UNIT IV STUDY GUIDE Foreign Currency Derivatives and Swaps and the Foreign Exchange Rate Determination

Course Learning Outcomes for Unit IV Upon completion of this unit, students should be able to:

6. Discuss how governments control the flow of currencies across borders, including international investments. 6.1 Assess foreign currency futures, forward contracts, valuation, and buying and writing options. 6.2 Evaluate interest rate risk and swaps and demonstrate their management. 6.3 Assess technical analysis, forecasting, and the combination approach to exchange rate


Reading Assignment Chapter 7: Foreign Currency Derivatives and Swaps Chapter 8: Foreign Exchange Rate Determination

Unit Lesson Labels and methods of currency valuation vary across international borders (Moffett, Stonehill, & Eiteman, 2015). For example, Mexico’s medium of exchange is known as the peso, and Switzerland’s medium of exchange is identified as the franc. However, not all mediums of exchange involve currencies. Other mediums include assets, such as stocks or bonds. These mediums are commonly referred to as derivatives. Financial tools, such as derivatives, play a prominent role in multinational business operations and contracts. Types of derivatives include foreign currency futures, currency options, option pricing and valuation, interest rate risk, and interest rate derivatives (Moffett et al., 2015). These investments or alternative instruments carry risks but can also be very lucrative opportunities. However, market participation requires a knowledgeable approach. Foreign currency futures center on providing a future exchange rate for a fixed time, place, and price. More importantly, foreign currency futures’ conditions are based by the exchange on which futures are traded. Components of foreign currency futures include the contract size, stating the method of exchange rates, maturity date, last trading day, collateral and maintenance margins, settlement, commissions, and use of a clearinghouse. Currency options are established by an agreement allowing the purchaser an opportunity to buy or sell currency at a set price per unit for a specified timeframe. Currency options are comprised of three elements: exercise price, premium, and spot exchange rate. The use of currency options is a growing practice of foreign exchange activity. Option pricing and valuation combine currency options into intrinsic and time value. The options are non- binding. Option pricing and valuation utilize a combination of six elements, including present spot rate, time to maturity, forward rate for matching maturity, U.S. dollar interest rate, foreign currency interest rate, and volatility. An analysis of option pricing leads to the complete value equal to the intrinsic value and time value. Interest rate risk involves fluctuation of rates that make all firms sensitive to the uncertainty. Debt service is considered the largest risk for nonfinancial firms while the MNE risk increases with multicurrency dimensions. Therefore, interest rates derivatives, such as swaps and interest rate futures, are alternatives applied in many transactions to minimize risk.

UNIT IV STUDY GUIDE Foreign Currency Derivatives and Swaps and the Foreign Exchange Rate Determination

BBA 4301, International Finance 2



Market participation is predicated upon the established foreign exchange rate. The determination of the rate includes parity conditions, asset approach, and balance of payments (Moffett et al., 2015). The rate is a reflection of external and internal forces such as infrastructure weaknesses and foreign-political risks. For example, the alleged ISIS militant group in Syria became a dominant market-influencing factor that heightened tension in the 2014 political climate (Huddleston, 2014). As indicated in Unit III, purchasing power parity is a well-established framework for determining rates. This framework includes the law of one price, absolute purchasing power parity, and relative purchasing power parity (Moffett et al., 2015). The law of one price suggests that similar goods are sold for the same price in different markets after the conversion of currency. For example, continuing on within the vein of climate tension of the ISIS militant group was their control and disruption of oil prices. Rates differed from region to region. Oil Prices in the Middle East were higher, while North America benefited from somewhat lower prices (Dowd, 2014). However, after the consideration and exclusion of these events, a price analysis should reveal a similar market rate of oil. Absolute purchasing power parity concepts assert that the exchange rate mirrors the ratio price points

between two countries. For example, the U.S. wireless service and advisory leader for

PricewaterhouseCoopers reports that the cost of an Apple iPhone is virtually the same in the U.S., Germany,

and Japan (Yamshon, 2013). Therefore, once the exchange rate is excluded, prices should be same.

Relative purchasing power parity, considered the most significant, suggests change drives rates and prices.

For example, research indicates that as life spans increase, consumers are becoming more conscientious of

health benefits from daily exercise (Gleick, 2004). Therefore, demand for sports and energy drinks as well as

bottled water is increasing. The relative purchasing power parity suggests the change in demand for bottled

water impacts the cost-per-unit per country. Hence, the percentage change in price is equivalent to the

difference in the rates.

The balance of payments approach argues that the equilibrium exchange rate is found when the net inflow matches outflow from financial activities. The country of India has a strong presence in the computer software and service industry. Therefore, if Wal-Mart (U.S. company) purchases $1 million of India’s software packages, there is a parallel entry of money exchange to the Indian producer. The asset approach maintains that rates are determined by supply and demand for financial assets (Moffett et al., 2015). Furthermore, this approach facilitates the assumption that foreign investment hinges on a variety of market forces and considerations. However, accuracy in forecasting exchange rate values is limited. Therefore, technical analysis requires assessing trends in pricing. A knowledge base of foreign exchange theory and markets in conjunction with foreign exchange rates is beneficial. The knowledge base aids in risk management naturally associated with international investments. Risk management provides alternatives.

References Dowd, J. (2014). ISIS and oil prices. Retrieved from https://www.fidelity.com/viewpoints/investing-ideas/ISIS-

and-oil-supply Gleick, P. H. (2004). The myth and reality of bottle water. In The world’s water, the biennial report on

freshwater resources: 2004-2005. Retrieved from http://pacinst.org/wp- content/uploads/sites/21/2013/04/myth_and_reality.pdf

Huddleston, T. (2014). Big sell-off on Wall Street as fears of global crisis weigh. Retrieved from

http://fortune.com/2014/10/01/dow-jones-down-market-sell-off-october/ Moffett, M. H., Stonehill, A. I., & Eiteman, D. K. (2015). Fundamentals of multinational finance (5th ed.).

Boston, MA: Pearson Education. Yamshon. L. (2013). No, U.S. Smartphone costs aren’t highest in the world. Retrieved from