International Finance

Lecture 5: The forward exchange markets and interest arbitrage

Reading: A and F chapter 21

The forward exchange rate is the agreed price of currency for delivery in the future, usually 30,60 and 90 days ahead.

The forward exchange market is used for three main classes of activity, hedging, arbitrage and speculation.

Hedging occurs when a trader wishes to avoid the risk of injury by adverse movements in the exchange rate. For example, an importer contracts to buy foreign goods with foreign currency. Payment is due when the goods are delivered, say in 30 days time. If the exchange rate depreciates during the delivery lag the importer would require more domestic currency to purchase the goods at the agreed foreign price. To avoid this risk the importer can contact now to take delivery of the necessary foreign currency at a price agreed today. If the importer chooses to take the risk we say he is taking an uncovered or open position

The object of speculation is to make profits by taking risks. To speculate on the forward market identify a foreign currency that you think will appreciate in the future. Buy that currency in the forward market. When the contact matures sell the currency on the spot market to make a profit (if you got it right). Buying a currency forward in the hope of making a profit is taking a long position. Speculating by selling a currency forward is taking a short position.

Arbitrage takes place whenever traders take advantage of differences in prices or returns in different locations. The action of arbitrageurs serves to eliminate such differences. Covered interest arbitrage involves the forward exchange markets.

Uncovered interest arbitrage

Consider an international investor who can purchase assets either at home or abroad. Assume the foreign interest rate is higher than the domestic interest rate, for similar instruments. If the investor makes a foreign investment he takes a risk that the exchange rate will change during the investment period.

If the exchange rate appreciates (the foreign currency depreciates) during the investment period the rate of return on the foreign investment will be lower than the interest rate. The return could be negative if the drop in the price of foreign currency large enough.

Exchange rate depreciation raises the return on the foreign investment above the interest rate.

Capital flows will depend not only on the interest differential, but also on the expected appreciation of the foreign currency.

Interest arbitrage ensures that the returns on identical investments in two countries will be the same, taking into account expected exchange rate changes:

          (i_d -i_f) = xa, where xa is the expected percentage appreciation of the foreign currency.

Small deviations from parity are to be expected due to differences in taxes, transactions costs etc.

Covered interest arbitrage

Uncovered investment in a foreign security involves exposure to exchange risk. Most foreign portfolio investment is covered; investors hedge by selling foreign currency forward. The return on the foreign investment is therefore the interest plus the cost of the forward market hedge.

Define the forward premium as:

p = (e_fwd/e) -1

The foreign currency is "at discount" when p is negative.

Covered interest arbitrage ensures that

          (i_d -i_f) = p

Whenever the interest rate differential is greater than the premium capital will flow into the home country. This will push the price of securities higher at home and decrease domestic interest rates. Abroad the opposite will be happening, until covered interest parity is restored. Adjustment may also take place in the exchange markets, as the spot demand for domestic currency increases and the forward demand for foreign currency increases. The spot rate appreciates and the forward rate depreciates, and p is increased.

Market efficiency and the risk premium

A market is said to be efficient if prices reflect all available information

If the exchange market were efficient we would expect the forward premium p to differ from the expected rate of appreciation xa only by a risk premium.

There may be a real or perceived difference in the risk associated with otherwise similar investments between different countries. Investors would therefore require a greater return on the risky investment. The differential in effective returns between countries is the risk premium.

The evidence on the efficiency of foreign exchange markets is mixed, which is unsurprising, given the difficulty of testing for efficiency.