP)hasbeen variouslyseenasa truism,anempiricalregularityoragrosslymisleading simplification.Economists lost some faith inPPPasaguide toexchange rates inthe1970s,after theworldscurrenciesabandoned theiranchors tothedollar.By theendof thedecade,exchange rates seemed tobedriftingwithout chartor compass.Later studiesshowed thatacurrency'spurchasingpowerdoesassert itselfover the long run.But itmight take three to five years foramisalignedexchange ratetomoveevenhalfwayback into line.Our index shows thatburgerprices can certainly falloutof linewitheachother. Ifhe couldkeep theburgers fresh,an ingeniousarbitrageur couldbuyBigMacs for theequivalentof$1.27 inChina,whoseyuan is themostundervaluedcurrency inour table,andsell them for$5.05 inSwitzerland,whose franc is themostovervaluedcurrency.The impracticalityofsucha tradehighlightssomeof the flaws inthePPP idea.Tradebarriers, transport costsanddifferences intaxesdriveawedgebetweenprices indifferent countries.More important, the$5.05charged foraSwissBigMachelps topay for the retail space inwhich it is served,and for the labourthat

serves

it.

Neither

of

these

two

crucial

ingredients

can

be

easily

tradedacrossborders.DavidParsley,ofVanderbiltUniversity,



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andShang-JinWei,of the InternationalMonetaryFund,estimatethatnon-traded inputs,suchas labour, rentandelectricity,accountforbetween55%and64%of thepriceofaBigMac.The twoeconomistsdisassemble theBigMac into itsseparateingredients.They find that thepartsof theburger thatare tradedinternationally converge towardspurchasing-powerparityquitequickly.Anydisparity inonionpriceswillbehalved in less thanninemonths, forexample.But thenon-tradedbitsconvergemuchmoreslowly:awagegapbetween countrieshasa half-lifeofalmost29months.Seen in this light,our indexprovides little comfort to Italian criticsof the singlecurrency. If theeurobuys lessburger than itshould,perhaps inflexiblewages,nota strongcurrency,are toblame.(TheEconomist,9June2005)

Table5.1 Thehamburgerstandard Big Mac

price(dollars)

Implied PPP**of the dollar Under (-)/over (+)valuation against dollar (%)

UnitedStates*** 3.06

Argentina 1.64 1.55 46Australia 2.50 1.06 18Brazil 2.39 1.93 22Britain 3.44 1.63## +12Canada 2.63 1.07 14Chile 2.53 490 17China 1.27 3.43 59CzechRep. 2.30 18.4 25Denmark 4.58 9.07 +50Egypt 1.55 2.94 49Euroarea 3.58# 1.05### +17HongKong 1.54 3.92 50Hungary 2.60 173 15Indonesia 1.53 4,771 50



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Japan 2.34 81.7 23Malaysia 1.38 1.72 55Mexico 2.58 9.15 16New

Zealand

3.17

1.45

+4

Peru 2.76 2.94 10Philippines 1.47 26.1 52Poland 1.96 2.12 36Russia 1.48 13.7 52Singapore 2.17 1.18 29SouthAfrica 2.10 4.56 31South

Korea

2.49

817

19

Sweden 4.17 10.1 +36Switzerland 5.05 2.06 +65Taiwan 2.41 24.5 21Thailand 1.48 19.6 52Turkey 2.92 1.31 5Venezuela 2.13 1,830 30*At prevailing exchange rates**Purchasing-power parity: local price (in local currency) divided by price inUSA (inUS$)***Average ofNewYork,Chicago,SanFrancisco andAtlanta#Weighted average ofmember countries##Dollars per pound###Dollars pereuroSource:McDonalds;TheEconomist, 9 June 2005.

Balance-of-payments modelAsyou might know, the balance of payments is a summary of alleconomic transactions between a country and all other countries.Changes in the balance of payments originate in the currentaccount, the capital account or in both the current and capitalaccounts. The flows emanating from these accounts do affectexchange rates and so many analysts focus on the balance ofpaymentswhen estimating future FX rates.Let us concentrate on how changes to the current account modifythe balance of payments and, in turn, the foreign exchange rate. Ifthe current accountworsens, that means the countrys imports aregrowing at a greater rate than its exports of goods and services.Under a fixed exchange rate, this leads to an increased demand for

Thecurrentaccountmeasuresaneconomysinternational trade ingoods

and

services.

The

capitalaccountmeasuresmovements in financialassetsand liabilities.



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foreign currency to pay for imports and pressurewill mount for theforeign currency to strengthen and the local currency toweaken.The local exchange ratewill eventually be adjusted, but by a stepchange: that is, a devaluation of the currency usually as a resultof a decision made by the government in consultationwith itscentral bank. By contrast,with a floating exchange rate, if importsare growing at a greater rate than exports then the foreign currency

will strengthen and, in this free-market environment, the exchangeratewill adjust almost immediately. The downside of a floating-rateregime, however, is that exchange rates are morevolatile andparticularly susceptible to short-termvariations in the terms oftrade.Modern adherents to the balance-of-payments approach toforecasting future exchange rates also look at movements in acountrys capital account. The capital account details internationalmovements of financial assets and liabilities: for example, overseasdirect investment by multinationals, investments from overseas inlocal bond and stock markets (sometimes called hot money) and loans from international banks and foreign multinationals to localcompanies. The capital account does not consider, however, profitsor dividends paid by foreign companies to local companies orindividuals.

An example of howyou must consider both current and capitalaccountswhen looking at balance-of-payments data to forecastfuture exchange rates is the USA between 1981 and 1985. Duringthat period the USA had a large and deteriorating current account.However,

the

factors

promoting

investment

demand

for

US

dollars

through the capital accountwere so strong that the flows necessaryto finance the current account deficitwere easily forthcoming. Only

when the factors promoting capital flows started to move againstthe dollar (interest-rate differentials narrowed, banking problemslimited thewillingness to hold dollar deposits and so on) did thecurrent account stand out as a problem as far as the dollarwasconcerned.Monetarist approachThe final example of a fundamental approach to forecastingexchange rates is the monetarist approach.Since monetary policy is an attempt to control the supply of moneyto the economy, the monetarist approach must be concernedwithinterest rates the price of money.We have seen that interestrates affect exchange rates both by altering the attractiveness ofholding a currency as an income generator and by impacting onsentiment about the currencys future prospects.We have also seenthe impact of interest rates through our analysis of the forwardmargin formula.Monetarist theory says that too much money chasing too few goodsin an economy is a prime cause of inflation the available cash

will increase demand, but supplywill not increase accordingly, so44 OU BUSINESS SCHOOL


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prices rise and/or imports increase. This results in the monetaryauthorities raising interest rates to curb inflation.We know that iflocal interest rates are higher than foreign interest rates the forwardmargin formula dictates that forward FX rates are lower than spotrates. Thus, an economywith a relatively high money supplygrowthwill experience aweakening exchange rate. This iswhyexchange dealers and forecasters spend a lot of time analysingmoney supply figures.

T E C H N I C AL ANAL YS I S 5 . 2 Technical analysis refers to the study of the behaviour of themarket over time, in particular market prices and tradingvolumes,rather than the fundamental approacheswhich look at thebehaviour of companies, countries or traded goods flows. Chartistanalysis is one branch of technical analysiswhich concentrates ongraphical representations of prices and tradingvolumes over time.Technical analysts and chartists do not believe that fundamentalanalysis is irrelevant, merely that other market forces, mainlypsychological, are more importantwhen trying to forecast futureprice movements.The technical analyst studies price changes and tradingvolumesover short or long time periods, in order to identify patterns that

will persist into the future. Some analysts look at daily orweeklyprice changes; others look at intra-day price changes to forecast

very short-term movements.Technicalanalystsbasetheirapproachontwofactors.First,theyarguethatstudyingpricetrendsandpatternsenablesthemtoremovethe noiseofrandompricemovements.Second,theybelievethatpricesarerelativelyslowtoadjusttonew information,leavingtrends inpricesthatwillpersist longenoughfor themtomakemoneyoutofexploitingthem.Attheheartof thetechnicalanalysisistheherdinstinctthebelief thatacollectivemarketpsychology

willdictatemarkettrendsrather thanaconsideredinterpretationoffundamentalfactors.Technicalanalystsalsobelievethattrendsarepredictablebecausehistoryhasahabitofrepeatingitself.Fundamental analysts largely reject technical analysis. They say thattechnical analysts look for (and find!) patterns that do not exist.

After all, theweak form of the efficient markets hypothesis statesthat there are no identifiable patterns in prices and that, as a result,technical analysis is awaste of time.Additionally, it could beargued that even if therewere any identifiable patterns, suchinformationwould be immediately reflected in the level of prices

with the result that therewould be no real advantage to be gainedfrom technical analysis.However, one of the key assumptions of the efficient marketshypothesis (that of rational and thus profit-maximising behaviour byparticipants) may not be true for currency markets. For example,



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when a government interferes in currency markets to support itscurrency at a particular level, there may indeed be identifiablepatterns in currency prices over time.

ACTIVITY 5.1Read the short article posted on the coursewebsite, Chartanalysis and the foreign exchange market from the BankofEngland Quarterly Bulletin.

EXERCISE 5.2Do the graphs in Chart 3 in the reading forActivity 5.1 showthat the chartistswere good forecasters over the periodassessed? Is there an irreconcilable conflict between theefficient-markets hypothesis and the evidence given abouttechnical analysis in the London FX market?

The article forActivity 5.1 givesyou a flavour ofwhat goes on inthe dealing rooms of the City of London. The answers to thequestions posed in Exercise 5.2 indicate that at 7.30 a.m. a tradermay consider lunch-time to be the long term,whereas a corporatetreasurer may be concerned aboutwhatwill happen in threeyearstime. Technical analysis an

b821 block4unit8 foreign exchange and contingent risk

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