Relevant

Financial Strategy in a Global Economy
Lecture 1
Introduction
Organizational Issues
• Instructor:
– Giovanni Pagliardi, Department of Finance
• Office Hours: Friday 10.00-12.00, or by appointment
• Office B4 063
• Email: giovanni.pagliardi@bi.no
• Literature:
– Bekaert and Hodrick: International Financial Management, 2nd ed.
– Additional material handed out over the course of the semester
(articles, cases)
• 12 sessions
2
1. Final Exam: 70%

– The exam will be based on what we covered in class and in the
homework.
2. 2 Projects (in groups of 4-5): 20%, around 6th and 10th session
3. Homework (in the same groups of 4-5): 10 %
You can get up to 100 points for each of the 3 grade components.
Thus, the final grade will be derived in the following way:
Final points = 0.7 x exam points + 0.2 x project points + 0.1 x homework points
3
• Homework assignments (in the same groups of 5): 10 %
• If there is a homework, the assignment will be posted on Tuesday around 2.30pm on

itslearning.
• Your group has to hand in the solution/report in written form next Monday, until
1.30pm on itslearning. Make sure that you indicate all members of the group.
• Every homework is graded on a pass/fail basis.
• Don’t copy other solutions and clearly indicate external sources. itslearning will
automatically check for plagiarism! BI is very strict on cheating. Depending on the
extent of the offense you may lose 50% of the homework points, have the course
annulled, or you may be excluded from BI for some time. So take this seriously.
• The homework exercises will be a good practice to apply what we learn in class.
4
Course Overview
1. Introduction International Economics:

• Institutional setup
2. Foreign Exchange Market • Determination of the
3. Forward Markets exchange rate
• Exchange rate
4. The International Monetary System forecasting
5. Parity Relationships
6. Forecasting Exchange Rates
7. Currency Futures and Options
8. Transaction (contractual) Exposure
9. Operating Exposure, Translation Exposure, and Hedging
Decision
Risk Management and Hedging
• Pricing of FX-rate derivatives 5
• How to guard cashflows against FX-rate fluctuations
Course Overview
9. Foreign Direct Investment, Political and Country Risks

10. International Capital Structure and the Cost of Capital
11. International Capital Budgeting
Corporate Finance
• Investment decision in a multinational corporation
• Cost of capital in international financial markets
6
Lecture I: Overview
• What’s Special about “International” Finance?
• Goals for International Financial Management
• Globalization of the World Economy – Major Trends
• Multinational Corporations
• Other Global Players You Should Know
• Globalization of Capital Flows and the Last Financial Crisis
7
What’s Special about “Intl” Finance?
Opportunities and Threats
• Frictions
– Foreign Exchange Risk
– Political Risk
– Country Risk
– Market Imperfections Affecting International Trade and
Financial Flows
• Expanded Opportunity Set
8
What’s Special about “International” Finance?
Foreign Exchange Risk
– Suppose the textbook for this

course sells in the UK for GBP 39.99 in 2013.
– If you bought it on the 24.6.2013, it would
have costed you NOK 378 (1 GBP = 9.45
NOK).
– If you had bought it on the 20.2.2013 it
would have cost you NOK 339 (1GBP = 8.48
NOK).
– Waiting until June has made it approx. NOK
40 (11%) more expensive.
– Foreign Exchange Risk:

The risk that foreign currency profits may evaporate in
domestic currency (NOK) terms due to unanticipated
unfavorable exchange rate movements.
9
– Suppose a Norwegian book seller sells textbooks for
NOK 350 per book. This price is fixed. She imports
1000 books from the UK for GBP 40 per book.
– If she buys them on the 24.6.2013 (1 GBP = 9.45
NOK), she imports them for NOK 378 per book and
makes a total loss of NOK -28000.
– If she buys them on the 20.2.2013 (1GBP = 8.48
NOK), she imports them for NOK 339 per book and
makes a total gain of NOK 10800.
– The exchange rate determines whether this project
is profitable or not.
• Purpose of International Finance:

– help to identify the risk (exchange rate theories)
– quantify the risk (risk management), and
– show how to decrease/eliminate the uncertainty (hedging)
10
The Venezuelan government said it would devalue
its currency by 32 per cent … The official exchange
rate for Venezuela’s bolívar is expected to move
from 4.3 per dollar to 6.3 per dollar on February 13.
Colgate, which gets roughly 5 per cent of its sales
from Venezuela, said on Monday that the $120m
post-tax loss would result from the translation of its
financial statements at the new rate. Its shares fell
0.2 per cent to $108.29 on Monday.
Financial Times, February 11, 2013
• Purpose of International Finance

– Understand different currency regimes
– Predict exchange rate changes/ How likely is a devaluation?
– Insure against the adverse affects of exchange rate changes
11
Political and Country Risk
President Cristina Kirchner's government on Monday proposed effectively
nationalizing Argentina's largest oil-and-gas company, YPF SA, by taking 51%
from Spain‘s Repsol at a price yet to be determined... Repsol shares fell as
much as 9% Tuesday amid uncertainty over the possibility of compensation.
The Wall Street Journal, April 17, 2012
• Political Risk is the risk that a government action will negatively affect a
company’s cashflow.
(Sovereign governments have the right to regulate the movement of goods, capital, and
people across their borders. These laws sometimes change in unexpected ways.)
• Country Risk comprises political risk and adverse changes in a country’s

economic and financial environment (e.g. sovereign default).
• Purpose of International Finance
– understand and manage political and country risk
– structure the investment so as to minimize the chance that the political risk
event occurs
– political risk insurance
12
Test Your Intuition
1. An example of a political risk is
3. Suppose that Great Britain is a major
a) expropriation of assets. export market for your firm, a U.S.-based
b) adverse change in tax rules. MNC. If the British pound depreciates
c) the opposition party being elected. against the U.S. dollar,
d) both answers a) and b) are correct. a) your firm will be able to charge more in
dollar terms while keeping pound
2. Suppose your firm invests $100,000 in a project in prices stable.
Italy. At the time the exchange rate is $1.25 = b) your firm may be priced out of the U.K.
€1.00. One year later the exchange rate is the market, to the extent that your dollar
same, but the Italian government has costs stay constant and your pound
expropriated your firm’s assets paying only prices will rise.
€80,000 in compensation. This is an example of c) to protect U.K. market share, your firm
a) exchange rate risk. may have to cut the dollar price of your
b) political risk. goods to keep the pound price the
c) market imperfections. same.
d) none of the above, since $100,000 = €80,000 d) both b) and c) are correct
× $1.25/€1.00
13
Test Your Intuition
• Answers:
– 1 d)
– 2 b) Why d is not correct: Although the amount which the
Italian government pays to you equals the original
investment expenditure, it is most likely not the (market)
value of the investment which might be worth much more
one year later. And your firm was taken away from you
without your consent.
– 3 d)
14
Market Imperfections
• Market Imperfections and Segmentation
– Legal restrictions on movement of goods, people, and money
– Transactions costs
– Shipping costs
– Tax differences
• Examples of Market Regulations
– Duties, tariffs, quotas (e.g. Japanese auto corridor)
– Insider trading
– Ownership restrictions
– Capital Controls
– Exchange Rate Policies
15
The Example of Nestlé’s Market Imperfection
• Nestlé used to issue two different classes of common

stocks: bearer shares and registered shares.
– Foreigners were only allowed to buy bearer shares.
– Swiss citizens could buy registered shares.
– The bearer stock was more expensive.
• On November 18, 1988, Nestlé lifted restrictions
imposed on foreigners, allowing them to hold
registered shares as well as bearer shares.
16
Nestlé’s Foreign Ownership Restrictions
12,000
10,000
Bearer share
8,000
SF
6,000
4,000
Registered share
2,000
0
11 20 31 9 18 24
Source: Financial Times, November 26, 1988 p.1. Adapted with permission.
17
The Example of Nestlé’s Market Imperfection
• Following this, the price spread between the two types of

shares narrowed dramatically.
– This implies that there was a major transfer of wealth from foreign
shareholders to Swiss shareholders.
• Foreigners holding Nestlé bearer shares were exposed to
political risk in a country that is widely viewed as a haven
from such risk.
• The Nestlé episode illustrates both the importance of
considering market imperfections and the peril of political
risk.
18
What’s Special about
“International” Finance?
• Expanded Opportunity Set
– It doesn’t make sense to play in only one corner of the
sandbox.
– True for corporations as well as individual investors.
– E.g., MNC can
• locate production in any country or region with the most efficient
input factors
• raise funds in any capital market where the cost of capital is the
lowest
• expand the market for its products (China)
19
Goals of International Financial Management
(What You Should Learn)
• Understand the risks involved in international business
– How do international financial markets work?
– What determines the exchange rate?
– Identify political and country risk.
• Know how to deal with these risks
– Forecasting exchange rates and hedging
– How to cope with country and political risk
• Corporate Finance Decisions in an International Context
– Financing a multinational corporation
– International capital budgeting
20
Globalization of the World Economy:
Major Trends - Background
• Emergence of Globalized Financial Markets
• Emergence of the Euro as a Global Currency
• Trade Liberalization and Economic Integration
• Privatization
21
Emergence of Globalized
Financial Markets
• Deregulation of Financial Markets

coupled with
• Advances in Technology
have greatly reduced information and
transactions costs, which has led to:
• Financial Innovations, such as
– Currency futures and options
– Multi-currency bonds
– Cross-border stock listings
– International mutual funds
– Hedge Funds
– Repackaging and sale of securities in portfolios (securitization)
• Crisis Spillover through Integration
22
Emergence of the Euro as a Global Currency
Opening of Opportunities
• A momentous event in the history of world financial
systems.
• Currently more than 333 million Europeans in 19
countries are using the common currency on a daily
basis.
• Before a country joins the Eurozone, it must spend two
years in European Exchange Rate Mechanism and fulfill
4 more convergence (Maastricht) criteria.
• The “transaction domain” of the euro may become
larger than the U.S. dollar’s in the near future (Cuba,
North Korea).
23
Regions/Countries by Size
List by the IMF (2016)
Rank Country GDP (PPP) $Billions

World 119,884.0
1 China 21,291.8
2 European Union 20,008.1
3 United States 18,569.1
4 India 8,662.4
5 Japan 5,237.8
Germany 3,980.3
United Kingdom 2,785.6
24
Euro Area
Countries participating* in the euro or ERM:
 Austria  Italy
 Belgium  Latvia
 Bulgaria**  Lithuania
 Croatia  Luxembourg
 Cyprus  Malta
 Czech Republic**  Poland**
 Denmark*  Portugal
 Estonia  Romania**
 Finland  Slovak Republic
 France  Slovenia
 Germany  Sweden**
 Greece  UK**
 Hungary**  Spain
 Ireland  The Netherlands https://en.wikipedia.org/wiki/Eurozone#/media/File:Eurozone_participation.svg
25
Value of 1 Euro in USD
January 1999 to August 2017
93% increase of the

euro value.
Eurozone MNCs had to
come up with strategies
to remain competitive
internationally.
26
Value of 1 NOK in USD -
January 1999 to August 2017
27
Financial Strategy in a Global Economy
Lecture 2
The Foreign Exchange Market
1
Lecture 2: Learning Objectives
• Market Overview
– Market Participants
– Contracts Traded
• Exchange Rate Quotation
– Triangular Arbitrage
• Inside the Interbank Market
• Describing FX-rate Changes
2
The Structure of the Foreign Exchange
Market
Most important cities:
London
New York
Tokyo
ForEx (or FX)

operates 24 hrs/day
Interbank market –
50% of transactions
Corporations – 13.4%
Other financial
institutions – 48%
Most trades are $1M

or more!
3
Foreign Exchange Trading Activity Across the
World
4
The Organization of the Foreign Exchange
Market
• Size of the market
– Largest financial market in the world
• Daily trading volume: $5.3 trillion per day in April 2013 (compare
that to the US GDP of $16.8 trillion for the year 2013)
• Compared to only $50 billion on NYSE (in 2010)
5
Distribution of the Daily Trading Volume
Circadian Rhythms of the FX Market
Electronic Conversations per Hour

average peak
45000
40000
35000
30000
25000
20000
15000
10000
5000
0
1:00 3:00 5:00 7:00 9:00 11:00 1:00 15:00 5:00 19:00 9:00 11:00
10 am in Lunch Europe Asia Lunch Americas London New 6 pm in
Tokyo hour in coming in going out hour in coming in going out Zealand NY
Tokyo London coming in
6
The FX market is a two-tiered market:
1. Interbank Market (Wholesale)

– Foreign exchange dealers in the interbank market…
• About 700 banks worldwide stand ready to make a market in foreign
exchange.
• Nonbank dealers account for about 20% of the market (e.g. hedge funds)
• (There are FX brokers, who match buy and sell orders but do not carry
inventory.)
– …serve as market makers – they make it easier for buyers and sellers
to come together
– and provide liquidity. A liquid market is characterized by
1. tightness (tight bid-ask spread)
2. depth (large transactions can be carried out w/o moving prices much)
3. resilience (ease with which prices revert to the “fair/fundamental” value)
2. Client Market (Retail)
7
FX-market has become less dealer-centric
• Non-reporting financial
institutions dominate the
interbank market (53% of total
volume).
• They comprise:
– Non-reporting banks (24% of
total volume), which often
don’t act as dealers.
– Institutional investors (11%
of totall volume))
– Hedge funds (11% of total
volume)
• Prime brokerage and electronic
trading platforms have created a
new network structure that has
Rime and Schrimpf 2013, The anatomy of the global FX market through the lens of the
2013 Triennial Survey, BIS Quarterly Review, December 2013 replaced the traditional dealer-
customer relationship. 8
Market
• Types of contracts traded
– Spot transactions
– Future transactions: swaps, forward contracts
– Derivatives: futures and options
• Conventions
– Transactions completed within 2 business days
• Exception 1: U.S. and Mexico/Canada (1 business day)
• Exception 2: Holidays don’t count in U.S. dollar transactions
• Exception 3: Fridays are not business days in Middle East but
Saturdays/Sundays are so – non-Middle Eastern currencies settle
on Fridays and Middle Eastern currencies settle on Saturdays
9
Turnover By Contract Type
Rime and Schrimpf 2013, The anatomy of the global FX market through the lens of the 2013 Triennial Survey, BIS
10
Quarterly Review, December 2013
Market
• The competitive marketplace
– No product differentiation – money is money
– A lot of players
• Top 4 account for only 30%
• Top 20 less than 75%
– Recently, there has been consolidation: now
• Top 4 account for over 40%
• Top 20 over 90%
– Still exceedingly competitive with no signs of any clear
leader in this market
– However, despite the enormous size of the market, dealer
banks have manipulated exchange rates.
11
FX-Market Manipulations
Types of improper behavior:
1. Attempts to manipulate the WM/Reuters 4pm and the ECB 1.15pm fix rates.
2. Attempts to trigger client stop loss orders for the firm’s own benefit.
3. Front-running: In 2011, Cairn Energy, a UK listed oil and gas producer, sold
an ownership interest in an Indian subsidiary for $3.5bn and wanted to
convert it into sterling to distribute it to shareholders. It hired HSBC and
required the bank to sign a confidentiality agreement. HSBC cheated the
client by deliberately buying pounds ahead of the customer’s $3.5bn
purchase of sterling and reselling it to the client at higher prices.
FT, July 20 2016: HSBC forex traders charged with criminal fraud http://on.ft.com/29MeqkY
4. Misuse of the “last look” trading system: Market makers might be exploited
by traders with superior information or trading technology. A last look policy
gives the market maker the right to observe market prices for a few
milliseconds after having entered into a trade with a client and turn down
the trade. Barclays allegedly misused its last-look policy to reject
unprofitable trades and lied to clients about the reasons.
FT, Nov. 18 2016: Barclays accused of abusing ‘last look’ trading system http://on.ft.com/1Ofutmf
Banks involved: Bank of America, Barclays, Deutsche Bank, Citibank, HSBC, JPMorgan, Royal Bank of
Scotland, and UBS
12
Currency Quotes and Prices
• Exchange rate – price of one currency in terms of

another
– JPY100 = USD1
– 100 JPY/USD
– ¥100 = $1
– ¥100/$1 or ¥100/$ (the number one is implied)
JPY and USD are the ISO (Intern. Organization for

Standardization) currency abbreviation for the Japanese yen
and the US dollar. ¥ and $ are the common currency symbols.
14
Exchange rate quotes
16
• Direct and indirect are inverse: Direct = 1/Indirect
17
U.S. Dollar Currency Quotes from Tuesday, December 21, 2010
For a US-resident,
this is the direct
quote, USD x/EUR.
For a US-resident, Relationship between direct and indirect quote:

this is the indirect
quote, EUR x/USD. 𝐸𝑈𝑅 0.7636 1
=
𝑈𝑆𝐷 𝑈𝑆𝐷 1.3096
𝐸𝑈𝑅
1
𝑆(𝐹𝐶/𝐷𝐶) =
𝑆(𝐷𝐶/𝐹𝐶) 18
Vehicle currencies and currency cross-rates
• Vehicle currency – a currency that is actively used in many

international financial transactions around the world
– transaction costs of making markets in many currencies can be too high
– E.g., if you have 10 currencies, you can quote 45 (=10x9/2) different
exchange rates. If you select one vehicle currency (e.g., USD) against
which you quote all other currencies, then you only need the 9 FX-rate
quotes with respect to that currency. Exchanging two non-vehicle
currencies, say the EUR for the JPY, requires first to exchange the EUR for
USD and then the USD for JPY.
– U.S. Dollar is the primary vehicle currency (85% of all transactions, 2010:
40% involved euro).
• Cross-rates
– Trading currency in the New York market where both currencies are not
expressed in U.S. dollars
• Trend toward cross-rate transactions 20
Representative Cross-Rate Quotes from
December 21, 2010
21
Triangular Arbitrage
• An arbitrage process involving three currencies.
• Keeps cross-rates in line with exchange rates quoted
relative to the U.S. dollar.
• Occurs when one can trade three currencies and
make a profit (versus two).
• Idea: It should not matter
– whether I change JPY to USD directly or
– whether I change JPY to GBP and then GBP to USD.
– law of one price (LOOP)
22
Suppose we
observe these
banks posting $
these exchange Barclays
Credit Lyonnais
rates.
S(¥/$)=120
S(£/$)=1.50
Credit Agricole
First calculate any ¥ £
implied cross rate S(¥/£)=85
to see if an
arbitrage exists. 𝒊𝒎𝒑𝒍𝒊𝒆𝒅
$1.00 ¥120 ¥80
𝑺 ¥/£ = × =
£1.50 $1.00 £1.00
23
The implied S(¥/£) cross rate is

$1.00 ¥120 ¥80 $
× = Barclays
£1.50 $1.00 £1.00 Credit Lyonnais
Credit Agricole has posted a
S(¥/$)=120
S(£/$)=1.50
quote of S(¥/£)=85. The bank’s
yen price of GBP 1 is higher
than the implied cross rate
¥ Credit Agricole
quote. There is an arbitrage £
opportunity.
S(¥/£)=85
So, how can we make money?
Whatever your starting currency is, make sure that you buy the £ at ¥80 and
sell it at ¥85.
24
E.g., for an US investor

as easy as 1 – 2 – 3:
$
1. Sell our $ for £, Barclays
Credit Lyonnais
2. Sell our £ for ¥, S(¥/$)=120 3 1
S(£/$)=1.50
3. Sell those ¥ for $.
2
¥ Credit Agricole
£
S(¥/£)=85
Check:
Via this strategy,
• we sold the £ at ¥85 (2) and
• bought it at ¥80 (1 and 3).
25
(For USD Investor)
Example: US investor uses $100,000 for this arbitrage trade:
1. Sell $100,000 for £ at S(£/$) = 1.50 receive £150,000

2. Sell our £150,000 for ¥ at S(¥/£) = 85 receive ¥12,750,000
Remark 1: This transaction includes the “overvalued” GBP relative to
the JPY quote which we identified.
Remark 2: But, we can’t say that the JPY/GBP quote is wrong. All three
quotes together are inconsistent! (see next slide)
3. Sell ¥12,750,000 for $ at S(¥/$) = 120 receive $106,250
profit per round trip = $106,250 – $100,000 = $6,250
26
(For GBP Investor)
It doesn’t matter where we start,

but we have to go “clockwise” to
make money. Try it out at home.
$
Barclays
Credit Lyonnais
S(¥/$)=120 2 3 S(£/$)=1.50
1
¥ Credit Agricole
£
S(¥/£)=85
If we went “counter clockwise” we would be the source of arbitrage profits,

not the recipient!
27
Inside the Interbank Market: Bid-Ask
Spreads and Bank Profits
• Bid – rate at which banks will buy the base currency
• Ask – rate at which banks will sell base currency
• The bank earns the bid-ask spread
reference currency
USD/EUR
base currency EUR/USD
USD/GBP
GBP/USD
www.oanda.com
28
Side Note: In practice FX-rates are often
quoted as «base currency / reference currency»
http://www.bloomberg.com/markets/currencies
Stands for:
USD 1.1202 /EUR
JPY 121.23 /USD
USD 1.5366 /GBP
29
S(USD/EUR)
𝒃𝒊𝒅
𝑬𝑼𝑹 𝟏
S(EUR/USD) 𝑺 = 𝒂𝒔𝒌
𝑼𝑺𝑫 𝑼𝑺𝑫
𝑺
𝑬𝑼𝑹
S(USD/GBP)
S(GBP/USD)
Trick: Selling GBP to the bank and getting paid in USD

is the same as buying USD and paying in GBP. 30
Test Your Intuition
Bid Ask
USD/EUR 1.1879 1.1882
EUR/USD 0.8416 ?
Bid Ask
USD/GBP ? 1.2957 1.2962
GBP/USD ? 0.7718
31
Test Your Intuition
Bid Ask
USD/EUR 1.1879 1.1882
𝒂𝒔𝒌
EUR/USD 𝑬𝑼𝑹 0.8416 𝟏 0.8418
𝑺 = 𝒃𝒊𝒅
𝑺
𝑬𝑼𝑹
Trick: Buying USD from the bank and paying in EUR is the same as selling
EUR and getting paid in USD.
Bid Ask
USD/GBP ? 1.2957 1.2962
𝒃𝒊𝒅
GBP/USD 0.7715 𝑮𝑩𝑷 0.7718 𝟏
𝑺 = 𝒂𝒔𝒌
𝑺
𝑮𝑩𝑷
Trick: Selling USD to the bank and getting paid in GBP is the same as buying
GBP and paying in USD.
32
• Magnitude of bid-ask spreads
– Interbank market
• Within 5 pips (fourth decimal point in a currency quote)
• 0.05% - 0.07% for major currencies
• Lower for extremely liquid currencies like U.S. dollar (i.e., 0.03% for $/€
exchange rate quote)
• Higher for less liquid currencies
– Physical exchange
• 3% or more
– Banks have to have inventory, which means it is not interest bearing
– Banks must transact with brokers
• Use credit cards (electronic money) to exchange when in another country.
This is the best possible rate for you!
– Differs across the day
33
Financial strategy in a global economy
Lecture 3
Forward Markets
1
• How Forward Contracts Work

• How They Eliminate Exchange Rate Risk
• How Forward Rates Are Determined: The Covered
Interest Parity (CIP)
• External Currency Markets: LIBOR and EURIBOR
2
Purpose of Forward Contracts
Fancy Foods (FF), a U.S. company imports meat pies from a British firm. FF
has to pay £1,000,000 in 90 days in return for supplies. The spot rate is
$1.50/£ and FF fears that the £ might appreciate by 10%. It can:
1) wait 90 days and buy £’s at the future spot rate unknown today, or
2) agree with a bank today on an exchange rate that will apply in 90 days.
Fundamental Questions for FF:

• How high is this risk?
 Lecture 6
• How can it mitigate/eliminate this risk?
 Today and lecture 8
• Should it eliminate the risk?
 Lecture 12
3
Payoff Profile of Unhedged FC Liabilities
$-Value in 90 Unhedged Position

days
$1.5/£ $1.65/£
S(90d) in [$/£]
-$1.5m
-$1.65m FC liability: £1m x S($/£, 90d)
$-value of FC liability
4
Hedging Exchange Rate Risk
Forward Contracts
• Forward contract specifies
– the forward rate:
exchange rate at which trade will take place in the future
– the forward value date/forward settlement date:
date at which transaction will take place
– how many units of foreign currency are to be bought/sold
• Forward payoff (with n days time to maturity):
– If you buy one unit of FC forward (long position):
𝑫𝑪 𝑫𝑪
𝑺 ,𝒕+𝒏 − 𝑭 , 𝒕, 𝒏
𝑭𝑪 𝑭𝑪
𝒇𝒖𝒕𝒖𝒓𝒆 𝒔𝒑𝒐𝒕 𝒓𝒂𝒕𝒆 𝒇𝒐𝒓𝒘𝒂𝒓𝒅 𝒓𝒂𝒕𝒆 𝒂𝒕 𝒕𝒊𝒎𝒆 𝒕
– If you sell one unit of FC forward (short position)

𝑫𝑪 𝑫𝑪
𝑭 , 𝒕, 𝒏 − 𝑺 ,𝒕+𝒏
𝑭𝑪 𝑭𝑪 5
Payoff Profile of a Forward Contract
Purchase of £1 Forward at F(t,90d)=$1.53/£
$-Value in 90 days Long Forward Contract (£1)
Long FC: S(t+90d)-F(t,90d)
$0.12 =
$1.65/£-$1.53/£
$1.53/£ $1.65/£ S(t+90d) in [$/£]

=F(t,90d)
Forward Purchase
6
Payoff Profile of a Forward Contract
Sale of £1 Forward at F(t,90d)=$1.53/£
$-Value in 90 days Short Forward Contract (£1)
F(t,90d)=
$1.53/£ $1.65/£
S(t+90d) in [$/£]
$-0.12 =
$1.53/£-$1.65/£
Short FC: F(t,90d)-S(t+90d)
Forward Sale
7
Hedging Exchange Rate Risk
Forward Contracts
• Forward
– eliminates risk/uncertainty:
transfers the underlying FC assets/liabilities into DC assets/liabilities
Example cont’d: bank A quotes a forward rate of $1.53/£.

Fancy Foods can buy £1,000,000 at $1.53/£ 90 days in the future. The
resulting £-inflow exactly matches the £-liability (also £1,000,000). As a result,
Fancy Foods has a $-liability at a known value ($1,530,000) but no exchange
rate risk.
8
Payoff Profile of Hedged FC Liability
$-Value in 90 Hedged FC Liability

days
$1.53/£
S(t+90d) in [$/£]
-$1.53m
FC liability hedged $-value of FC liability Forward Purchase

9
Test Your Intuition
• Hedging export receipts

– Your company has exported goods from the US to the UK. At the
moment it has a £10M receivable to arrive in 30 days.
– Current spot rate : $1.50/£
– 30-day forward rate: $1.45/£
• How can you eliminate the exchange rate risk?
1. Describe the hedging strategy, i.e. which position do you enter in the
forward market (long/short, contract size?).
2. Draw the payoff profile of the unhedged position, the forward, and
the hedged position.
3. How would you assess the hedge ex-post, if the USD had depreciated
to $1.56/£ after 30 days.
10
Test Your Intuition
Solution
• Hedging export receipts
– Hedging Strategy: Sell £10m forward in 30 days. The export receipts
which you receive in 30 days will exactly match the amount of GBP
that you have to deliver to honor your forward contract.
– As you will receive $14.5m in 30 days for sure from the forward
contract, you have eliminated the exchange rate risk.
– If the dollar had weakened you would have earned more by remaining
unhedged. Since a forward hedge eliminates any risk, it also eliminates
the potential profit from a favorable exchange rate movement.
However, whether the hedge was a good idea should not be assessed
based on the ex-post FX-rate development but on how meaningful is
was to hedge given the information (on the riskiness of the FX-rate,
possible future FX-rate scenarios, value consequences of hedging and
not hedging) available at that time.
11
Test Your Intuition
Solution
$-Value at T Hedged Positions
£ receivables
$15.6m
$14.5m=
$1.45/£ x
£10m
$1.45/£ $1.56/£
S(30d) in [$/£]
-
Forward Sale
FC receivable hedged
12
The Forward Foreign Exchange Market
• Market organization
– Outright forward contracts
– Swaps: Simultaneous purchase (or sale) of foreign currency against a
sale (or purchase) of this currency at two different dates in the future
13
The Forward Foreign Exchange Market
• Forward contract maturities and value dates

– Forward value or settlement date
• Most active dates are 30, 60, 90, 180 days
• Highly customizable
• Exchange takes place on the forward value date
• Forward bid/ask spreads
– Larger than in spot market
– Spreads higher for greater maturities
– 0.10% for major currencies
– 90 day: 15% greater than spot contracts
14
Forward Premiums and Discounts
• Forward premium - occurs when the forward price of a

currency contract is higher than the spot rate.
– F($/€) > S($/€) (the price of €1 is higher for forward and the euro is
said to be at a forward premium in terms of the dollar)
• Forward discount - occurs when the forward price of the
currency contract is lower than the spot rate
– F($/€) < S($/€) (the price of €1 is lower for forward and the euro is
said to be at a forward discount in terms of the dollar)
• The forward premium/discount is often expressed as an
annualized percentage. The % per annum forward
premium/discount of an N day forward rate:
𝐹(𝑡, 𝑡 + 𝑁) − 𝑆(𝑡) 360
𝑓𝑝(𝑡, 𝑡 + 𝑁) = ×
𝑆(𝑡) 𝑁
16
Historical Means of Forward Premiums or
Discounts
• What does that mean?
17
The Theory of Covered Interest Rate Parity
How Can We Determine the Forward Rate?
• Law of one price (LOOP)
• If the payoff of a forward contract can be perfectly replicated,
then its price is given by a no-arbitrage condition.
• The covered interest rate parity (CIP) is this no-arbitrage
condition.
– covered … not exposed to FX risk
• It holds if
– markets are efficient
– no government controls prevent arbitrage trades
• The CIP determines a relationship between interest rates and
spot and forward FX-rates. No causality!
18
Derivation
profit:
19
Derivation
20
Derivation
21
Diagram of
Covered Interest
Arbitrage
22
Test Your Intuition
Is the Arbitrage Relationship Fulfilled?
• The following quotes are given in the market
– i($)=8%; i(£)= 12%;
– S=$1.60/£; F(1-yr) = $1.53/£
• Question: Does the arbitrage relationship hold?
23
Test Your Intuition
Is the Arbitrage Relationship Fulfilled?
Forward rate according to CIP: F=$1.54/£
Arbitrage Strategy using £ 1M:

1. Borrow pounds: £1M (£1M * 1.12 = £1.12M is the repayment amount)
2. Convert pounds to dollars: £1M * ($1.60/£) = $1.6M
3. Invest at U.S. interest rate: £1.6M * 1.08 = $1.728M
4. Convert back at forward rate: $1.728M /($1.53/£) = £1,129,411.76
£9,411.76 (Step 4 – Step 1) profit for every £1M that is

borrowed! => interest rates and spot and forward FX-rates are
not in equilibrium
24
Lecture 4
International Monetary System
1
Lecture 4: Overview
• The Balance of Payments and Supply and Demand in

the FX-market.
• Different Exchange Rate Regimes
• Monetary Policy and the Central Bank as a Key Actor
in the FX-Market
• Managed Floating System
• Fixed Exchange Rate Systems
• Currency Risk In Different Regimes
2
Ultimate Goal:
• Be able to make short-run and long-run qualitative predictions for the
currency and
• Estimate the currency risk
which requires knowing (sub goals)
• the different exchange rate systems
• the risk inherent in the different regimes
• how a central bank can manage its currency with the monetary policy
tools at its hand
• the relationship between the central bank's foreign exchange reserves, its
purchases and sales in the foreign exchange market, and the money
supply.
• the economic consequences of interventions
3
Where do supply and demand in FX-markets come
from?
• Trade: Import and export of goods and services

• Investment income: interest and dividend receipts and
payments
• Financial investment
– FDI
– Portfolio investment (includes speculation)
• Unilateral transfers
• Central bank intervention
All transactions are recorded in the Balance of Payments
– Current account: trade and investment income
– Capital account: capital out- and inflows 6
Balance of Payments
where all FX-market relevant transactions are recorded.
The Balance of Payments is the statistical record of a

country’s international transactions over a certain
period of time presented in the form of double-entry
bookkeeping.
• Credit transactions give rise to conceptual inflows of foreign

exchange. E.g., export of goods and services, asset sales,…
• Debit transactions give rise to conceptual outflows of foreign
exchange. E.g., import of goods and services, asset
purchases,…
• Double-entry bookkeeping: every transaction gives rise to a
credit entry and a debit entry of equal value. 7
Example 1: Export of Goods
• Suppose that Mercian Bicycles in Darby England exports £300,000 worth

of bicycles to H-max, a Norwegian sports retailer. H-max pays Mercian
Bicycles by crediting the amount due to Mercian Bicycles’ Norwegian bank
account in Oslo.
UK BOP Credit Debit
Export of bicycles + £300,000
Deposit at Norwegian bank - £300,000
• Every credit in the BOP is matched by a debit somewhere to conform to

double-entry bookkeeping.
• If we consider the parts of the transaction individually we see that
– the export generates demand for pounds in the FX-market,
– the deposit at the Norwegian bank generates supply of pounds in the FX-
market.
8
Structure of the Balance of Payments
Credits (recorded with a +) Debits (recorded with a -)

Current Account
(A) TRADE BALANCE (goods and services)
Exports of goods and services Imports of goods and services
(B) INVESTMENT INCOME ACCOUNT (dividends and interest)
Receipt of dividends,… Payment of dividends,…
Capital Account
Capital inflows Capital outflows
Official Reserves Account
Decrease (In-) of reserves at Increase (De-) of reserves at
domestic (foreign) central bank domestic (foreign) central bank
9
Example 2: Import of Goods
• Suppose that Mercian Bicycles in Darby England imports

£100,000 worth of bicycle frames from Maplewood Bicycle in
Maplewood, USA. Mercian Bicycles transfers the amount due
to Maplewood Bicycle’s British bank account at its London
bank.
UK BOP Credit Debit

Import of bicycles - £100,000
(current account)
Foreign deposit increase + £100,000
(capital account)
10
UK BOP – 2013 (in billion £)
Credit Debit
Current Account
Exports / Imports 505.6 -534.1
Investment income / payment 145.5 -162.2
Unilateral Transfers 16.3 -43.9 In 2013 the UK
Balance on Current Account -72.8 imported more than
Capital Account it exported, thus
Direct Investment (net) 27.1
running a current
Portfolio Investment (net) 39.8
account deficit of
Other Investments (net) 15.4
£72.8 billion.
Balance of Capital Account 82.3
Official Reserve Account
Balance -5.0
Statistical Discrepancy -4.5 11
Credit Debit
Current Account
Unilateral Transfers 16.3 -43.9 During the same
Balance on Current Account -72.8 year, the UK
Capital Account attracted net
investment of £82.3
billion.
Balance of Capital Account 82.3
Balance -5.0
Credit Debit
Current Account
Exports / Imports 505.6 -534.1 Under a pure
Investment income / payment 145.5 -162.2 flexible exchange
Unilateral Transfers 16.3 -43.9 rate regime, these
Balance on Current Account (CA) -72.8 numbers would
Capital Account balance each other
Direct Investment (net) 27.1 out as the central
Portfolio Investment (net) 39.8 bank is not active in
the FX-market:
Balance of Capital Account (KA) 82.3
Balance (RA) -5.0
Credit Debit
Current Account
Unilateral Transfers 16.3 -43.9 Cross- border
Balance on Current Account (CA) -72.8 transactions
Capital Account (especially
financial) are hard
to measure. There
is a statistical
Balance of Capital Account (KA) 82.3
discrepancy.
Balance (RA) -5.0
Balance of Payments Identity
• When the transactions are recorded correctly, the combined

balance of the current account, the capital account, and the
official reserve account must be zero:
• Under a pure flexible exchange rate regime, central banks do

not intervene in the FX market. Thus, the current account
balance must equal the capital account balance.
• These are just accounting identities (like in national income

accounting). They do not imply causality by itself!
15
Alternative Exchange Rate Arrangements
• Floating currencies
– FX-rate determined by the market forces of supply and
demand (e.g., U.S., Japan, European Union, Australia, and
Sweden)
– Since no country completely refrains from intervening, we
talk of “dirty floating”.
• Managed floating
– countries whose Central Banks intervene enough that the
IMF can’t classify them as freely floating (e.g., Argentina,
Brazil, Columbia, Indonesia, Israel, Mexico, South Africa)
21
Alternative Exchange Rate Arrangements
• Fixed/pegged currencies
– “pegging” a currency to another or a basket of currencies
(e.g., IMF’s SDR and the Chinese yuan)
• Often implemented using a currency board
• Crawling pegs
– FX-rates are kept lower than preset limits that are adjusted
regularly (e.g., with inflation)
• Target zone
– FX rate is kept within a band (e.g., ERM 2)
• No separate legal tender (“Dollarization”)
– adopt a currency (e.g., Ecuador, El Salvador and Panama
have adopted the U.S. dollar) 22
Central Banks –
A Key Player in the FX-Market
• To understand how exchange rate systems operate, you must
first understand how central banks function.
• To anticipate the moves of central banks we need to know
– their goal(s):
– their tools:
– their influence on the economy via:
27
Central Banks –
A Key Player in the FX-Market
• To understand how exchange rate systems operate, you must
first understand how central banks function.
• To anticipate the moves of central banks we need to know
– their goal(s):
• low inflation, full employment, financial stability, fixed exchange rate (one
or more of them)
– their tools:
• domestic open market operations (buying or selling government bonds),
reserve requirements, currency interventions (buying or selling foreign
assets), management of expectations
– their influence on the economy via:
• interest rates, exchange rate, values of the assets which the economic
agents hold.
28
Central Banks
Goals
• The impossible trinity – only two of the following

three are possible (you can’t have everything)
– Perfect capital mobility (no capital controls)
– Fixed exchange rates
– Domestic monetary autonomy to pursue goals such as
price stability and full employment.
29
The Quantity Theory of Money
Empirical Evidence
Inflation is a monetary phenomenon
in the long run
– Support for the QTM in the long run
– Bad performance in the short run
Other Inflation theories:

• Demand–pull inflation
– E.g., Phillips curve
• Cost-push inflation And in the long-run?
– Oil-price shock
• Build-in inflation
– Inflationary expectations
– Wage/price spiral
32
Central Banks –
How They Control the Domestic Money Supply
• The central bank’s balance sheet (Exhibit 5.5)
Exhibit 5.5 Central Bank Balance Sheet
Sum of these two is called the

Influences money supply
“monetary base” or “base money”. It
through open market
is the (or one) determinant of the
operations
money supply in an economy
(corresponding to Ms in the quantity
theory of money model).
33
How Does a Central Bank Affect the FX-Rate?
E.g., Boosting UK Exports Via a Lower $/£ Exchange Rate
FX rate w/o intervention
Desired lower FX-rate
In order to lower the FX-

rate, the Central Bank
has to supply this excess
demand. This is where
FX-reserves come in.
Remark: A country that keeps the FX-rate artificially low,
34
accumlates foreign reserves (e.g., China).
How Does a Central Bank Intervene in the FX
Market?
• Official International Reserves of Central Banks
– Foreign exchange reserves (86%)
• Usually t-bills of other countries but recently more adventurous!
• China’s has reached $1 trillion!
– Gold reserves (10%)
– IMF-related reserve assets (4%)
• 2 Types of Foreign Exchange Interventions
– Non-sterilized
– Sterilized
35
Exhibit 5.6 Foreign Exchange Reserves
36
How Does a Central Bank Intervene in the FX Market?
Sterilized and Non-Sterilized Foreign Exchange Intervention
The central bank buys FX from a bank thereby expanding the money supply.
The Bank has now additional domestic currency available for lending.
Sterilization part. Result: No increase in the money supply!

37
Managed Floating
A Country’s Toolbox
• A country has more than one tool to influence the FX
rate:
– Direct FX intervention (sale/purchase of foreign assets
against domestic assets by the central bank)
– Tax/subsidize international trade to influence demand for
foreign currency
– Domestic monetary policy (money supply/interest rates)
– Restriction of capital movements
38
Managed Floating
How Central Bank Interventions Work
• The effects of central bank interventions
– Direct effects of interventions – supply/demand of currency
• Immediate impact on the FX-market is argued negligible due to small
amount (i.e., $50 billion versus $4 trillion overall trade in a day).
• With sterilization: changes in portfolio composition – bond portfolio
effect
• Creates inventory imbalances for foreign exchange dealers and order
flow that can be exploited.
– Indirect Effects of Interventions
• Affect the exchange rate through expectations
• Ongoing debate on the result of interventions:
• Have they increased volatility or calmed markets?
• Do they have a lasting effect? (can a central bank win against the
market?) 39
Exhibit 5.9 The Effects of Foreign Exchange Interventions
40
Fixed Exchange Rate Systems
A Long History
• The International Monetary System before 1971
– The Gold Standard
– WWI, hyperinflation (Germany) and the Interwar Period
• Gold Standard was suspended by many
• Interwar – some countries allowed float
– The Bretton Woods System (1944) – participating countries
agreed to link their currency to $ (which was pegged to
gold)
44
A Long History
– Individual incentives versus aggregate incentives
• Potential problems with a “bank run” on gold in U.S. with no
solution; not sustainable
– Special Drawing Rights (1968)
• An alternative reserve asset created by IMF with the same gold
value as the dollar
• Stayed pegged to gold until 1976, when it was then pegged to a
basket of currencies
– Due to incessant BOP deficits, U.S. abolished gold standard
in 1971
– 1973 Bretton Woods system collapsed and major
currencies transitioned into freely-floating currencies.
45
Pegging an Exchange Rate in a Developing
Country
Suppose peg>market rate;

=> there is an excess
supply of ringgit (MYR).
(peg) The central bank has to
use FX reserves to buy up
the excess supply of
ringgit.
(market rate)
If this situation continues,
then the central bank might
run out of FX reserves. In
that case it needs to give
up the peg.
46
• Why not simply float?

– Economists don’t agree – some believe that a pegged forex
regimes offers stability.
– Many economists believe, however, that pegged regimes
are not ultimately sustainable – the average duration is
only 4.67 years!
• Dollarization
– A country has no own legal tender and consequently no
own monetary policy. Such a country does not only adopt
the currency of another country but also its monetary
policy.
47
• Currency Board:
– Independent monetary institution that issues a countries base money
(notes and coins and required reserves of banks)
– The money is fully backed by a foreign reserve currency and fully
convertible into the reserve currency at a fixed rate
– Touted as a miracle cure for cutting inflation without high cost to the
economy (e.g., Hong Kong)
– Cannot monetize fiscal deficits; cannot rescue banks!
• The Balance Sheet of a Currency Board

(Compare it with the balance sheet of the central bank above.)
base money
48
Attacking and Defending Pegs and
Target Zones
• Speculative attacks:
– borrow in weak currency (that is expected to depreciate)
– invest in assets denominated in strong currency
– This is a one sided bet!!!
• Additional pressure from lead-lag operations: If devaluation is
expected,
– importers prepay to avoid higher prices after devaluation
– exporters extend maturity of trade credit
• Defending the target zone/peg
– Intervene through open market operations (i.e., buy/sell)
– Raise interest rates (borrowing becomes more costly)
– Impose capital controls to limit foreign exchange transactions
49
Lecture 5
Parity Relations and Exchange Rate

Determination
1
At the end of 2011, the Mexican peso was undervalued by 44 percent against the
dollar. Last year, it was the biggest gainer, rising 8.4 percent. Brazil’s real was 27
percent overvalued in December 2011, preceding a 9 percent slump in 2012.
Bloomberg, Jan 25, 2013
• How can we identify an over-/undervalued currency?

• Will this tell us something about its future development?
The euro came under pressure after European Central Bank President Mario Draghi
earlier said the central bank's monetary policy will remain accommodative for as long
as necessary and that interest rates should remain at present or lower levels for an
extended period of time.
Investing.com, Sep 05, 2013
• How are FX-rates and economic fundamentals related?
2
Lecture 5: Overview
• Uncovered Interest Rate Parity

• Unbiasedness Hypothesis
• Purchasing Power Parity
– Identify over- and undervalued currencies
– Compare incomes across countries
• Fisher Effect
3
A Note on the Notation
To save some space, the notation will sometimes be simplified by

omitting information that should be clear.
• Exchange rates will always be in the form of direct quotes, i.e.,
in DC/FC.
• Forward rates and interest rates are for the appropriate time
period.
• Examples:
𝐹𝐹 = 𝐹𝐹 𝑡𝑡, 𝑡𝑡 + 𝑛𝑛, 𝐷𝐷𝐷𝐷/𝐹𝐹𝐹𝐹
𝑆𝑆 = 𝑆𝑆 𝑡𝑡, 𝐷𝐷𝐷𝐷/𝐹𝐹𝐹𝐹
30
i DC = i(€, 30d) (if € is the DC and 30 days the period analyzed.)
360
4
International Parity Conditions
E (S ¥ / $ )
? S¥ /$ ?
?
1 + i¥ F¥ / $
?
1 + i$ S¥ /$
? ?
𝟏𝟏 + 𝝅𝝅¥
E
𝟏𝟏 + 𝝅𝝅$
𝝅𝝅¥ /𝝅𝝅$ … inflation in Japan/USA
5
Interest Rates and Forward FX-Rates:
The Covered Interest Parity (CIP)
E (S ¥ / $ )
S¥ /$
1 + i¥ F¥ / $
CIP
1 + i$ S¥ /$
𝟏𝟏 + 𝝅𝝅¥
E
𝟏𝟏 + 𝝅𝝅$
6
Covered Interest Rate Parity
The Effect of the Bid-Ask Spread
Remember (w/o bid-ask spreads):
𝐹𝐹(𝐷𝐷𝐷𝐷/𝐹𝐹𝐹𝐹) 1 + 𝑖𝑖 𝐷𝐷𝐷𝐷
=
𝑆𝑆(𝐷𝐷𝐷𝐷/𝐹𝐹𝐹𝐹) 1 + 𝑖𝑖(𝐹𝐹𝐹𝐹)
𝐷𝐷𝐷𝐷 𝐷𝐷𝐷𝐷
𝐹𝐹 − 𝑆𝑆
𝐹𝐹𝐹𝐹 𝐹𝐹𝐹𝐹
(1 + 𝑖𝑖 𝐹𝐹𝐶𝐶) = 𝑖𝑖 𝐷𝐷𝐷𝐷 − 𝑖𝑖(𝐹𝐹𝐹𝐹)
𝐷𝐷𝐷𝐷
𝑆𝑆
𝐹𝐹𝐹𝐹
Note that i(FC) corresponds to r£

in the figure.
This is a result of the bid-ask

spread.
Levi, International Finance, 4ed. 7

Covered Interest Rate Parity in Practice
• Does the covered interest rate parity hold?

– Prior to 2007, documented violations of interest rate parity
were very rare.
– Frequency, size, and duration of apparent arbitrage
opportunities do increase with market volatility.
8
Why Deviations from Interest Rate Parity
May Seem to Exist
• Not every deviation from the CIP is an arbitrage
opportunity!
– Default risks – risk that one of the counterparties may fail
to honor its contract.
– Exchange controls
• Limitations, Taxes
– Political/Country risk
• A crisis in a country could cause its government to restrict any
exchange of the local currency for other currencies.
• Investors may also perceive a higher default risk on foreign
investments: Deviations from the CIP can be seen as a country risk
premium.
9
Covered Interest Parity Deviations During the
Financial Crisis
𝑭𝑭
𝑫𝑫𝑫𝑫𝑫𝑫 = 𝟏𝟏 + 𝒊𝒊 𝑭𝑭𝑭𝑭 − [𝟏𝟏 + 𝒊𝒊 $ ]
𝑺𝑺
• The deviation reminds us that the
forward rate is not necessarily only
determined by the CIP relationship
but that
• every single asset has its own
market with specific demand and
supply.
• In normal times, the arbitrage trade
should act as an additional source
of supply or demand and restore
the CIP.
• Not so in the financial crisis.
Mispricing came mostly from the
forward rate, F, i.e. the forward $-
price of € was too high.
10
Covered Interest Parity Deviations During the
Financial Crisis
1. Why did the demand for $-long forward contracts increase?
• Many European banks had long-term $-assets (American MBS) funded by borrowing short-
term in $ in the external currency market (roll-over needs).
• This money market froze up beginning in summer 2007 and nearly completely after the
Lehman collapse. Thus the usual channels dried up.
• S($/€) dropped as flight to safety was ongoing but F did not decrease proportionally.
• Reason: Banks used another funding channel: covered dollar yield (1+i(€))*F/S, i.e. borrow in
€ but transform it into a $ loan via converting the loan principal into $ (that is 1/S) and
eliminate the FX-risk at the repayment date via selling € forward. But obviously, many FX-
dealers did not want to buy € forward against the $ and instead kept $-assets which were
seen as safe haven. Thus, the $-long forward became more expensive.
• Additional evidence: the deviation decreased as the Fed provided global dollar liquidity to
central banks in Europe, Latin America, and Asia.
2. Where were the arbitrageurs?
• Many investors switched to safe assets.
• => investment funds faced redemption from risk-averse investors
• => little speculative capital that would be able to countervail the demand effect.
11
Interest Rates and Future FX-Rates:
The Uncovered Interest Parity (UIP)
E (S ¥ / $ )
UIP S¥ /$
1 + i¥ F¥ / $
CIP
1 + i$ S¥ /$
𝟏𝟏 + 𝝅𝝅¥
E
𝟏𝟏 + 𝝅𝝅$
12
Uncovered Interest Rate Parity
• Compare DC (domestic currency) risk-free investment to FC

(foreign currency) investment into risk-free bond:
time t time t+1
DC-bond 1 + 𝑖𝑖(𝐷𝐷𝐷𝐷)
𝐷𝐷𝐷𝐷 1
investment
1
𝐷𝐷𝐷𝐷 1 1 + 𝑖𝑖 𝐹𝐹𝐶𝐶 𝑆𝑆(𝑡𝑡 + 1, 𝐷𝐷𝐷𝐷/𝐹𝐹𝐹𝐹)
FC-bond 𝑆𝑆 𝑡𝑡, 𝐷𝐷𝐷𝐷/𝐹𝐹𝐹𝐹
investment
1 1
1 + 𝑖𝑖(𝐹𝐹𝐶𝐶)
𝑆𝑆(𝑡𝑡, 𝐷𝐷𝐷𝐷/𝐹𝐹𝐹𝐹) 𝑆𝑆(𝑡𝑡, 𝐷𝐷𝐷𝐷/𝐹𝐹𝐹𝐹)
13
• How are the returns of the two investment strategy related?

• Note that the return on the FC investment is not riskless
(why?) – important difference to CIP!
• If the following 2 assumptions hold…
1. Investors are risk-neutral, i.e. they care only about expected returns
but not the risk of an investment
2. free capital mobility
• …then “arbitrage” will ensure that the expected returns of
the 2 strategies are equal and we get the
UNCOVERED INTEREST PARITY:
𝟏𝟏
𝟏𝟏 + 𝒊𝒊 𝑫𝑫𝑫𝑫 = 𝟏𝟏 + 𝒊𝒊(𝑭𝑭𝑭𝑭) 𝑬𝑬𝒕𝒕 𝑺𝑺(𝒕𝒕 + 𝟏𝟏, 𝑫𝑫𝑫𝑫/𝑭𝑭𝑭𝑭)
𝑺𝑺(𝒕𝒕, 𝑫𝑫𝑫𝑫/𝑭𝑭𝑭𝑭)
14
UNCOVERED INTEREST PARITY (UIP)

• Idea: On average you will not make money by switching funds
between two countries.
• UIP links FX-rate changes to interest rate differentials:
𝑬𝑬𝒕𝒕 𝑺𝑺(𝒕𝒕 + 𝟏𝟏, 𝑫𝑫𝑫𝑫/𝑭𝑭𝑭𝑭) − 𝑺𝑺(𝒕𝒕, 𝑫𝑫𝑫𝑫/𝑭𝑭𝑭𝑭) 𝒊𝒊 𝑫𝑫𝑫𝑫 − 𝒊𝒊 𝑭𝑭𝑭𝑭

=
𝑺𝑺(𝒕𝒕, 𝑫𝑫𝑫𝑫/𝑭𝑭𝑭𝑭) 𝟏𝟏 + 𝒊𝒊(𝑭𝑭𝑭𝑭)
𝒆𝒆𝒆𝒆𝒆𝒆𝒆𝒆𝒆𝒆𝒆𝒆𝒆𝒆𝒆𝒆 𝑭𝑭𝑭𝑭−𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓 𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄 𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊 𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓 𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅
• Approximation:
𝑬𝑬𝒕𝒕 𝑺𝑺(𝒕𝒕 + 𝟏𝟏) − 𝑺𝑺(𝒕𝒕)
≈ 𝒊𝒊 𝑫𝑫𝑫𝑫 − 𝒊𝒊 𝑭𝑭𝑭𝑭
𝑺𝑺(𝒕𝒕)
15
Forward FX-Rates and Future FX-Rates:
The Unbiasedness Hypothesis (UH)
E (S ¥ / $ )
UIP S¥ /$ UH
1 + i¥ F¥ / $
CIP
1 + i$ S¥ /$
𝟏𝟏 + 𝝅𝝅¥
E
𝟏𝟏 + 𝝅𝝅$
16
Unbiasedness Hypothesis
UNBIASEDNESS HYPOTHESIS (UH)

• Remember the CIP:
𝐹𝐹(𝑡𝑡, 𝑡𝑡 + 1) − 𝑆𝑆(𝑡𝑡) 𝑖𝑖 𝐷𝐷𝐷𝐷 − 𝑖𝑖 𝐹𝐹𝐹𝐹
=
𝑆𝑆(𝑡𝑡) 1 + 𝑖𝑖(𝐹𝐹𝐹𝐹)
• If the CIP and the UIP hold then the forward rate is an
unbiased predictor of the future spot FX-rate :
𝑬𝑬𝒕𝒕 𝑺𝑺(𝒕𝒕 + 𝟏𝟏) = 𝑭𝑭(𝒕𝒕, 𝒕𝒕 + 𝟏𝟏)

• Unbiased predictor means that you make no systematic error
when you use the forward rate as predictor for the future spot
FX-rate.
17
Test Your Intuition
Forecasting with UIP and UH
• On 12.6.2014 you want to forecast the NOK/USD exchange rate
for 10.9.2014. You have obtained the following data from
Reuters:
– i(NOK,90d) = 1.82% i(USD,90d) = 0.07%
– S(NOK/USD, 12.6.2014) = 5.9902 F(NOK/USD, 90d,12.6.2014) = 6.0145
– Remark: The interest rates are quoted in annualized form. To calculate
the appropriate interest rate for the holding period you have to use the
money market day-count convention:
𝟗𝟗𝟗𝟗
𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊 𝒆𝒆𝒆𝒆𝒆𝒆𝒆𝒆𝒆𝒆𝒆𝒆 𝒐𝒐𝒐𝒐𝒐𝒐𝒐𝒐 𝟗𝟗𝟗𝟗𝟗𝟗𝟗𝟗𝟗𝟗𝟗𝟗 = 𝒊𝒊(𝑵𝑵𝑵𝑵𝑵𝑵, 𝟗𝟗𝟗𝟗𝟗𝟗) ×
𝟑𝟑𝟑𝟑𝟑𝟑
• What is your forecast for the NOK/USD exchange rate based on

1. the UIP?
2. the UH?
18
Expected Inflation Rates and Future FX-Rates:
Purchasing Power Parity (PPP)
E (S ¥ / $ )
UIP S¥ /$ UH
PPP
1 + i¥ F¥ / $
CIP
1 + i$ S¥ /$
𝟏𝟏 + 𝝅𝝅¥
E
𝟏𝟏 + 𝝅𝝅$
20
The Law of One Price
In the Goods Market
• The price of a good quoted in a common currency should be

the same in different countries given competitive markets
and absence of transaction costs.
• This is a no-arbitrage condition in the goods market
• Formal condition for good i:
𝑷𝑷 𝒕𝒕, 𝒊𝒊, 𝑭𝑭𝑭𝑭 𝑺𝑺(𝒕𝒕, 𝑫𝑫𝑫𝑫/𝑭𝑭𝑭𝑭) = 𝑷𝑷(𝒕𝒕, 𝒊𝒊, 𝑫𝑫𝑫𝑫)
𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑 𝒐𝒐𝒐𝒐 𝒈𝒈𝒈𝒈𝒈𝒈𝒈𝒈 𝒊𝒊 𝒊𝒊𝒊𝒊 𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑 𝒐𝒐𝒐𝒐 𝒈𝒈𝒈𝒈𝒈𝒈𝒈𝒈 𝒊𝒊 𝒊𝒊𝒊𝒊
𝒇𝒇𝒇𝒇𝒇𝒇𝒇𝒇𝒇𝒇𝒇𝒇𝒇𝒇 𝒎𝒎𝒎𝒎𝒎𝒎𝒎𝒎𝒎𝒎𝒎𝒎 𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅 𝒎𝒎𝒎𝒎𝒎𝒎𝒎𝒎𝒎𝒎𝒎𝒎
21
In the Goods Market
• Why do violations of the law of one price occur?
• Punch line: Arbitrage in goods markets is a lot more costly

than in financial markets!
22
In the Goods Market
• Why do violations of the law of one price occur?

– Tariffs and quotas
– Transaction costs – would you go to Italy to get a haircut?
– Difficulty in finding buyers for some goods abroad
– Noncompetitive markets
– Sticky prices due to costs for switching prices (“menu costs”)
• Punch line: Arbitrage in goods markets is a lot more costly

than in financial markets!
23
Purchasing Power Parity
• A simple model of the determination of exchange rates.

• FX-rate predictions of the PPP are based on price-level
differences between countries.
• Baseline forecast for predicting exchange rate
• Plays a fundamental role in corporate decision making
– Location of plants
– Pricing products
– Hedging decisions
• Useful for assessing the cost of living in different countries
(how much does your salary buy you?)
24
What Is the Purchasing Power of a Currency?
Price Level
• Price Level of a Country
– is the nominal price level of a typical
consumption bundle in a country
(“basket of goods”)
– is a weighted average of goods and
services
(i.e., we spend 1% of our income on shoes)
P (t ,$) = ∑i =1 wi P (t , i,$)
N
– measures the cost of living in a country. E.g., the typical US

cons. bundle might cost $15,000. 25
Price Indices and Inflation
• Price index is usually reported instead of price level:
∑ w P(t + k , i,$) ×100

N
 P (t + k ,$) 
PI (t + k ,$) =   ×100 = i =1 i
∑ w P(t , i,$)
N
 P (t ,$)  i =1 i
• Inflation t is the base year
– is defined as the change in the price level

• Inflation – when price level is rising
• Deflation – when price level is falling
– usually based on price index changes
𝑃𝑃𝑃𝑃(𝑡𝑡 + 1) 𝑃𝑃(𝑡𝑡 + 1, $)
1 + 𝜋𝜋 𝑡𝑡 + 1 = =
𝑃𝑃𝑃𝑃(𝑡𝑡) 𝑃𝑃(𝑡𝑡, $) 26
Price Indexes 1960–2010
Inflation in 2010:
199.3
𝜋𝜋 𝑡𝑡 + 1 = −1
197.1
= 1.12%
Average annual inflation from

1985-2010
1
199.3 25
𝜋𝜋� 𝑡𝑡 + 1 = −1
100
= 2.79%
27
Internal and External Purchasing Power
• Internal purchasing power – the amount of goods and
services that can be purchased with $1 in the U.S.
1
=
𝑃𝑃(𝑡𝑡, $)
– If price level is $15,000, what is purchasing power of $1 mil?
– (1/$15,000) * $1 mil = 66.67 consumption bundles
$1 Million
• External purchasing power - the amount of goods and
services that can be purchased with $1 outside the U.S.
1 1
=
𝑆𝑆(𝑡𝑡, $/𝐹𝐹𝐹𝐹) 𝑃𝑃(𝑡𝑡, 𝐹𝐹𝐹𝐹)
– Check whether this ratio is in FC consumption bundles per $1

28
Absolute Purchasing Power Parity
• States that the exchange rate adjusts to equalize the internal

with external purchasing powers of a currency.
1 1 1
= 𝑃𝑃𝑃𝑃𝑃𝑃
𝑃𝑃(𝑡𝑡, 𝐷𝐷𝐷𝐷) 𝑆𝑆 (𝑡𝑡, 𝐷𝐷𝐷𝐷/𝐹𝐹𝐹𝐹) 𝑃𝑃(𝑡𝑡, 𝐹𝐹𝐹𝐹)
• Theoretical exchange rate is given by:

𝑷𝑷(𝒕𝒕, 𝑫𝑫𝑫𝑫)
𝑺𝑺𝑷𝑷𝑷𝑷𝑷𝑷 𝒕𝒕, 𝑫𝑫𝑫𝑫/𝑭𝑭𝑭𝑭 =
𝑷𝑷(𝒕𝒕, 𝑭𝑭𝑭𝑭)
• What if FX-rate doesn’t adjust? Then arbitrage is possible.

– Buy goods at cheaper price, ship them to where goods are more
expensive and sell them.
29
Absolute Purchasing Power Parity
• Internal purchasing power of $1M based on $15,000 price

level
– $1M*1/$15,000=66.67 cons. bundle
• External purchasing power of $1M based on £10,000 price
level given the FX-rate $1.4/£
– $1M*[1/($1.4/£)]=£714,286
– £714,286*1/ £10,000 = 71.43 cons. bundle
• Because external PP > internal PP, one can profit from buying
UK goods and shipping them to US for resale
– Sell 71.43 cons. bundles (from UK) in US at $15,000/cons. bundle, we
receive: $1,071,450 = (71.43*$15,000)
30
Extension: A Simple Monetary Model of a
Small Open Economy
• Building Blocks (Assumptions)
– Quantity Theory of Money (at home and abroad*)
𝑷𝑷𝑷𝑷 𝑷𝑷∗ 𝒀𝒀∗
𝑴𝑴𝒔𝒔 = 𝑴𝑴∗𝒔𝒔 = ∗
𝒗𝒗 𝒗𝒗
– Purchasing Power Parity:
𝑷𝑷
𝑺𝑺 𝑫𝑫𝑫𝑫/𝑭𝑭𝑭𝑭 = ∗
𝑷𝑷
– domestic quantities do not affect foreign quantities, hence, “small
open economy”
• Exchange Rate Determination

𝒗𝒗 𝑴𝑴𝒔𝒔 𝒀𝒀∗
𝑺𝑺(𝑫𝑫𝑫𝑫/𝑭𝑭𝑭𝑭) = ∗ × ∗ ×
𝒗𝒗 𝑴𝑴𝒔𝒔 𝒀𝒀
31
The Economist’s Big Mac Index: The Big Mac price serves as the
price level (incorporates prices of the ingredients, wages, rents)
𝑃𝑃(𝑁𝑁𝑁𝑁𝑁𝑁) 42.94
𝑆𝑆 𝑃𝑃𝑃𝑃𝑃𝑃 = = = 11.99
𝑃𝑃(𝑈𝑈𝑈𝑈𝑈𝑈) 3.58
𝑆𝑆 𝑃𝑃𝑃𝑃𝑃𝑃 11.99
= = 1.92
𝑆𝑆 6.25
34
Describing Deviations from PPP
• Some predictions of currency appreciations

– Predicting British Heartburn in 1991
• Pound set too high by ERM – The Economist suggested that they
devalue it or they would be sorry
• In 9/92, British authorities were forced to withdraw from ERM
• Not before they lost $12 billion trying to defend the higher rate!
– Predicting initial weakness of the euro
• Euro depreciated by 13% in 1999!
– The econometric evidence
• Several studies find that although there are deviations, they are
temporary
• A 10% undervalued currency tends to appreciate by 3.5% the next
year
37
Actual USD/GBP and PPP Exchange Rates
ERM crisis
Sep 1992: GBP is 34% overvalued
Nov 1992: GBP is 7% overvalued
The GBP dropped by 20% from Sep to
Nov 1992
38
Actual USD/EUR and PPP Exchange Rates
39
Actual JPY/USD and PPP Exchange Rates
40
Actual MXN/USD and PPP Exchange Rates
41
Explaining the Failure of Absolute PPP
• Suppose good 1 and good 2 are the only two goods in the US and the
British economy. The price levels are given by:
𝑃𝑃 𝑡𝑡, $ = 𝑤𝑤1$ 𝑃𝑃1$ 𝑡𝑡 + (1 − 𝑤𝑤1$ )𝑃𝑃2$ 𝑡𝑡
𝑃𝑃 𝑡𝑡, £ = 𝑤𝑤1£ 𝑃𝑃1£ (𝑡𝑡) + (1 − 𝑤𝑤1£ )𝑃𝑃2£ (𝑡𝑡)
• Case 1: Suppose LOOP holds for both goods and consumption baskets are
the same, i.e: 𝑤𝑤1$ = 𝑤𝑤1£
𝑃𝑃𝑖𝑖$ 𝑡𝑡 = 𝑃𝑃𝑖𝑖£ 𝑡𝑡 𝑆𝑆(t, $/£) for 𝑖𝑖 ∈ {1,2}
Then the absolute PPP will hold:

𝑃𝑃 𝑡𝑡, £ 𝑆𝑆(𝑡𝑡, $/£) = 𝑤𝑤1£ 𝑃𝑃1£ 𝑡𝑡 𝑆𝑆(𝑡𝑡, $/£) + (1 − 𝑤𝑤1£ )𝑃𝑃2£ 𝑡𝑡 𝑆𝑆(𝑡𝑡, $/£)
= 𝑤𝑤1$ 𝑃𝑃1$ 𝑡𝑡 + (1 − 𝑤𝑤1$ )𝑃𝑃2$ 𝑡𝑡 = 𝑃𝑃(𝑡𝑡, $)
𝑃𝑃 𝑡𝑡,$
𝑆𝑆 𝑃𝑃𝑃𝑃𝑃𝑃 𝑡𝑡, $/£ =
𝑃𝑃 𝑡𝑡,£
Thus, all reasons that cause the failure of the LOOP will cause the failure
of the PPP.
42
PPP and the Future FX-Rate
1. Prediction based on the model

E 𝑆𝑆(𝑡𝑡 + 1, 𝐷𝐷𝐷𝐷/𝐹𝐹𝐹𝐹) 1 + 𝜋𝜋 𝑡𝑡 + 1, 𝐷𝐷𝐷𝐷
=E
𝑆𝑆(𝑡𝑡, 𝐷𝐷𝐷𝐷/𝐹𝐹𝐹𝐹) 1 + 𝜋𝜋 𝑡𝑡 + 1, 𝐹𝐹𝐶𝐶
E 𝑠𝑠(𝑡𝑡 + 1, 𝐷𝐷𝐷𝐷/𝐹𝐹𝐹𝐹) ≈ E 𝜋𝜋 𝑡𝑡 + 1, 𝐷𝐷𝐷𝐷 − E 𝜋𝜋 𝑡𝑡 + 1, 𝐹𝐹𝐶𝐶
2. Predictions based on Over-/Undervaluation, i.e.

reversion to the long-run equilibrium FX-rate:
– Overvalued currencies should depreciate
– Undervalued currencies should appreciate
47
Test Your Intuition
• You work for a large Norwegian bank that wants to evaluate

the consequences of Greece leaving the eurozone (Grexit). If
Greece were to reintroduce the drachma (GRD), what would
be a sensible estimate for the GRD/EUR exchange rate?
• You have downloaded the following data from Datastream:
– Producer Price Index in Greece in Dec 2000/Aug 2014: 87.8 / 136
– Producer Price Index in Germany in Dec 2000/Aug 2014: 84 / 105.8
Idea: The German producer price index serves as a proxy for the price
level of the countries remaining in the eurozone.
– Final drachma/euro exchange rate fixed on 01.01.2001: 340.75
• Use the relative PPP to calculate an estimate for the GRD/EUR
exchange rate after the Grexit.
48
Expected Inflation Rates and Forward FX-Rates:
The Forward-PPP (FRPPP)
E (S ¥ / $ )
UIP S¥ /$ UH
PPP
1 + i¥ F¥ / $
CIP
1 + i$ S¥ /$
FRPPP
𝟏𝟏 + 𝝅𝝅¥
E
𝟏𝟏 + 𝝅𝝅$
50
PPP and the Forward FX-Rate
• If the UH and the PPP hold we get the Forward-PPP
𝐹𝐹(𝑡𝑡 + 1, 𝐷𝐷𝐷𝐷/𝐹𝐹𝐹𝐹) 1 + 𝜋𝜋 𝑡𝑡 + 1, 𝐷𝐷𝐷𝐷

=E
𝑆𝑆(𝑡𝑡, 𝐷𝐷𝐷𝐷/𝐹𝐹𝐹𝐹) 1 + 𝜋𝜋 𝑡𝑡 + 1, 𝐹𝐹𝐶𝐶
• Approximation:
𝐹𝐹(𝑡𝑡 + 1, 𝐷𝐷𝐷𝐷/𝐹𝐹𝐹𝐹) − 𝑆𝑆(𝑡𝑡, 𝐷𝐷𝐷𝐷/𝐹𝐹𝐹𝐹)
≈ E 𝜋𝜋 𝑡𝑡 + 1, 𝐷𝐷𝐶𝐶 − E 𝜋𝜋 𝑡𝑡 + 1, 𝐹𝐹𝐶𝐶
𝑆𝑆(𝑡𝑡, 𝐷𝐷𝐷𝐷/𝐹𝐹𝐹𝐹)
51
Interest Rates and Expected Inflation Rates:
The Fisher Effect
E (S ¥ / $ )
UIP S¥ /$ UH
PPP
1 + i¥ F¥ / $
CIP
1 + i$ S¥ /$
FE FRPPP
𝟏𝟏 + 𝝅𝝅¥
E
𝟏𝟏 + 𝝅𝝅$
52
The Fisher Equation
International Version
• If investors care only about the real return and capital markets around the
world are integrated, then real interest rates should converge. If the real
interest rate were higher in one country, capital would flow from other
countries into that country until real returns were equalized.
1 + 𝑟𝑟 𝑒𝑒 𝑡𝑡 + 1, 𝐷𝐷𝐷𝐷 = 1 + 𝑟𝑟 𝑒𝑒 𝑡𝑡 + 1, 𝐹𝐹𝐹𝐹
• Plugging in the Fisher equation yields a generalized Fisher effect:
𝟏𝟏 + 𝒊𝒊(𝒕𝒕, 𝑫𝑫𝑫𝑫) 𝟏𝟏 + 𝝅𝝅𝒆𝒆 𝒕𝒕 + 𝟏𝟏, 𝑫𝑫𝑫𝑫
=
𝟏𝟏 + 𝒊𝒊(𝒕𝒕, 𝑭𝑭𝑭𝑭) 𝟏𝟏 + 𝝅𝝅𝒆𝒆 𝒕𝒕 + 𝟏𝟏, 𝑭𝑭𝑭𝑭
– If real interest rates are similar around the world, then nominal interest rates differ only
because of different expected inflation rates.
• Real interest rates are not equal if
– investors require a risk premium for bearing currency risk,
– investors require a risk premium because of sovereign default risk, or political risk,
– countries have imposed currency controls or have regulated capital flows.
54
The Fisher Effect
Average Long-Term Government Bond Yields and Inflation Rates
• Fisher Effect/Hypothesis:
– The real interest rate is an
important determinant of firms’
investment decisions.
– If real interest rates are similar
across countries, a higher
inflation rate will translate into a
higher nominal interest rate
• Graph on the lhs: average inflation

rates and government bond yields
for 1990-2010 for 16 countries.
– Real interest rate = 2.396
55
Exact Parity Conditions
E (S ¥ / $ )
UIP S¥ /$ UH
PPP
1 + i¥ F¥ / $
CIP
1 + i$ S¥ /$
FE FRPPP
𝟏𝟏 + 𝝅𝝅¥
E
𝟏𝟏 + 𝝅𝝅$
56
Approximate Parity Conditions
E(s)
≈ UIP ≈ UH
≈ PPP
(i¥ – i$) ≈ CIP
F–S
S
≈ FE ≈ FRPPP
E(π¥ – π$)
57
What You Should Take Away
• Remember the big picture: FX-rate and

– the forward premium
– the interest rate differential
– the inflation rate differential
• When is a currency over-/undervalued and what
does that mean for the future FX-rate?
• How can we compare international salaries?
• Be aware of the weaknesses of the theories!
58
Lecture 6
Exchange Rate Forecasting
1
Learning Objectives
• Conditional expectation and variance of FX-rate

changes
– Should we forecast levels or changes?
– Should we care about the variance as well?
– Volatility Clustering and Consequences for Risk Management
• What is a good forecast? – Forecast Quality Criteria
• Different Forecasting Methods
2
Why Firms Forecast Exchange Rates
Decide whether to
Hedge Foreign Currency
Cash Flows
Decide Whether to DC value of

Invest in Foreign Projects Cashflows ↑
Forecasting
Exchange
Rates
Decide Whether Foreign Value of the
Subsidiaries Should Firm ↑
Remit Earnings
Decide Whether To Cost of

Obtain Financing in Capital ↓
Foreign Currencies
3
Forecasting the Future Spot Rate
• Expected Future Spot Rate in the next period (t+1)

conditional on this period’s information
𝐸𝐸 𝑆𝑆(𝑡𝑡 + 1)|𝐼𝐼𝑡𝑡
– where It denotes the information set containing all the information
available at time t that is used to form the conditional expectation
– shorthand notation:
𝐸𝐸𝑡𝑡 𝑆𝑆(𝑡𝑡 + 1)
• It is more convenient to reformulate this expectation of the

spot rate as an expectation of the change in the spot rate.
4
Expected FX-Rate Changes
Expected Future FX-Rate Changes

𝑆𝑆 𝑡𝑡 + 1 − 𝑆𝑆(𝑡𝑡)
• Discrete changes: 𝑠𝑠 𝑡𝑡 + 1 =
𝑆𝑆(𝑡𝑡)
𝐸𝐸𝑡𝑡 𝑆𝑆(𝑡𝑡 + 1) = 𝑆𝑆𝑡𝑡 (1 + 𝐸𝐸𝑡𝑡 𝑠𝑠 𝑡𝑡 + 1 )
𝑠𝑠(𝑡𝑡 + 1) ∈ (−1, ∞)
• Continuous changes: 𝑠𝑠 𝑡𝑡 + 1 = ln 𝑆𝑆 𝑡𝑡 + 1 − ln 𝑆𝑆 𝑡𝑡
𝐸𝐸𝑡𝑡 ln 𝑆𝑆(𝑡𝑡 + 1) = ln 𝑆𝑆𝑡𝑡 + 𝐸𝐸𝑡𝑡 𝑠𝑠 𝑡𝑡 + 1
𝑠𝑠(𝑡𝑡 + 1) ∈ (−∞, ∞)
• Advantage of using expected changes instead of expected

levels of the future spot rate:
– The spot rate can only take on values on the positive real line.
Consequently, S(t+1) cannot be normally distributed.
5
FX-Rate Volatility
• Conditional Variance of FX-rate changes

2
𝑉𝑉𝑉𝑉𝑟𝑟𝑡𝑡 𝑠𝑠(𝑡𝑡 + 1) = 𝐸𝐸𝑡𝑡 𝑠𝑠(𝑡𝑡 + 1) − 𝐸𝐸𝑡𝑡 𝑠𝑠(𝑡𝑡 + 1)
• The volatility is defined as the annualized standard deviation

of the FX-rate changes. If daily returns are used to calculate
the volatility, we often use 252 days (some people use 250)
𝜎𝜎𝑡𝑡+1 = 𝑉𝑉𝑉𝑉𝑟𝑟𝑡𝑡 𝑠𝑠(𝑡𝑡 + 1) × 252
• We often assume that the volatility is constant. In that case,

the conditional volatility is equal to the unconditional:
𝜎𝜎𝑡𝑡+1 = 𝜎𝜎
• In reality, we observe periods of lower and periods of higher

volatility, i.e. volatility clustering (see last part of lecture). 6
Assessing the Forecast Quality
• What is a good forecast?

– Accuracy: MAE (mean absolute error), RMSE (root mean
squared error).
– Right Side of the Forward Rate: E.g. For the hedging
decision, which is a yes – no – decision, it is enough if you
are on the right side of the forward rate.
– Profitability: You can afford to be wrong over 50% of the
time as long as you earn a lot of money when you are right
and lose little when you are wrong.
7
Accuracy of Forecasts
• Let ln 𝑆𝑆̂ 𝑡𝑡 + 𝑘𝑘 be the forecast of your model and ln 𝑆𝑆(𝑡𝑡 + 𝑘𝑘)

the realized spot rate at time t+k. The forecast error produced
by a k-period ahead forecast is defined as:
̂ + 𝑘𝑘)
𝑒𝑒 𝑡𝑡 + 𝑘𝑘 = ln 𝑆𝑆 𝑡𝑡 + 𝑘𝑘 − ln 𝑆𝑆(𝑡𝑡
• Summary measures to assess the accuracy of forecasts:

– Mean absolute error 𝑇𝑇
1
𝑀𝑀𝑀𝑀𝑀𝑀 = � 𝑒𝑒(𝑡𝑡 + 𝑘𝑘)
𝑇𝑇
𝑡𝑡=1
– Root mean squared error
𝑇𝑇
1 2
𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 = � 𝑒𝑒 𝑡𝑡 + 𝑘𝑘
𝑇𝑇
𝑡𝑡=1
8
Exchange Rate Forecasting Techniques
Exchange Rate
Forecasting
Techniques
Market Based Fundamental Technical

Forecasts Analysis Analysis
Random Walk Judgmental Econometric Statistical

UIP and UH (e.g. Big Mac Chartism
Assumption Index)
Analysis Analysis
9
FX-Rates As Random Walks
• Random walk - ∆𝑡𝑡 is the length of a period

𝑆𝑆 𝑡𝑡 + 1 = 𝑆𝑆 𝑡𝑡 + 𝜀𝜀(𝑡𝑡 + 1) 𝜀𝜀𝑡𝑡+1 ~𝑁𝑁(0, 𝜎𝜎 ∆𝑡𝑡)
– The best forecast is the past value:
𝐸𝐸𝑡𝑡 𝑆𝑆 𝑡𝑡 + 1 = 𝑆𝑆(𝑡𝑡)
• Random walk in logs:
ln 𝑆𝑆 𝑡𝑡 + 1 = ln 𝑆𝑆 𝑡𝑡 + 𝜀𝜀(𝑡𝑡 + 1) 𝜀𝜀𝑡𝑡+1 ~𝑁𝑁(0, 𝜎𝜎 ∆𝑡𝑡)
– The best forecast is the past value:
𝐸𝐸 ln𝑆𝑆 𝑡𝑡 + 1 = ln 𝑆𝑆 𝑡𝑡
– Returns are just noise (completely random)
s t + 1 = ln 𝑆𝑆 𝑡𝑡 + 1 − ln 𝑆𝑆 𝑡𝑡 = 𝜀𝜀(𝑡𝑡 + 1)
– Multiperiod returns are the sum of the single-period returns:
𝑁𝑁 𝑁𝑁
s t, t + N = � 𝜀𝜀(𝑡𝑡 + 𝑖𝑖) Var(s t, t + N ) = � 𝑉𝑉𝑉𝑉𝑉𝑉 𝜀𝜀 𝑡𝑡 + 𝑖𝑖 = 𝑁𝑁𝜎𝜎 2 ∆t

10
𝑖𝑖=1 𝑖𝑖=1
FX-Rates As Random Walks
and the UIP/UH
• Random Walk and UH/UIP don’t go together:
– If the FX-rate follows a random walk, then the expectation of the
future spot rate is equal to the current spot rate.
– But, if the UH/UIP holds, then the expectation of the future spot rate
equals the forward rate.
– Thus, we have
𝟏𝟏 + 𝒊𝒊 𝒕𝒕, 𝑫𝑫𝑫𝑫 ?
𝑬𝑬𝒕𝒕 𝑺𝑺 𝒕𝒕 + 𝟏𝟏 = 𝑭𝑭 𝒕𝒕, 𝒕𝒕 + 𝟏𝟏 = 𝑺𝑺 𝒕𝒕 = 𝑺𝑺(𝒕𝒕)
𝟏𝟏 + 𝒊𝒊 𝒕𝒕, 𝑭𝑭𝑭𝑭
which can only hold if the interest rates are equal in both countries all
the time!
12
Exchange Rate
Forecasting
Techniques


Assumption Index)
Analysis Analysis
13
Testing The Predictive Power Of The UIP And
UH
• Regression test of the uncovered interest parity
s t + 1 = 𝑎𝑎 + 𝑏𝑏 𝑖𝑖 𝑡𝑡, 𝐷𝐷𝐷𝐷 − 𝑖𝑖 𝑡𝑡, 𝐹𝐹𝐹𝐹 + 𝜀𝜀(𝑡𝑡 + 1)
– If UIP holds, a = 0 and b = 1

• Regression tests of the unbiasedness of forward rates
s t + 1 = 𝑎𝑎 + 𝑏𝑏𝑏𝑏𝑏𝑏 𝑡𝑡 + 𝜀𝜀(𝑡𝑡 + 1)
– Unbiasedness hypothesis is true if a = 0 and b = 1

• Results suggest that none of the relationships holds in the
data. Existence of a “forward rate bias”.
15
Regression Tests of the Unbiasedness Hypothesis
s(t+30) = a + b fp(t) + ε(t+30)
16
Exhibit 7.6 Interpreting the Unbiasedness
Regression for ¥/$
𝐸𝐸𝑡𝑡 𝑓𝑓𝑓𝑓𝑓𝑓 𝑡𝑡 = 𝐸𝐸𝑡𝑡 𝑠𝑠𝑡𝑡+1 − 𝑓𝑓𝑓𝑓(𝑡𝑡)
1.
2.
3. –
𝟏𝟏. 𝐸𝐸𝑡𝑡 𝑠𝑠 𝑡𝑡 + 1 = 𝑓𝑓𝑓𝑓(𝑡𝑡)

𝟐𝟐. 𝐸𝐸𝑡𝑡 𝑠𝑠 𝑡𝑡 + 1 = 𝑏𝑏 ∗ 𝑓𝑓𝑓𝑓(𝑡𝑡)
𝟑𝟑. 𝐸𝐸𝑡𝑡 𝑠𝑠 𝑡𝑡 + 1 = 𝑎𝑎 + 𝑏𝑏 ∗ 𝑓𝑓𝑓𝑓(𝑡𝑡)
17
Empirical Evidence on the Unbiasedness
Hypothesis
• Interpreting the forward bias
– Some suggest that the results are evidence against
unbiasedness hypothesis but they are forgetting about the
constant term
– Exh. 7.6 shows the importance of the constant term in the
regression (see third line for correct interpretation)
– Results suggest a speculator should buy dollars forward if
he believes in the predictability of the regression
18
Uncovered Foreign Money Market
Investment
𝑆𝑆 𝑡𝑡+1
• Gross return 1 + 𝑟𝑟(𝑡𝑡 + 1) =
𝑆𝑆 𝑡𝑡
(1 + 𝑖𝑖(𝑡𝑡, 𝐹𝐹𝐹𝐹) )
• Excess return (return in excess of DC risk-free rate)

e𝑥𝑥𝑥𝑥 𝑡𝑡 + 1 = 𝑟𝑟 𝑡𝑡 + 1 − 𝑖𝑖 𝑡𝑡, 𝐷𝐷𝐷𝐷
𝑆𝑆 𝑡𝑡+1
= (1 + 𝑖𝑖(𝑡𝑡, 𝐹𝐹𝐹𝐹) ) − (1 + 𝑖𝑖 𝑡𝑡, 𝐷𝐷𝐷𝐷 )
𝑆𝑆 𝑡𝑡
– can be interpreted as the return from borrowing at home and
investing in the FC money-market without hedging the currency risk,
i.e. the return on a self-financing arbitrage portfolio.
– remember the derivation of the UIP!
– At which future spot rate is this strategy as profitable as the DC
investment, i.e. exr(t+1)=0 (break-even future spot rate)?
1+𝑖𝑖 𝑡𝑡,𝐷𝐷𝐷𝐷
𝑆𝑆 BE = 𝑆𝑆 𝑡𝑡 = 𝐹𝐹(𝑡𝑡)
1+𝑖𝑖 𝑡𝑡,𝐹𝐹𝐹𝐹
19
Forward Market Investment
• Payoff from buying a FC forward:

𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 = 𝑆𝑆 𝑡𝑡 + 1 − 𝐹𝐹(𝑡𝑡)
• Return from buying a FC forward (forward market return)

𝑆𝑆 𝑡𝑡 + 1 − 𝐹𝐹 𝑡𝑡
𝑓𝑓𝑓𝑓𝑓𝑓 𝑡𝑡 + 1 = = 𝑠𝑠 𝑡𝑡 + 1 − 𝑓𝑓𝑓𝑓(𝑡𝑡)
𝑆𝑆 𝑡𝑡
• Comparing forward market investment and uncovered foreign
money market investment (assuming CIP holds):
𝑆𝑆 𝑡𝑡+1
𝑓𝑓𝑓𝑓𝑓𝑓(𝑡𝑡 + 1)(1 + 𝑖𝑖(𝑡𝑡, 𝐹𝐹𝐹𝐹) = (1 + 𝑖𝑖(𝑡𝑡, 𝐹𝐹𝐹𝐹) ) − (1 + 𝑖𝑖 𝑡𝑡, 𝐷𝐷𝐷𝐷 )
𝑆𝑆 𝑡𝑡
– Intuition: The FC MM-investment is undertaken at time t while the

forward market trade is carried out at t+1 and thus foregoes the
interest earned in the foreign money market.
20
Test Your Intuition
• Before, we wanted to be long in the FC (invest in the FC

money market). What would you do if you want to invest in
the DC money market (be short in the FC)?
1. How would you set up the trade with a forward contract and what is
its return?
2. How would you set up the trade with a FC and a DC money market
investment (deposit and loan) and what is its return?
21
Test Your Intuition
Solution
1. Forward market investment
– Sell the FC short in the forward market.
– Return:
𝐹𝐹 𝑡𝑡 − 𝑆𝑆 𝑡𝑡 + 1
𝑓𝑓𝑓𝑓𝑓𝑓 𝑡𝑡 + 1 = = 𝑓𝑓𝑓𝑓 𝑡𝑡 − 𝑠𝑠 𝑡𝑡 + 1
𝑆𝑆 𝑡𝑡
(just -1 times the return on the long position)
2. Money market investment
– Borrow in the FC and invest in a DC money market deposit.
– Return:
𝑆𝑆 𝑡𝑡 + 1
𝑒𝑒𝑒𝑒𝑒𝑒 𝑡𝑡 + 1 = 1 + 𝑖𝑖 𝑡𝑡, 𝐷𝐷𝐷𝐷 − 1 + 𝑖𝑖(𝑡𝑡, 𝐹𝐹𝐹𝐹)
𝑆𝑆 𝑡𝑡
(just -1 times the return on the long position)
22
Carry Trades – Is It Possible To Exploit The
Failure Of The UIP And UH?
• Simple Carry Trade Strategy Based on Random Walk
Assumption
– Borrow in low interest currency and invest in high interest
currency (buy currency that trades at a discount)
• You hope that the spot rate does not change much (random walk
assumption).
• If the FX-rate doesn’t change, you earn the “carry” which is the
interest rate differential.
• Popular strategy among hedge funds! A standard strategy is to go
long in 3 currencies that trade at steepest forward discounts
against $ and go short 3 currencies that trade at highest forward
premiums against $
23
• Why the two rules are the same:
1. Borrow in low interest currency and invest in high interest currency.
2. Buy currency that trades at a forward discount.
Suppose, without loss of generality, i(FC)>i(DC). Then,

𝑆𝑆 𝑡𝑡+1
𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 > 0 ⇔ (1 + 𝑖𝑖(𝑡𝑡, 𝐹𝐹𝐹𝐹) ) − 1 + 𝑖𝑖 𝑡𝑡, 𝐷𝐷𝐷𝐷 >0
𝑆𝑆 𝑡𝑡
1+𝑖𝑖 𝑡𝑡,𝐷𝐷𝐷𝐷
⇔ 𝑆𝑆 𝑡𝑡 + 1 − 𝑆𝑆 𝑡𝑡 >0
1+𝑖𝑖 𝑡𝑡,𝐹𝐹𝐹𝐹
⇔ 𝑆𝑆 𝑡𝑡 + 1 − 𝐹𝐹 𝑡𝑡, 𝑡𝑡 + 1 > 0
⇔ 𝑓𝑓𝑓𝑓𝑓𝑓 𝑡𝑡 + 1 > 0
24
• Simple Carry Trade Strategy
– Example: i(¥,6m)=0.005, i($,6m)=0.035
• Strategy: borrow in yen and invest in dollar deposit
• The carry is equal to (0.035-0.005)*180/360=0.015 per 6m
• The return of this strategy is equal to
180 𝑆𝑆 𝑡𝑡 + 1 180
𝑟𝑟𝑡𝑡+1 = 1 + 𝑖𝑖 𝑡𝑡, $ − (1 + 𝑖𝑖 𝑡𝑡, ¥ )
360 𝑆𝑆 𝑡𝑡 360
• The log return of this strategy is approximately (approx. b/c interest
rates are not adjusted to continuous compounding) equal to
180
𝑟𝑟𝑡𝑡+1 ≈ −𝑠𝑠𝑡𝑡+1 + (𝑖𝑖 𝑡𝑡, $ − 𝑖𝑖 𝑡𝑡, ¥ )
360
≈ −𝑠𝑠𝑡𝑡+1 + 0.015
– As long as the dollar doesn’t depreciate by more than the carry, you
earn a profit. 25
• Have carry trades been profitable?
– Sharpe ratio – excess return per unit of risk
𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 − 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 =
𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣
• In U.S. stock market – 0.3 – 0.4; excess return 5-6% and annualized
standard deviation is 15%
– Sharpe ratio for a carry trade strategy

𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 =
𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣
• The carry trade return is already the difference between a risky uncovered FC-
investment and a DC loan or the other way round.
• Carry trade strategies have been shown to produce similar or even higher Sharpe
ratios as the stock market.
27
Historically Carry Trades Have Been Very
Profitable
From Gyntelberg and Schrimpf (2011): FX Strategies in Periods of Distress, BIS Quarterly Review, Dec 2011
28
Carry Trades Lose Considerably in Crisis
Periods
From Gyntelberg and Schrimpf (2011): FX Strategies in Periods of Distress, BIS Quarterly Review, Dec 2011
29
Unstable coefficients in the unbiasedness
hypothesis regressions
Rolling Monthly 5-Year Regression: Monthly Spot Rate Percentage

Change Versus Monthly Forward Premium, February 1976–April 2010
30
Alternative Interpretations of the Test Results
• Risk premiums – existence is suggested by regression results,

but is this definitely risk?
– Basic models of risk, such as CAPM, have a hard time generating risk
premiums as variable as implied by the regressions
– Carry trades often unwind in bad economic times so it’s tough to tell
because risk tolerance changes in these times
• Peso problem – expecting something dramatic to happen and
it doesn’t (at least not when you expect it to)
– Name from experience in Mexico with fixed exchange rates where
rational investors anticipated a devaluation of the peso
• Can peso problem explain carry trades performance – yes if
one assumes agents become very risk averse when an unwind
happens (i.e., time-varying risk premiums)
31
Exchange Rate
Forecasting
Techniques


Assumption Index)
Analysis Analysis
32
Risk Management Application
Value at Risk
• Value at Risk measures the potential loss in value of an asset or portfolio over
a defined period h for a given significance level α (or confidence level 1- α).
– 5%-VaR for a 1 month horizon measures the loss that is exceeded with a 5%
chance within one month.
• Formal definition of the α-VaR for a h-day horizon:
– Let W(t) be the value of the asset/portfolio at time t. The change in value is given
by: ∆𝑊𝑊 𝑡𝑡, 𝑡𝑡 + ℎ = 𝑊𝑊 𝑡𝑡 + ℎ − 𝑊𝑊 𝑡𝑡 . Then, the 𝑉𝑉𝑉𝑉𝑅𝑅𝛼𝛼 (ℎ) is given by
𝑷𝑷 ∆𝑾𝑾 𝒕𝒕, 𝒕𝒕 + 𝒉𝒉 ≤ −𝑽𝑽𝑽𝑽𝑹𝑹𝜶𝜶 (𝒉𝒉) = 𝜶𝜶
– Example: Suppose a risk-manager reports a 5%-VaR for a 30 day horizon for a $1m
asset of $10,000. With that number she tells us that she is 95% (= 1- α) certain
(confident) that we won’t see a loss of more than $10,000 over the next 30 days.
𝑉𝑉𝑉𝑉𝑅𝑅5% 30𝑑𝑑 = $10k solves 𝑃𝑃 ∆𝑊𝑊 𝑡𝑡, 𝑡𝑡 + 30𝑑𝑑 ≤ −𝑉𝑉𝑉𝑉𝑅𝑅5% 30𝑑𝑑 = 5%
– Remark 1: Loss refers to the loss in value (e.g., dollars) not in percent.
– Remark 2: The VaR-definition is very similar to a quantile in statistics! 52
Value at Risk
• Often it is easier to obtain the distribution of changes in percent than
changes in value. Let’s denote the percentage change as s(t,t+h).
∆𝑊𝑊 𝑡𝑡, 𝑡𝑡 + ℎ = 𝑊𝑊 𝑡𝑡 + ℎ − 𝑊𝑊 𝑡𝑡 = 𝑾𝑾 𝒕𝒕 × 𝒔𝒔(𝒕𝒕, 𝒕𝒕 + 𝒉𝒉)
• Using that, we can redefine the VaR as a percentage of the portfolio value
W(t):
𝑃𝑃 𝑊𝑊 𝑡𝑡) × 𝑠𝑠(𝑡𝑡, 𝑡𝑡 + ℎ ≤ −𝑉𝑉𝑉𝑉𝑅𝑅𝛼𝛼 ℎ = 𝛼𝛼
𝑉𝑉𝑉𝑉𝑅𝑅𝛼𝛼 ℎ
𝑃𝑃 𝑠𝑠 𝑡𝑡, 𝑡𝑡 + ℎ ≤ − = 𝛼𝛼
𝑊𝑊(𝑡𝑡)
%𝑉𝑉𝑉𝑉𝑅𝑅𝛼𝛼
• Thus, the relationship between the standard VaR and the VaR in percent is:
𝑉𝑉𝑉𝑉𝑅𝑅𝛼𝛼 ℎ
%𝑉𝑉𝑉𝑉𝑅𝑅𝛼𝛼 ℎ = 𝑉𝑉𝑉𝑉𝑅𝑅𝛼𝛼 ℎ = 𝑊𝑊(𝑡𝑡) × %𝑉𝑉𝑉𝑉𝑅𝑅𝛼𝛼 ℎ
𝑊𝑊(𝑡𝑡)
• Important remark: h is measured as fraction of the year, e.g., 30/252!
53
Historical Value at Risk
• The historical VaR model assumes that the return distribution over the
forward looking risk horizon is identical to the historical distribution.
• Thus, the %𝑽𝑽𝑽𝑽𝑹𝑹𝜶𝜶 𝟏𝟏𝟏𝟏𝟏𝟏𝟏𝟏 corresponds to the α-quantile (times -1) of the
daily %changes. (longer horizons require approprate scaling)
• Example: On 23 December 2008, a US investor calculates the %𝑉𝑉𝑉𝑉𝑅𝑅5% 1𝑑𝑑𝑑𝑑𝑑𝑑
for his EUR 1mil deposit with a bank in Frankfurt.
– Based on the sample of daily %-changes in the USD/EUR FX-rate from 01.01.1999
to 23.12.2008 he finds that the 5%-quantile is equal to -1.003%. Thus, the
%𝑉𝑉𝑉𝑉𝑅𝑅5% 1𝑑𝑑𝑑𝑑𝑑𝑑 is 1.003%.
– The VaR in dollar terms is given by multiplying the %VaR with the current value of
his position. At a spot rate of USD1.3942/EUR, his asset is currently worth USD
1.3942mil. The 𝑉𝑉𝑉𝑉𝑅𝑅5% 1𝑑𝑑𝑑𝑑𝑑𝑑 is USD 13,942.
• Important remark: For a FC position of size N, we have W(t)=FC N x S(t,DC/FC)

– In the example above, the US-investor has a deposit worth €1mil in Frankfurt. Given that the
spot exchange rate is USD 1.3942/EUR, his position is currently worth USD 1.3942mil.
54
Historical Value at Risk
5%-quantile = -1.003% (see Excel file) 55

Refresher on Quantiles
• Remember the definition of an α-quantile of a random variable X:
𝑃𝑃(𝑋𝑋 ≤ 𝑄𝑄𝛼𝛼𝑋𝑋 ) = 𝛼𝛼
𝑋𝑋 )
𝐹𝐹(𝑄𝑄𝛼𝛼
• If F(x) is the distribution function of X, then the

α-quantile of X is simply given by the inverse of F(X):
𝑄𝑄𝛼𝛼𝑋𝑋 = 𝐹𝐹 −1 (𝛼𝛼)
• Example 1: If Z is standard normally distributed, i.e., Z ~ N(0,1), what is the 5%-
quantile of Z?
– Using the function norm.inv(0.05;0;1) in Excel we find that 𝑄𝑄𝛼𝛼𝑍𝑍 = 𝐹𝐹 −1 0.05 = −1.64
• Example 2: If X is normally distributed with mean μ=0.1 and standard deviation

σ=0.3, i.e., X ~ N(μ, σ), what is the 5% quantile of X? 2 ways to solve this:
1. norm.inv(0.05;0.1;0.3) in Excel gives us 𝑄𝑄𝛼𝛼𝑋𝑋 = −0.39
2. We use the properties of the quantile function:
𝑄𝑄𝛼𝛼𝑋𝑋 = 𝜇𝜇 + 𝜎𝜎𝑄𝑄𝛼𝛼𝑍𝑍 = 0.1 + 0.3 × −1.64 = −0.39 56
Value at Risk
• Assuming that s(t,t+h) is normally distributed, i.e., 𝑠𝑠 𝑡𝑡, 𝑡𝑡 + ℎ ~𝑁𝑁(𝑠𝑠ℎ,
̅ 𝜎𝜎 ℎ)
𝑃𝑃 𝑠𝑠 𝑡𝑡, 𝑡𝑡 + ℎ ≤ −%𝑉𝑉𝑉𝑉𝑅𝑅𝛼𝛼 (ℎ) = 𝛼𝛼
𝑠𝑠 annualized return
𝑄𝑄𝛼𝛼
volatility
we can look up the quantile directly or exploit the properties of horizon adjustment
the normal distribution: (fraction of a year)
𝑄𝑄𝛼𝛼𝑠𝑠 = 𝑠𝑠ℎ
̅ + 𝜎𝜎 ℎ𝑄𝑄𝛼𝛼𝑍𝑍
• Relationship %VaR and α-quantile of s(t,t+h)
%𝑉𝑉𝑉𝑉𝑅𝑅𝛼𝛼 (ℎ) = −𝑄𝑄𝛼𝛼𝑠𝑠 = −𝑠𝑠ℎ
̅ − 𝜎𝜎 ℎ𝑄𝑄𝛼𝛼𝑍𝑍
• Relationship between VaR and %VaR
̅ − 𝜎𝜎 ℎ𝑄𝑄𝛼𝛼𝑍𝑍 ) × 𝑊𝑊 𝑡𝑡
𝑉𝑉𝑉𝑉𝑅𝑅𝛼𝛼 ℎ = %𝑉𝑉𝑉𝑉𝑅𝑅𝛼𝛼 ℎ × 𝑊𝑊 𝑡𝑡 = (−𝑠𝑠ℎ
• Example from S54: We assume that the mean change and the volatility remain
constant over time. The volatility 0.10 and the average change is 0. We get:
1
%𝑉𝑉𝑉𝑉𝑅𝑅5% 1𝑑𝑑𝑑𝑑𝑑𝑑 = −0.1 −1.6449 = 1.01%
252 57
Test Your Intuition
Above, we used different methods to calculate the volatility of the

USD/EUR exchange rate and on 23.12.2008 we got the following
estimates:
using the entire sample EWMA
Volatility 0.10 0.26
1. Calculate the 5%-%VaR for a 1-month horizon (h=1/12) using

the 2 volatility estimates. Assume that the average change is 0.
2. Suppose you, as an US investor, have a EUR 1mil deposit. The
current spot rate is USD1.3942/EUR. What is the 5%-VaR for a
1-month horizon in USD-terms?
3. Do you think that the volatility estimate matters?
58
Test Your Intuition
Solution
• Results
using the entire sample EWMA
Volatility 0.10 0.26
1. %VaR 4.6 % 12.2 %
2. VaR USD 64,753 USD 169,740
• Calculation example
1
%𝑉𝑉𝑉𝑉𝑅𝑅5% 1𝑚𝑚 = −0.10 × × −1.6449 = 0.046
12
𝑈𝑈𝑈𝑈𝑈𝑈
𝑉𝑉𝑉𝑉𝑅𝑅5% 1𝑚𝑚 = 𝑆𝑆 𝑡𝑡, × 𝐸𝐸𝐸𝐸𝐸𝐸1𝑚𝑚𝑚𝑚𝑚𝑚 × %𝑉𝑉𝑉𝑉𝑅𝑅5% 1𝑚𝑚 = 𝑈𝑈𝑈𝑈𝑈𝑈 64.753
𝐸𝐸𝐸𝐸𝐸𝐸
• The way in which the volatility is measured matters
tremendously! The VaR based on the EWMA vola is nearly
three times as high! 59
Take Away
• Tools:
– Conditional expectation and variance of FX-rate changes
– Risk management application
– Different models to predict the exchange rate
– None does particularly well
– Carry trade strategy
• Theory
– Some FX-trading strategies produce positive excess returns
that cannot be reconciled with the models presented.
– That does not mean that arbitrage opportunities exist. It
could be a compensation for risk not accounted for in the
model! 60
Lecture 7a
Currency Futures And Options
1
• Future Contracts
– What‘s special about futures?
– How does marking to market work?
– Are futures and forward prices equal?
• Option Contracts
– Call and put
– American and European
– Payoff and profit
– Option price bounds and put-call parity
– Pricing of options (lecture 7b)
2
Futures Contracts: Preliminaries
• A futures contract is like a forward contract:

– It specifies that a certain currency will be exchanged for
another at a specified time in the future at prices
specified today.
• A futures contract is different from a forward
contract:
– Futures are standardized contracts trading on organized
exchanges with daily resettlement through a
clearinghouse.
3
Futures Contracts: Preliminaries
• Standardizing Features:
– Contract Size
– Delivery Month
– Daily resettlement
• Futures (vs Forwards)
– Traded on an exchange (e.g., CME (Chicago Mercantile Exchange)
Group, NYSE Euronex’s LIFFE CONNECT, and Tokyo Financial Exchange)
– Standardized, smaller amounts (e.g., ¥12.5M, €125,000, C$100,000)
– Fixed maturities (e.g., 30, 60, 90, 180, 360 days)
– Daily resettlement (marking to market) and margin account
4
The Basics of Futures Contracts:
Margin Account
• An investor who buys or sells a futures contract must deposit some assets
into a margin account.
• Initial Margin: When you enter a futures contract you are required to
deposit assets worth the initial margin requirement.
• Marking to market (daily resettlement)– deposit of daily losses/profits
• Maintenance margins – minimum amount that must be kept in the account
to guard against severe fluctuations in the futures prices. If the balance of
the margin account falls below the maintenance margin you receive a …
• ...Margin call and the account must be brought back to this value defined by
the initial margin by depositing more assts.
• If you fail to increase the margin account back to the level of the initial
margin, your position will be liquidated by your broker and you are paid out
what is left on the margin account.
5
The Basics of Futures Contracts:
Margin Account
• Idea behind the margin account:
– Reduce the credit risk; the assets in the margin account act as collateral.
• Which assets can be deposited? The CME accepts
– cash, U.S. government obligations, letters of credit
– securities listed on NYSE and American Stock Exchange, gold warehouse
receipts (both valued at 70% of their market prices!)
• Size of the margin requirement
– Depend on size of contract and variability of currency involved. Margin
requirements are lower if you are granted the status of a hedger.
– Initial margin at CME: e.g., $2,750 for USD/EUR, $3,850 for USD/JPY
– Maintenance margins at CME: e.g., $2,500 for USD/EUR, $3,500 for
JPY/USD
• Aka initial and maintenance performance bond at CME
6
Marking to market: An Example
• Consider a long position in the CME Euro/U.S. Dollar contract.

– It is written on €125,000 and quoted in $ per €.
– The maturity is 3 months and the current future price is $1.30.
– At initiation of the contract, the long posts an initial margin of $6,500.
– The maintenance margin is $4,000.
• Recall that an investor with a long position gains from increases

in the price of the underlying asset.
With a forward contract:
– If the euro increases to $1.35/€, the long-investor in the forward
contract would gain $6,250 = ($1.35/€ – $1.30/€) × €125,000.
– If the euro decreases to $1.24 at maturity, he will lose -$7,500 = ($1.24/€
– $1.30/€) × €125,000.
7
• But, with futures, we have daily resettlement of gains and

losses rather than one big settlement at maturity.
• Every trading day:

– if the price goes down, the long pays the short, i.e., the price change
times the contract size is debited from the long’s margin account and
credited to the short’s margin account.
– if the price goes up, the short pays the long
– Note: futures trading between the long and short is a zero-sum game.
• After the daily marking to market, it is as if each party has a

new contract at the new price with one-day-shorter maturity.
8
Marking to market: Margin Account
• Each day’s losses are subtracted from the investor’s account.
• Each day’s gains are added to the account.
• In this example, at initiation the long posts an initial margin of

$6,500.
• The maintenance level is $4,000.

– If this investor loses more than $2,500, he has a decision to make: he
can maintain his long position only by adding more funds—if he fails to
do so, his position will be closed out with an offsetting short position.
9
• We start with a futures price of $1.30/€. Over the next 3 days, the
euro strengthens then depreciates in dollar terms:
Settle Gain/Loss Account Balance

$1.31 $1,250 = ($1.31 –$7,750
$1.30)×125,000
= $6,500 + $1,250
$1.30 –$1,250 $6,500
$1.27 –$3,750 $2,750 + $3,750 = $6,500
On the third day: Suppose our investor keeps his long

position open by posting an additional $3,750.
10
• Over the next 2 days, the long keeps losing money and closes out
his position at the end of day five.

$1.31 $1,250 $7,750
$1.30 –$1,250 $6,500
$1.27 –$3,750 $2,750 + $3,750 = $6,500
$1.26 –$1,250 $5,250 = $6,500 – $1,250
$1.24 –$2,500 $2,750
11
Marking to market: Summing Up
How to calculate Gains and Losses

$1.30 –$– $6,500
$1.31 $1,250 $7,750
$1.30 –$1,250 $6,500
method 2
method 1
$1.27 –$3,750 $2,750 + $3,750

$1.26 –$1,250 $5,250
$1.24 –$2,500 $2,750
Total loss = – $7,500 = $2,750 – ($6,500 + $3,750)
= ($1.24 – $1.30) × 125,000 method
12
3
Summing Up
• Our investor has three ways of computing his gains and

losses:
1. Sum of daily gains and losses
– $7,500 = $1,250 – $1,250 – $3,750 – $1,250 – $2,500
2. Ending balance on account minus beginning balance
on account, adjusted for deposits or withdrawals.
– $7,500 = $2,750 – ($6,500 + $3,750)
3. Contract size times the difference between initial
contract price and last settlement price.
– $7,500 = ($1.24/€ – $1.30/€) × €125,000
Note: We have neglected the interest payments on the margin
account! Only method 2 gives us the accurate gain/loss on
the future contract. Method 1 can be adjusted for the
interest payments.
13
Futures and Forwards: A Comparison Table
Futures Forwards
Default Risk: Borne by Clearinghouse Borne by Counter-Parties
What to Trade: Standardized Negotiable
The Forward/Futures Agreed on at Time Agreed on at Time
Price of Trade Then, of Trade. Payment at
Marked-to-Market Contract Termination
Where to Trade: Standardized Negotiable
When to Trade: Standardized Negotiable
Liquidity Risk: Clearinghouse Makes it Cannot Exit as Easily:
Easy to Exit Commitment Must Make an Entire
New Contrtact
How Much to Trade: Standardized Negotiable
What Type to Trade: Standardized Negotiable

Margin Required Collateral is negotiable
Typical Holding Pd. Offset prior to delivery Delivery takes place
14
Should Futures Prices Equal
Forward Prices?
Consider a long position in a forward contract with maturity T and a forward rate
of F(t,T) and a long position in a future with the same maturity and settle prices
f(t+k) k = 1,…,n.
Time Forward Future
gain/loss gain/loss cumulative gain/loss
(changes of margin account) (w/o interest payments)
𝑡𝑡 − − −
𝑡𝑡 + 1 𝑓𝑓 𝑡𝑡 + 1, 𝑇𝑇 − 𝑓𝑓(𝑡𝑡, 𝑇𝑇) 𝑓𝑓 𝑡𝑡 + 1, 𝑇𝑇 − 𝑓𝑓(𝑡𝑡, 𝑇𝑇)
𝑡𝑡 + 2 𝑓𝑓 𝑡𝑡 + 2, 𝑇𝑇 − 𝑓𝑓(𝑡𝑡 + 1, 𝑇𝑇) 𝑓𝑓 𝑡𝑡 + 2, 𝑇𝑇 − 𝑓𝑓(𝑡𝑡, 𝑇𝑇)
t+3 𝑓𝑓 𝑡𝑡 + 3, 𝑇𝑇 − 𝑓𝑓(𝑡𝑡 + 2, 𝑇𝑇 ) 𝑓𝑓 𝑡𝑡 + 3, 𝑇𝑇 − 𝑓𝑓(𝑡𝑡, 𝑇𝑇 )
⋮ ⋮ ⋮
t + n = T 𝑆𝑆 𝑇𝑇 − 𝐹𝐹(t, T) 𝑓𝑓 𝑇𝑇, 𝑇𝑇 − 𝑓𝑓(T − 1, T) 𝑓𝑓 𝑇𝑇, 𝑇𝑇 − 𝑓𝑓(t, T)
= 𝑆𝑆(𝑇𝑇) = 𝑓𝑓 𝑡𝑡 + 2 − 𝑓𝑓 𝑡𝑡 + 1 + 𝑓𝑓 𝑡𝑡 + 1 − 𝑓𝑓(𝑡𝑡)
𝐹𝐹 𝑡𝑡, 𝑇𝑇 = 𝑓𝑓 𝑡𝑡, 𝑇𝑇 … ? 21
Forward Prices?
Time Future
gain/loss gain/loss
(changes of the margin account) (as t+n values, i.e. plus interest earned on margin acc.)
𝑡𝑡 − −
𝑛𝑛−1
𝐷𝐷𝐷𝐷
𝑡𝑡 + 1 𝑓𝑓 𝑡𝑡 + 1, 𝑇𝑇 − 𝑓𝑓(𝑡𝑡, 𝑇𝑇) 𝑓𝑓 𝑡𝑡 + 1, 𝑇𝑇 − 𝑓𝑓(𝑡𝑡, 𝑇𝑇) �(1 + 𝑖𝑖𝑡𝑡+𝑘𝑘 )
𝑘𝑘=1
𝑛𝑛−1
𝐷𝐷𝐷𝐷
𝑡𝑡 + 2 𝑓𝑓 𝑡𝑡 + 2, 𝑇𝑇 − 𝑓𝑓 𝑡𝑡 + 1, 𝑇𝑇 𝑓𝑓 𝑡𝑡 + 2, 𝑇𝑇 − 𝑓𝑓(𝑡𝑡 + 1, 𝑇𝑇) �(1 + 𝑖𝑖𝑡𝑡+𝑘𝑘 )
𝑘𝑘=2
⋮ ⋮ ⋮
The total gain/loss until t+n is the sum of this
column! This is not equal to S(T) – f(t,T), thus:
𝐹𝐹 𝑡𝑡, 𝑇𝑇 ≠ 𝑓𝑓 𝑡𝑡, 𝑇𝑇 22
Forward Prices?
• Future prices differ from forward rates because of the different payment
maturity. Futures pay out the price changes every day => interest rates
applied to these intermediate payments matter. Thus prices can slightly
differ.
• If interest rates are non-stochastic (i.e., known), then futures prices =
forward prices. This is because a forward investment can be replicated by a
special investment strategy into futures and the impact of the daily
resettlement in futures contracts can be eliminated.
• In general, they will not be equal.
– If corr(∆F, ∆i(DC)) >> 0, then futures prices > forward prices
– If corr(∆F, ∆i(DC)) << 0, then futures prices < forward prices
• In practice, the difference between future and forward prices is very small
in the FX-market. A study by Chang and Chang (1990, Journal of Finance, vol
45, no 4) finds no significant difference (at the 5% level) between USD
forward and futures prices for GBP, CAD, DEM, JPY, SFR from 1974 to 1987. 23
Practical Problem: Basis Risk
• Futures are only available for a

limited set of maturity dates. Thus,
a company with hedging needs will
not find a perfectly matching
future contract.
• Prior to the maturity date of the
contract the futures price will not 𝑺𝑺𝑻𝑻 = 𝒇𝒇𝑻𝑻
equal the spot price. The
difference is called basis.
𝑺𝑺𝒕𝒕𝟐𝟐 ≠ 𝒇𝒇𝒕𝒕𝟐𝟐
Basis = Spot price – Futures price
= S(t) – f(t,T)
• Due to maturity mismatch a future
might not be a perfect hedge T
against exchange rate risk.
24
How the Basis Affects the Hedge of a
Receivable
= f(t) - S(T)
basis
• Prior to the maturity date T the futures price f(t+i), i=1,…T-t-1,

is more or less equal to the forward rate.
• Only at the maturity date T will the futures price be equal to
the spot FX-rate, i.e. f(T) = S(T).
25
Test Your Intuition
Euro Receivable and Basis Risk
Nancy Foods has a receivable €250,000 on 4th of March. But the futures contract
delivery date is the 3rd week of March.
t t2 T
(10th of January) (4th of March) (3rd week of March)
Spot rate $1.23/€ $1.13/ € (= 𝑺𝑺𝒕𝒕𝟐𝟐 )

Futures Rate $1.22/ € $1.135/ € (= 𝒇𝒇𝒕𝒕𝟐𝟐 )
(March contract)
1. Suppose Nancy Foods enters into a tailor-made forward contract with a forward rate
of $1.22/€. What is the payoff of the forward contract on the 4th of March?
2. What is the payoff from the futures contract on the 4th of March (w/o interest
payments!)?
3. At which rate would Nancy Foods effectively have converted the €250,000 receivable
to USD on the 4th of March if it had used a Forward contract or a Futures contract?
(Effective FX-rate = total payoff of hedged position in USD / € 250,000.)
26
Test Your Intuition
Euro Receivable and Basis Risk
Nancy Foods has a receivable €250,000 on 4th of March. But the futures contract
delivery date is the 3rd week of March.
t t2 T
(10th of January) (4th of March) (3rd week of March)
Spot rate $1.23/€ $1.13/ € (= 𝑺𝑺𝒕𝒕𝟐𝟐 )

Futures Rate $1.22/ € $1.135/ € (= 𝒇𝒇𝒕𝒕𝟐𝟐 )
(March contract)
1. Forward payoff: ($1.22/ € - $1.13/ €) x €250,000 = $22,500

2. Futures payoff: ($1.22/ € - $1.135/ €) x €250,000 = $21,250
3. Forward: $1.22/ €
Future:
– Total payoff of hedged position: : $1.13/€ x €250,000 + $21,250 = $303,750
– Effective FX-rate: $303,750/€250,000 = $1.215/€
This doesn’t equal the futures rate from 10th of January because of basis risk! 27
Do We Always Want to Eliminate FX-Rate
Risk?
• Suppose that an US software firm has sold one of its products
to a French customer for EUR 30,000,000, payable in 90 days.
The current exchange rate is USD1.4/EUR. The firm’s
controlling department is convinced that the euro is going to
appreciate in the near future. At the same time, the firm faces
a large loan repayment of USD 40,000,000 in 90 days. It
cannot afford to default on this payment. Can it insure against
the downside risk, which might cause it to default, and retain
the chance to gain from a euro appreciation?
28
Options Contracts: Preliminaries
• An option gives the holder the right, but not the

obligation, to buy or sell a given quantity of an asset
in the future, at prices agreed upon today.
• Calls vs. Puts
– Call options gives the holder the right, but not the
obligation, to buy a given quantity of some asset at some
time in the future, at prices agreed upon today.
– Put options gives the holder the right, but not the
obligation, to sell a given quantity of some asset at some
time in the future, at prices agreed upon today.
29
Option Contracts
An option contract specifies

– the underlying: A currency option is written on one unit of
FC. It’s DC-price is of course the exchange rate S(t,DC/FC).
– the strike (exercise) price: often denoted by K. This specifies
the amount of DC-units per unit of FC for future delivery
(similar to a forward rate).
– the maturity date: here T
Currency Contract Size
– the amount of the underlying Australian dollar AUD10,000
(contract size), e.g., British pound £10,000
NASDAQ OMX PHLX example: Euro €10,000
Japanese yen ¥1,000,000
Norwegian krone NOK100,000
Swiss franc SF10,000
30
Options Contracts
Exercise Styles
• European vs. American options
– European options can only be exercised on the expiration
date.
– American options can be exercised at any time up to and

including the expiration date.
– Since this option to exercise early generally has value,

American options are usually worth more than European
options, other things equal.
31
Currency Options Markets
• Exchanges: NASDAQ OMX PHLX, International Securities

Exchange, CME
• FX-options are mostly European style (stock options are
mostly American style)
• OTC volume is much bigger than exchange volume, also
written for much larger amounts and broader range of
currencies.
• There exist also options written on currency futures (CME).
– Reason: Transactions costs and liquidity.
32
Basic Option Pricing
CALL-Option Payoff at Exercise Date
• You would only exercise a call option if you can buy the underlying
currency at a cheaper price (the strike price) than in the spot market.
– …the right, but not the obligation…
• If this is the case, we say that the call option is in-the-money and it is
worth ST – K.
• If the strike price is higher than the spot exchange rate we would make a
loss through this transaction and thus not exercise the option. We say that
the call option is out-of-the-money and it is thus worthless.
• Thus, the payoff of the option as a function of the underlying is given by:
CaT = CeT = Max[ST - K, 0]
– Remark 1: At expiry, an American call option is worth the same as a

European option with the same characteristics.
– Remark 2: Compare this to the forward purchase payoff: ST - K
33
Basic Option Pricing
PUT-Option Payoff at Exercise Date
• You would only exercise a put option if you can sell the underlying
currency at a higher price (the strike price) than in the spot market.
• If this is the case we say that the put option is in-the-money and it is
worth K - ST.
• If the strike price is smaller than the spot exchange rate we would make a
loss through this transaction and thus not exercise the option. We say that
the put option is out-of-the-money and it is thus worthless.
• Thus, the payoff of the put option as a function of the underlying is given
by:
PaT = PeT = Max[K - ST, 0]
– Remark 1: At expiry, an American put option is worth the same as a

European option with the same characteristics.
– Remark 2: Compare this to the forward sale payoff: K - ST
34
Options Contracts
Components of the Option Price
• The price of an option is also called option premium.
Note that the option is very similar to an insurance.
• Intrinsic Value
– The difference between the exercise price of the option
and the current spot price of the underlying asset.
• max(St-K,0) for the call and
• max(K-St,0) for the put.
• Time Value
– The difference between the option price (premium) and
the intrinsic value of the option.
Option Premium = Intrinsic Value + Time Value
35
Options Contracts
Relating the Strike Price to the Spot Rate
A call option is
• in-the-money
– If the exercise price is less than the current spot price of
the underlying asset.
• at-the-money
– If the exercise price is equal to the current spot price of
• out-of-the-money
– the exercise price is more than the current spot price of
Remark: We use this terminology throughout the entire life of the option.
36
Basic Option Payoff/Profit Profiles
long
payoff/profit 1 call
If the call is in-the- payoff = max(ST – K,0)

money, it is worth
ST – K.
If the call is out-of-
the-money, it is profit = max(ST – K,0) – c0
worthless and the
buyer of the call ST
–c0
loses his entire K + c0
investment of c0. K
Out-of-the-money In-the-money
loss
37
short
payoff/profit 1 call
If the call is in-the-

money, the writer
loses ST – K.
If the call is out-of- profit = c0 – max(ST – K,0)
the-money, the writer c0
keeps the option
premium. ST
K + c0
K
Out-of-the-money In-the-money
loss
38
payoff = – max(ST – K,0)
long
payoff/profit
1 put
If the put is in- K
the-money, it is
worth K – ST. The
K – p0 payoff = max(K – ST,0)
maximum gain is
K – p0
If the put is out-
of-the-money, it
is worthless and
the buyer of the – p0 ST
put loses his profit = max(K – ST,0) – p0
K – p0
entire investment
of p0.
K
In-the-money Out-of-the-money
loss 39
Basic Option Profit Profiles
short
payoff/profit 1 put
If the put is in-
the-money, it is
worth K –ST. The
maximum loss is
– K + p0
If the put is out- profit = p0 – max(K – ST,0)
of-the-money, it p0
is worthless and
the seller of the ST
payoff = – max(K – ST,0)
put keeps the K – p0
option premium
of p0.
K
– K + p0 In-the-money Out-of-the-money
loss 40
Test Your Intuition
payoff/profit
 Consider a call option
on £1.
 The option premium
is $0.25 per pound
 The exercise price is
$1.50 per pound.
 Draw the payoff and
the profit of the call as ST
a function of the
underlying.
loss
41
Test Your Intuition
payoff/profit
 Consider a call option
on £1. payoff = max(ST – K,0)
 The option premium Long 1
is $0.25 per pound
call on 1
$1.50 per pound. pound
–$0.25 ST
$1.75
$1.50
loss
42
Test Your Intuition
profit
 Now consider a call
option on £31,250.
is $0.25 per pound Long 1
 The exercise price is call on
$1.50 per pound.
£31,250
 Draw the profit profile.
ST
loss
43
Test Your Intuition
profit
 Now consider a call
option on £31,250.
is $0.25 per pound Long 1
 The exercise price is call on
$1.50 per pound.
£31,250
 Draw the profit profile.
–$7,812.50 ST
$1.75
$1.50
loss
44
Example: Put Option
Profit What is the maximum gain on this put option?
$42,187.50 $42,187.50 = £31,250×($1.50 – $0.15)/£
 Consider a put option

At what exchange rate do you break even?
on £31,250.
is $0.15 per pound
–$4,687.50 ST
$1.35 Long 1
$1.50 per pound. $1.50 put on
£31,250
loss $4,687.50 = £31,250×($0.15)/£
45
European Option Pricing Relationships
Put-Call Parity
• What is the payoff
payoff if you go
long a call and
short a put with call payoff = max(ST – K,0)
the same strike
price K?
ST
put payoff = max(K – ST,0)
51
European Option Pricing Relationships
Put-Call Parity
• What is the payoff if you go long a call and short a put with
the same strike price K?
𝐶𝐶𝑇𝑇 − 𝑃𝑃𝑇𝑇 = max 𝑆𝑆𝑇𝑇 − 𝐾𝐾, 0 − max 𝐾𝐾 − 𝑆𝑆𝑇𝑇 , 0
= 𝑆𝑆𝑇𝑇 − 𝐾𝐾
– This portfolio is equivalent to a portfolio including a FC1 deposit

(which is converted back to the DC at T at rate ST) and a DC loan of size
K.
• What is the PV of this portfolio?
𝑆𝑆𝑡𝑡 𝐾𝐾
𝐶𝐶𝑡𝑡 − 𝑃𝑃𝑡𝑡 = −
1+𝑖𝑖 𝑡𝑡,𝑇𝑇,𝐹𝐹𝐹𝐹 1+𝑖𝑖(𝑡𝑡,𝑇𝑇,𝐷𝐷𝐷𝐷)
• This relationship between call and put prices is called put-call

parity.
52
Lecture 7b
Currency Futures And Options

Option Pricing
1
Lecture 7b: Learning Objectives
• Become familiar with two widely used option pricing

models
– Binomial Model
– Lognormal Model
• Be able to apply those models

– For pricing
– For Hedging
• Understand the weaknesses of the model

2
Binomial Option Pricing Model
A Motivating Example
• Imagine a simple world where the dollar-euro exchange rate is

S0= $1/€ today and in the next year, S1 is either $1.1/€ or
$.90/€.
S0($/€) S1($/€)
$1.10
$1/€
$. 90
3
• A call option on the euro with exercise price K= $1/€ will have
the following payoffs. (C1 is the exercise value of the option)
S0($/€) S1($/€) C1($/€)
$1.10 $. 𝟏𝟏𝟏𝟏
$1/€
$. 90 $𝟎𝟎
4
• We can replicate the payoffs of the call option with a levered
position in the euro.
S0($/€) S1($/€) C1($/€)
$1.10 $. 𝟏𝟏𝟏𝟏
$1/€
$. 90 $𝟎𝟎
5
• Borrow the present value of $.90 today and invest in a euro
deposit that yields €1 at date 1.
• Your net payoff in one period is either $.20 or $0.
REPLICATING PORTFOLIO
S0($/€) S1($/€) C1($/€) € deposit $ debt portfolio
$1.10 $. 𝟏𝟏𝟏𝟏 $1.10/€ × €1 −$. 90 $. 𝟐𝟐𝟐𝟐
$1/€
$. 90 $𝟎𝟎 $. 90/€ × €1 −$. 90 $𝟎𝟎

6
• The portfolio has twice the option’s payoff so the portfolio
should be worth twice the call option value (no-arbitrage
principle).
$1.10 $. 𝟏𝟏𝟏𝟏 $1.10/€ × €1 −$. 90 $. 𝟐𝟐𝟐𝟐
$1/€
$. 90 $𝟎𝟎 $. 90/€ × €1 −$. 90 $𝟎𝟎

7
• The portfolio value today is today’s value of the euro deposit
less the present value of a $.90 debt:
$1/€ 0.9
𝑃𝑃𝑃𝑃 𝑜𝑜𝑜𝑜 𝑡𝑡𝑡𝑡𝑡 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 = −
1 + 𝑖𝑖(€) 1 + 𝑖𝑖($)
$1.10 $. 𝟏𝟏𝟏𝟏 $1.10/€ × €1 −$. 90 $. 𝟐𝟐𝟐𝟐
$1/€
$. 90 $𝟎𝟎 $. 90/€ × €1 −$. 90 $𝟎𝟎

8
We can value the option as half of the value of the portfolio:
𝟏𝟏 $𝟏𝟏/€ 𝟎𝟎. 𝟗𝟗
𝑪𝑪𝟎𝟎 = −
𝟐𝟐 𝟏𝟏 + 𝒊𝒊(€) 𝟏𝟏 + 𝒊𝒊($)
$1.10 $. 𝟏𝟏𝟏𝟏 $1.10/€ × €1 −$. 90 $. 𝟐𝟐𝟐𝟐
$1/€
$. 90 $𝟎𝟎 $. 90/€ × €1 −$. 90 $𝟎𝟎

9
• Why could we derive a price for the option?

– We were able to replicate the uncertain (stochastic) payoff
of the option state-by-state with a portfolio consisting of
the underlying FC deposit and a risk-free DC loan.
– If two investment strategies have the same payoff in every
state in the future, then they must have the same present
value today (no-arbitrage principle, LOOP).
• Is there a systematic way to find the replicating
portfolio?
– Yes, see next slides.
10
• Notation: domestic interest rate 𝑖𝑖ℎ

foreign interest rate 𝑖𝑖ℎ∗ 𝑡𝑡 𝑇𝑇
exchange rate in DC/FC 𝑆𝑆 ℎ
strike price in DC/FC 𝐾𝐾
value of the call option C
• All contracts have the same maturity date T and h is the time-length of the
investment period in years. Interest rates are adjusted for it (we will see
later how this is done).
• A model for the stochastic exchange rate process:
Exchange rate process • The exchange rate either
• increases by a factor u, or
𝑝𝑝 𝑆𝑆1𝑢𝑢 = 𝑆𝑆0 𝑢𝑢 • decreases by a factor d.
• The probability of an increase
S0 is p and (1- p) for a decrease.
1 − 𝑝𝑝 𝑆𝑆1𝑑𝑑 = 𝑆𝑆0 𝑑𝑑
11
• Consider a European call option.
• The expiration date is only one period from now.
• C1u is the call payoff at time one if the FX-rate moves up to S1u
• C1d is the call payoff at time one if the FX-rate moves down to
S1d.
• Thus,
Exchange rate process Option Payoff
𝑝𝑝 S1u 𝐶𝐶1𝑢𝑢 = max(𝑆𝑆1𝑢𝑢 − 𝐾𝐾, 0)
S0
1 − 𝑝𝑝 S1d 𝐶𝐶1𝑑𝑑 = max(𝑆𝑆1𝑑𝑑 − 𝐾𝐾, 0)

12
Replicating the Call Option
• Set up a replicating portfolio that invests b in the foreign
money market and B in the domestic money market.
– At time t=0, this portfolio is worth 𝑏𝑏𝑆𝑆0 + 𝐵𝐵
• The value of this portfolio at time one is either
– 𝑏𝑏𝑆𝑆1𝑢𝑢 (1 + 𝑖𝑖ℎ∗ ) + 𝐵𝐵(1 + 𝑖𝑖ℎ ) or
– 𝑏𝑏𝑆𝑆1𝑑𝑑 (1 + 𝑖𝑖ℎ∗ ) + 𝐵𝐵(1 + 𝑖𝑖ℎ )
• The Trick: Choose b and B such that the portfolio replicates
the payoff of the call in every future state
𝑝𝑝 S1u 𝐶𝐶1𝑢𝑢 = 𝑏𝑏𝑆𝑆1𝑢𝑢 (1 + 𝑖𝑖ℎ∗ ) + 𝐵𝐵(1 + 𝑖𝑖ℎ )
S0
1 − 𝑝𝑝
S1d 𝐶𝐶1𝑑𝑑 = 𝑏𝑏𝑆𝑆1𝑑𝑑 (1 + 𝑖𝑖ℎ∗ ) + 𝐵𝐵(1 + 𝑖𝑖ℎ )
13
Replicating the Call Option
• We can solve the above equation and obtain:
𝑪𝑪𝟏𝟏𝟏𝟏 − 𝑪𝑪𝟏𝟏𝒅𝒅
𝒃𝒃 =
(𝑺𝑺𝟏𝟏𝒖𝒖 −𝑺𝑺𝟏𝟏𝒅𝒅 )(𝟏𝟏 + 𝒊𝒊∗𝒉𝒉 )
𝒖𝒖𝑪𝑪𝟏𝟏𝒅𝒅 − 𝒅𝒅𝑪𝑪𝟏𝟏𝒖𝒖
𝑩𝑩 =
(𝒖𝒖 − 𝒅𝒅)(𝟏𝟏 + 𝒊𝒊𝒉𝒉 )
• By the no-arbitrage principle, the European call should cost
the same as the replicating portfolio:
𝑪𝑪𝟎𝟎 = 𝒃𝒃𝑺𝑺𝟎𝟎 + 𝑩𝑩
• As B≤0, the replicating portfolio for the call is short in the DC

money market (see motivating example).
14
Applying The Approach
• Example again: S0($/€) S1($/€) C1($/€)
$1.10 $. 10
𝒊𝒊𝒉𝒉 = 𝟎𝟎. 𝟎𝟎𝟎𝟎
$1
𝒊𝒊∗𝒉𝒉 = 𝟎𝟎. 𝟎𝟎𝟎𝟎
𝑲𝑲 = $𝟏𝟏/€ $. 90 $0
• Finding the replicating portfolio:

𝐶𝐶1𝑢𝑢 − 𝐶𝐶1𝑑𝑑 0.1 − 0
𝑏𝑏 = = = 0.4854
(𝑆𝑆1𝑢𝑢 − 𝑆𝑆1𝑑𝑑 )(1 + 𝑖𝑖ℎ∗ ) (1.1 − 0.9)(1 + 0.03)
𝑢𝑢𝐶𝐶1𝑑𝑑 − 𝑑𝑑𝐶𝐶1𝑢𝑢 1.1 × 0 − 0.9 × 0.1
𝐵𝐵 = = = −0.4412
(𝑢𝑢 − 𝑑𝑑)(1 + 𝑖𝑖ℎ ) (1.1 − 0.9)(1 + 0.02)
• Value of the option:

𝐶𝐶0 = 𝑏𝑏𝑆𝑆0 + 𝐵𝐵 = 0.0443 15
Risk-Neutral Probability
• After substitution and rearrangement

𝐶𝐶0 = 𝑏𝑏𝑆𝑆0 + 𝐵𝐵
1 + 𝑖𝑖ℎ 1 + 𝑖𝑖ℎ
− 𝑑𝑑 𝑢𝑢 −
1 1 + 𝑖𝑖ℎ∗ 1 + 𝑖𝑖ℎ∗
= 𝐶𝐶1𝑢𝑢 + 𝐶𝐶1𝑑𝑑
1 + 𝑖𝑖ℎ 𝑢𝑢 − 𝑑𝑑 𝑢𝑢 − 𝑑𝑑
𝒒𝒒 𝟏𝟏−𝒒𝒒
• We can rewrite the pricing formula in the following

way: 𝑸𝑸
𝟏𝟏 𝑬𝑬 [𝑪𝑪𝑻𝑻 ]
𝑪𝑪𝟎𝟎 = 𝒒𝒒𝑪𝑪𝟏𝟏𝟏𝟏 + 𝟏𝟏 − 𝒒𝒒 𝑪𝑪𝟏𝟏𝟏𝟏 =
𝟏𝟏 + 𝒊𝒊𝒉𝒉 𝟏𝟏 + 𝒊𝒊𝒉𝒉
• As 0<q<1, we can interpret q as a probability.
16
• Where did the real world probability p show up in the pricing formula?
– Nowhere!
– The real world probability did not matter because we did not need to calculate
the expected payoff. Instead we could form a replicating portfolio whose price
we know today if the market is arbitrage free.
– Remember the forward contract. There it was similar.
• What is the expected value of the future exchange rate using the risk-
neutral probabilities?
𝑄𝑄
S0
𝐸𝐸 𝑆𝑆1 × 𝐹𝐹𝐹𝐹𝐹 = 𝑞𝑞𝑆𝑆1𝑢𝑢 + 1 − 𝑞𝑞 𝑆𝑆1𝑑𝑑 = 1 + 𝑖𝑖ℎ ∗ =?
1 + 𝑖𝑖ℎ
inital investment
• The expected rate of return of every security calculated using the risk-
neutral probabilities must be the risk-free rate.
• If the market is arbitrage-free, we can always find such a risk-neutral
probability (first fundamental theorem of asset pricing).
17
18
Risk-Neutral Pricing
• Pricing implication: If we use the risk-neutral probabilities to

calculate the expected future payoff of an asset, then the
appropriate discount rate for deriving the present value is the
risk-free rate!
𝐸𝐸 𝑄𝑄 [𝐶𝐶𝑇𝑇 ] 1
– E.g., 𝐶𝐶0 = = 𝑞𝑞𝐶𝐶1𝑢𝑢 + 1 − 𝑞𝑞 𝐶𝐶1𝑑𝑑
1 + 𝑖𝑖ℎ 1 + 𝑖𝑖ℎ
• In many cases (especially for derivative pricing) it is much
easier to find the risk-neutral probabilities (q) and apply the
risk-free rate as discount factor than to find the risk-adjusted
discount rate and use the real-world probabilities (p).
• This form of pricing is also called arbitrage pricing or
redundant asset pricing.
19
Quick Wrap-Up:
We Saw Two Ways to Price The Option
1. Replication Approach
– Find the replicating portfolio.
– The current option price is equal to the current value of
the replicating portfolio.
2. Risk-neutral pricing
– Derive the risk-neutral probabilities.
– Calculate the expected value of the payoff using the risk-
neutral probabilities.
– Discount this risk-neutral expected value with the risk-free
rate.
20
Risk-Neutral Pricing
• Example again: S0($/€) S1($/€) C1($/€)
$1.10 $. 10
𝒊𝒊𝒉𝒉 = 𝟎𝟎. 𝟎𝟎𝟎𝟎
$1
𝒊𝒊∗𝒉𝒉 = 𝟎𝟎. 𝟎𝟎𝟎𝟎
𝑲𝑲 = $𝟏𝟏/€ $. 90 $0
• Finding the risk neutral probability:

1 + 𝑖𝑖ℎ 1 + 0.02
∗ − 𝑑𝑑 − 0.9
1 + 𝑖𝑖ℎ 1 + 0.03
𝑞𝑞 = = = 0.4515
𝑢𝑢 − 𝑑𝑑 1.1 − 0.9
• Value of the option:
1 1
𝐶𝐶0 = 𝑞𝑞𝐶𝐶1𝑢𝑢 + 1 − 𝑞𝑞 𝐶𝐶1𝑑𝑑 = 0.4515 × 0.1 + 0.5485 × 0
1 + 𝑖𝑖ℎ 1.02
= 0.0443
21
Multiperiod Binomial Model
• The single period model is clearly too much of a simplification.

• A multiperiod model allows us to model the stochastic
process of the underlying much more realistically.
• A multiperiod model divides the time to maturity into several
periods. The FX-rate is allowed to move up or down in every
period.
𝑡𝑡� � � �𝑇𝑇
ℎ ℎ ℎ ℎ
• Luckily, the intuition of the one-period model carries over to

the multiperiod model.
24
A 2-period binomial model

• The FX-rate can go up or down in every period. 𝑡𝑡 ℎ ℎ
𝑇𝑇
• The tree is recombining: 𝑆𝑆2𝑢𝑢𝑢𝑢 = 𝑆𝑆0 𝑢𝑢𝑢𝑢 = 𝑆𝑆0 𝑑𝑑𝑑𝑑 = 𝑆𝑆2𝑑𝑑𝑑𝑑

• The number of final states is equal the number of steps plus one.
𝑝𝑝
𝑆𝑆2𝑢𝑢𝑢𝑢 = 𝑆𝑆0 𝑢𝑢2 𝑝𝑝2
𝑝𝑝 𝑆𝑆1𝑢𝑢 = 𝑆𝑆0 u
1 − 𝑝𝑝 𝑆𝑆2𝑢𝑢𝑢𝑢 = 𝑆𝑆0 𝑢𝑢𝑢𝑢
𝑆𝑆0 𝑝𝑝 2𝑝𝑝(1 − 𝑝𝑝)
1 − 𝑝𝑝 𝑆𝑆1𝑑𝑑 = 𝑆𝑆0 d
2
1 − 𝑝𝑝 𝑆𝑆2𝑑𝑑𝑑𝑑 = 𝑆𝑆0 𝑑𝑑 2 1 − 𝑝𝑝
25
26
Example: S0=1, u=1.1, d=0.9; i=0.02, i*=0.03

• Call option: K=1, maturity=2ys
1. Step: calculate the exchange rate process (includes finding u and d!)
2. Step: calculate the terminal payoff of the option
𝑞𝑞 S_2uu 1.21
C_2uu 0.21 𝐶𝐶2𝑢𝑢𝑢𝑢 = max(𝑆𝑆2𝑢𝑢𝑢𝑢 − 𝐾𝐾, 0)
𝑞𝑞 S_1u 1.10
1 − 𝑞𝑞
C_1u
S_0 1 𝑞𝑞 S_2ud 0.99
C_0 C_2ud 0 𝐶𝐶2𝑢𝑢𝑢𝑢 = max(𝑆𝑆2𝑢𝑢𝑢𝑢 − 𝐾𝐾, 0)
1 − 𝑞𝑞 S_1d 0.90
C_1d
1 − 𝑞𝑞 S_2dd 0.81
C_2dd 0 𝐶𝐶2𝑑𝑑𝑑𝑑 = max(𝑆𝑆2𝑑𝑑𝑑𝑑 − 𝐾𝐾, 0)
27
3. Step: calculate the risk neutral probability (includes finding ih , ih.)

1 + 𝑖𝑖ℎ
− 𝑑𝑑
1 + 𝑖𝑖ℎ∗
𝑞𝑞 = = 0.4515
𝑢𝑢 − 𝑑𝑑
4. Step: solve for the option prices by going backward from the last
date to the initial date. The option price in every node prior to
maturity is given by the risk-neutral expectation of the option
payoff discounted with the risk free rate.
I.e., use the following recursion to find the price at time t-1 in state
s (which could be u,d):
𝟏𝟏
𝑪𝑪𝒕𝒕−𝟏𝟏,𝒔𝒔 = 𝒒𝒒𝑪𝑪𝒕𝒕,𝒔𝒔𝒖𝒖 + 𝟏𝟏 − 𝒒𝒒 𝑪𝑪𝒕𝒕,𝒔𝒔𝒅𝒅
𝟏𝟏 + 𝒊𝒊𝒉𝒉
28
4. Step (continued): Calculate the option price by going backward
1
𝐶𝐶1𝑢𝑢 = 𝑞𝑞𝐶𝐶2𝑢𝑢𝑢𝑢 + 1 − 𝑞𝑞 𝐶𝐶2𝑢𝑢𝑢𝑢
1 + 𝑖𝑖ℎ
1 S_2uu 1.21
𝐶𝐶0 = 𝑞𝑞𝐶𝐶1𝑢𝑢 + 1 − 𝑞𝑞 𝐶𝐶1𝑑𝑑 C_2uu 0.21
1 + 𝑖𝑖ℎ
S_1u 1.10
C_1u 0.0929
S_0 1 S_2ud 0.99
C_0 0.0411 C_2ud 0
S_1d 0.90
C_1d 0
S_2dd 0.81
C_2dd 0
1
𝐶𝐶1𝑑𝑑 = 𝑞𝑞𝐶𝐶2𝑢𝑢𝑢𝑢 + 1 − 𝑞𝑞 𝐶𝐶2𝑑𝑑𝑑𝑑 29
1 + 𝑖𝑖ℎ
The replication approach is more cumbersome because the delta

changes in every node as the price of the underlying FX-rate
changes. In reality, the hedging portfolio has to be adjusted after
every change in the price of the underlying (dynamic hedging).
S_2uu 1.21
S_1u 1.10 C_2uu 0.21
delta 0.9267
B -0.9265
S_0 1 C_1u 0.0929
delta 0.4512 S_2ud 0.99
B -0.4101 C_2ud 0
C_0 0.0411 S_1d 0.90
delta 0
B 0
C_1d 0 S_2dd 0.81
C_2dd 0 30
Practical Advise
How To Choose The Parameters?
• We are given the following statistics of the exchange rate:
– mean annualized %-change 𝜇𝜇 = 0.03
– volatility 𝜎𝜎 = 0.1
• Which parameters for a binomial process result in the same
mean annualized %-change and volatility?
– If we consider a binomial tree with N steps, then the step-length h is
equal to the time-to-maturity divided by N.
𝑇𝑇 − 𝑡𝑡 #𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑 #𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑
𝑡𝑡� � � �𝑇𝑇 ℎ= 𝑤𝑤𝑤𝑤𝑤𝑤𝑤𝑤𝑤 𝑇𝑇 − 𝑡𝑡 = 𝑜𝑜𝑜𝑜
ℎ ℎ ℎ ℎ
𝑁𝑁 360 365
– The up and down moves are given by:
𝑢𝑢 = 𝑒𝑒 𝜎𝜎 ℎ
𝑑𝑑 = 𝑒𝑒 −𝜎𝜎 ℎ
1 𝜇𝜇 ℎ
– The (real-world) probability is given by 𝑝𝑝 = +
2 2𝜎𝜎 31
Practical Advise
How To Choose The Parameters?
• How to transform the market interest rates i and i*?
– If the time to maturity is T-t, then the effective interest rate over that
time interval is i x (T-t).
– The standard approach is to take the effective interest rate for the
maturity of the option and translate it into a compound rate of return
per subperiod (of length h) denoted by ih.
– That is, after compounding over the N steps, the accrued interest
should equal the effective interest rate.
1
𝑁𝑁
1 + 𝑖𝑖 × 𝑇𝑇 − 𝑡𝑡 = 1 + 𝑖𝑖ℎ 1 + 𝑖𝑖ℎ = (1 + 𝑖𝑖 × 𝑇𝑇 − 𝑡𝑡 )𝑁𝑁
• Example:
– Let the time to maturity be 180 days, T-t=0.5, and the US-interest rate
for 180 be i(US,180days)=0.1 p.a. The effective interest rate over 180
days is 5%. If we use 30 steps then we need to find the interest rate for
h=180/30=6 days such that (1+ ih)30=1.05. We find ih =1.051/30=0.1628%
32
Test Your Intuition
• What is the price of a call option written on the $/€ FX-rate

with 180 days time to maturity and strike price $1/€?
– The volatility of the exchange rate is 0.1, its current value equals $1/€.
– The 180-day interest rate is 0.02 p.a. for the $ and 0.03 p.a. for the €.
• What is the price of the call option using a 1 step binomial
model?
1. Calculate the parameters of the stochastic model (u,d), what is h?
2. Find the appropriate interest rate.
3. Calculate the risk-neutral probability.
4. Find the call option price.
33
Test Your Intuition
1. The stochastic process: (h=180/360=0.5)

𝑢𝑢 = 𝑒𝑒 𝜎𝜎 ℎ = 𝑒𝑒 0.1 0.5 = 1.07
𝑑𝑑 = 𝑒𝑒 −𝜎𝜎 ℎ
= 𝑒𝑒 −0.1 0.5 = 0.93
2. The appropriate interest rate:
1 + 𝑖𝑖ℎ = (1 + 𝑖𝑖 × 𝑇𝑇 − 𝑡𝑡 ) = 1 + 0.02 ∗ 0.5 = 1.01
1 + 𝑖𝑖ℎ∗ = 1 + 0.03 ∗ 0.5 = 1.015
3. Risk-neutral probability:
1 + 𝑖𝑖ℎ 1 + 0.01
∗ − 𝑑𝑑 − 0.93
1 + 𝑖𝑖ℎ 1 + 0.015
𝑞𝑞 = = = 0.4475
𝑢𝑢 − 𝑑𝑑 1.07 − 0.93
4. The call price:
1 1
𝐶𝐶0 = 𝑞𝑞𝐶𝐶1𝑢𝑢 + 1 − 𝑞𝑞 𝐶𝐶1𝑑𝑑 = 0.4475 × 0.07 + 0.5525 × 0
1 + 𝑖𝑖ℎ 1.01
= 0.0325 34
Example Continued
• What is the price of a call option written on the $/€ FX-rate

with 180 days time to maturity and strike price $1/€?
– The volatility of the exchange rate is 0.1, its current value equals $1/€.
– The 180-day interest rate is 0.02 p.a. for the $ and 0.03 p.a. for the €.
• What is the price of the call option using a 1, 2, 20, and 100
step binomial model?
Model Call price
1-period binomial 0.0325
Lognormal Model 0.0255
35
36
37
Convergence of the Call Value
38
• The most important lesson from the binomial option

pricing model:
– the replicating portfolio intuition.
• Many derivative securities can be valued by valuing

portfolios of primitive securities when those
portfolios have the same payoffs as the derivative
securities.
39
Lecture 8
Hedging Transaction Exposure
1
Lecture 8: Managing Transaction Exposure
• Our Financial Tool Box

– Forward, Future, and Money Market Hedge
– Swap Market Hedge
– Options Market Hedge
• Hedging Problems
– Hedging Payables and Receivables
– Cross-Hedging Minor Currency Exposure
– Hedging Contingent Exposure
– Hedging Recurrent Exposure with Swap Contracts
• Other Approaches to Manage Transaction Exposure
– Hedging Through Invoice Currency
– Hedging via Lead and Lag
– Exposure Netting
2
A Brief Taxonomy of FX-Risk Exposure
• Transaction (contractual) exposure

– Arises if there are assets or liabilities (such as accounts
receivable/payable, deposits or loans) that are denominated in foreign
currency and whose value in home currency, therefore, depends on
the future exchange rates. Transaction exposure reflects the exposure
of past contractual undertakings that have future cash flow
implications because the asset or liability is still outstanding.
• Economic (operational) exposure
– Refers to the effect of changes in the exchange rate on the future cash
flows of the firm through the effect on future operational or strategic
decisions. (e.g., exchange rate changes affect the firm’s future
competitive position).
• Translation (accounting) exposure
– Refers to the effect of unexpected exchange rate changes on the
consolidated balance sheet or income statement of the MNC. 3
Hedging In A Multinational Corporation
Payables and Receivables
• We will use Boeing, one of the two largest producers of
commercial airplanes as our object of study.
• Example 1: Boeing has ordered aircraft components for its
Dreamliner aircraft from a large British supplier. The contract
specifies the delivery of a certain amount of components over
the next year. Payment of £100M is due in one year.
Boeing has already sold the aircrafts for which these
components are used and knows how much it will earn. It wants
to lock in the difference between the selling price of the
aircrafts and the production costs. You are responsible for
dealing with the FX-risk of the £100M contract.
• Task 1: Eliminate the currency risk from the procurement
contract. 4
Forward Market Hedge: an Example
• Boeing knows that a payment of £100M is due

in one year.
Question: How can you fix the future cash

outflow in dollars?
SOLUTION 1A:
Purchase a forward contract on the pound.
(Enter into a contract that delivers £100M in one
year when you need it.)
5
Forward Market Hedge
• If you are going to owe foreign currency in the

future, agree to buy the foreign currency at a price
fixed now by entering into long position in a forward
contract.
• If you are going to receive foreign currency in the
future, agree to sell the foreign currency at a price
fixed now by entering into short position in a
forward contract.
6
Exposure From An Amount Payable
payoff
Suppose that
today’s exchange The importer will be better off
rate is $1.50/£. if the pound depreciates:
When paying £100m he
If Boeing does not saves $30m if he can convert
hedge the £100m at an FX-rate of only $1.20/£
payable in one year, relative to $1.50/£.
its payoff of the
unhedged position $1.20/£ $1.50/£
$0
is shown in green. Value of £1 in $
in one year
–$120m
$1.80/£
–$150m
–$180m Unhedged
But he will be worse off if the payable
pound appreciates. 7
Long Forward
payoff
If Boeing agrees Long
to buy £100m in forward
one year at If you agree to buy £100 million at
$1.50/£ its gain a price of $1.50 per pound, you
(loss) on the will make $30 million if the price of
forward are shown a pound reaches $1.80.
in blue. $30m
$0
Value of £1 in $
$1.20/£
$1.50/£ $1.80/£ in one year
–$30m
If you agree to buy £100
million at a price of $1.50
per pound, you will lose $30
million if the price of a
pound is only $1.20.
8
An Amount Payable Completely Hedged
payoff
The red line shows Long
the payoff of the forward
hedged payable.
Note that gains on
one position are
offset by losses on
the other position.
$0
Value of £1 in $
$1.50/£ $1.80/£ in one year
Hedged payable
–$150 m
–$180 m Unhedged
payable9
Hedging Transaction Risk with Futures
• SOLUTION 1B: Use Futures Contracts and enter into

a long position in the pound futures.
• Potential problems with a futures hedge

– What if you need to hedge an odd amount?
– What if the contract delivery date doesn’t match your
receivable/payable date?
10
Hedging Transaction Risk with Futures
• What if you need to hedge an odd amount?

– If you buy more futures than you need, then, in net, you have a long
position in the future and are speculating on the pound to appreciate.
– If you buy less futures than you need, then, in net, you have a payable
still outstanding which is still exposed to FX-rate risk. You will lose on
this net position if the pound appreciates.
• What if the contract delivery date doesn’t match your
receivable/payable date?
– You buy futures contracts whose maturity exceeds the maturity of the
receivable/payable.
– You are exposed to basis risk if the price of the futures contract does
not move one-for-one with the spot exchange rate.
Basis = Spot price – Futures price = S(t) – f(t,T)
11
Money Market Hedge
Solution 1C: Use a money market hedge

• This is the same idea as covered interest arbitrage.
• The only difference to a forward contract is that the time
of payment is shifted from the future date to today
(which can be easily extended into the future through the use of the
appropriate domestic money market instrument).
• To hedge a foreign currency payable, buy a bunch of that
foreign currency today and sit on it.
– Buy the present value of the foreign currency payable today.
– Invest that amount at the foreign interest rate.
– At maturity your investment will have grown enough to cover
your foreign currency payable.
12
Money Market Hedge
• Boeing has this account payable in GBP:

– In one year it owes £100,000,000 to the UK supplier.
– The spot exchange rate is $1.5102/£.
– The one-year interest rate in the UK is i£ = 4%.
• It can hedge this payable by
£100,000,000
– Buying today: £96,153,846 £96,153,846 =
1.04
– And investing this GBP amount at 4% in the UK for 1 year.
– At maturity it will have £100,000,000=£96,153,886 x 1.04
– The dollar cost today is
$145,211,539= £96,153,846 × $1.5102/£
13
Money Market Hedge
• With this money market hedge, we have redenominated a

payable £100,000,000 due in one year into $145,211,539 due
today, i.e. we changed time and currency!
To complete the picture:
• If the U.S. interest rate is i$ = 3.30% we could borrow the
$145,211,539 today and would owe in one year
$150,003,519= $145,211,539 × 1.033
• Note the similarity to the forward contract!
£100,000,000
$150,003,519 = 𝑺𝑺($/£) (𝟏𝟏 + 𝒊𝒊$ )
𝟏𝟏 + 𝒊𝒊£
– We have done nothing else but replicated the forward
contract with money market instruments. 14
Money Market Hedge
The Recipe To Hedge A FC Payable in The Size Of FC y (e.g. y =

£100,000,000):
1. Calculate the present value of the payable FC.
𝐹𝐹𝐹𝐹𝐹𝐹 £100𝑚𝑚𝑚𝑚𝑚𝑚
𝑒𝑒. 𝑔𝑔.
1 + 𝑖𝑖𝐹𝐹𝐹𝐹 1 + 0.4
This is exactly the amount of FC units you have put into a FC-deposit
today, such that you will have FC y which is the payment due in the
future.
2. Determine the DC value of the present value of the payable:
𝐹𝐹𝐹𝐹𝐹𝐹 𝐷𝐷𝐷𝐷 £100𝑚𝑚𝑚𝑚𝑚𝑚
𝐷𝐷𝐷𝐷𝐷𝐷 = × 𝑆𝑆 𝑒𝑒. 𝑔𝑔. × $1.5102/£
1 + 𝑖𝑖𝐹𝐹𝐹𝐹 𝐹𝐹𝐹𝐹 1 + 0.04
This is the amount x in DC units which you need to convert to the FC

and invest in the FC-deposit. At maturity of the deposit, you will have
FC y which equals the payment due in the foreign currency. 15
Money Market Hedge
The Recipe To Hedge A FC Receivable in The Size Of FC y (e.g. y =

£100,000,000):
1. Calculate the present value of the receivable FC.
𝐹𝐹𝐹𝐹𝐹𝐹 £100𝑚𝑚𝑚𝑚𝑚𝑚
𝑒𝑒. 𝑔𝑔.
1 + 𝑖𝑖𝐹𝐹𝐹𝐹 1 + 0.4
This is the amount of FC units which you can borrow because in the
future you will exactly receive FC y to repay your loan.
2. Determine the DC value of the present value of the receivable:
𝐹𝐹𝐹𝐹𝐹𝐹 𝐷𝐷𝐷𝐷 £100𝑚𝑚𝑚𝑚𝑚𝑚
𝐷𝐷𝐷𝐷𝐷𝐷 = × 𝑆𝑆 𝑒𝑒. 𝑔𝑔. × $1.5102/£
1 + 𝑖𝑖𝐹𝐹𝐹𝐹 𝐹𝐹𝐹𝐹 1 + 0.04
This is the amount x in DC units which you will receive today from
your FC-loan. At maturity of the loan, you can simply pay back the
FC-loan with your receivable.
16
Test Your Intuition
• Suppose Boing expected a pound inflow from a £100m

receivable in one year from now (October 2015). How would
you hedge this receivable via
1. a forward
2. futures contracts traded on the CME with
1. contract size: £62500
2. available maturities: Mar, Jun, Sep, Dec
3. the money market?
In particular, answer the following:

– Which positions would you enter?
– When does the payment happen? 17
Test Your Intuition
Solution
1. Sell the £100m forward (forward sale).
– Payment takes place in 1 year.
2. Enter into a short position in the £-futures contract
– You sell 1600 contracts (1600 x 62500 =£100m) using the December
2015 contract.
– You have some of your capital tied all the time because of the margin
requirement. Gains and losses are constantly added to your margin
account. If you experienced gains you might be able to withdraw
them, if you experienced losses you might have to inject money.
Note that you have basis risk because of the maturity mismatch.
3. Money market hedge:
1. Borrow the present value of £100m in the British money market.
2. Convert this amount of money into USD. You will use the pound
inflow in one year to pay back the loan. 18
You have advanced the payment to today.
Criteria To Decide Between The Three
Alternatives
Which reasons affect the choice of the hedging
instrument?
19
Criteria To Decide Between The Three
Alternatives
Which reasons affect the choice of the hedging
instrument?
• Transaction Costs
• How closely can you match the terms of the payment
(size, maturity)?
• Do you want to shift the payment to today?
• Counterparty risk in the money market.
20
Hedging In A Multinational Corporation
Payables and Receivables
• Example 2: Boeing’s treasury department has a strong view on
the $/£ FX-rate. It believes that the $ will appreciate over the
next year which would make the £100,000,000 payment due in
one year cheaper in $-terms. Since Boeing is aware of the high
uncertainty of its forecast, the treasury wants you to limit the
loss potential from the payable while at the same time preserve
the gain potential which the treasury department has identified.
• Task 2: Hedge the downside risk from the procurement
contract.
21
Option Market Hedge
SOLUTION 2: Use options

• Options provide a flexible hedge against the
downside, while preserving the upside potential.
• This insurance is costly (option premium)!
• To hedge a foreign currency payable buy calls on the
currency.
– If the currency appreciates, your call option lets you buy
the currency at the exercise price of the call.
• To hedge a foreign currency receivable buy puts on
the currency.
– If the currency depreciates, your put option lets you sell
the currency for the exercise price.
22
Option Market Hedge
payoff
Suppose that
today’s exchange The importer will be better off
rate is $1.50/£. if the pound depreciates:
When paying £100m he
If Boeing does not saves $30m if he can convert
hedge the £100m at an FX-rate of only $1.20/£
payable in one year, relative to $1.50/£.
its payoff of the
unhedged position $1.20/£ $1.50/£
$0
is shown in green. Value of £1 in $
in one year
–$120m
$1.80/£
–$150m
–$180m Unhedged
But he will be worse off if the payable
pound appreciates. 23
Option Market Hedge
profit Long call on

Suppose our importer £100m
buys a call option on
£100m with an
exercise price of
$1.50 per pound.
He pays $0.05 per
pound for the call.
–$5m Value of £1 in $
$1.55/£ in one year
$1.50/£
loss
24
Option Market Hedge
profit
The profit of the
portfolio of a call
and a payable is
shown in red.
Boeing can still
profit from
$1.50/£
decreases in the
exchange rate $1.20/£
$0
below $1.45/£ but Value of £1 in $
has a hedge against in one year
unfavorable
–$125m
increases in the
exchange rate Hedged payable
–$155m
Unhedged
payable
25
Option Market Hedge
If the exchange rate profit
increases to $1.80/£
the importer’s
payable increases
to $180m. At the
same time he gains
$25 m on the call $25 m
which reduces his $1.50/£
payment to $155m.
$0
The maximum loss Value of £1 in $
is $5 million in one year
(compared to no $1.80/£
change), equaling
Hedged payable
the call price which–$155m
can be thought of
as an insurance –$180m Unhedged
premium. payable
26
Option Market Hedge
An IMPORTER who OWEs foreign An EXPORTER with accounts

currency in the future should BUY receivable denominated in foreign
CALL OPTIONS. currency should BUY PUT
OPTIONS.
– If the price of the currency goes – If the price of the currency

up, his call will lock in an upper goes down, puts will lock in a
limit on the dollar cost of his lower limit on the dollar value
imports. of his exports.
– If the price of the currency goes – If the price of the currency
down, he will not exercise the goes up, he will not exercise
option and buy the foreign the option and sell the foreign
currency at a lower price in the currency at the higher price in
spot market. the spot market.
27
Test Your Intuition
Hedging Exports with Put Options
• Show the overall profit of an exporter who is
expecting £1 million in one year and considers an
option hedge.
• The current exchange rate is $2/£.
• Instead of entering into a short forward contract, he
buys a put option written on £1 million with a
maturity of one year and a strike price of $2/ £.
– The cost of this option is $0.05 per pound.
• Draw the profit profile for the receivable, the put
option, and the resulting hedged receivable.
28
Option Market Hedge:
Exporter buys a put option to

protect the dollar value of his
receivable.
$1.95m
–$50k
Long put S($/£)360
$2
29
Hedging Contingent Exposure
• If only certain contingencies give rise to exposure, then

options can be effective insurance.
• Example 3: The French/Dutch carrier Air France KLM wants to buy 10
airplanes for medium-distance flights. As the $ has recently depreciated
against the € to $1.4/€, Boeing can offer the aircrafts at lower €-prices
than its rival Airbus. Boeing offers 10 planes for € 1 billion in total due in 1
year which is only slightly above its total production costs of $1.33 billion
if the exchange rate stays the same. However, its low prices will only cover
production costs if the $ does not appreciate (which would mean lower $-
revenues for Boeing). That means, that Boeing has FX-risk exposure only
if it succeeds in winning the contract. Since signing a contract with a
European carrier is very prestigious, Boeing asks its treasury department
to come up with an appropriate hedging strategy that allows it to charge
the low price but does not expose it to large FX-rate risk.
– Task 3: How can Boeing hedge this contingent exposure?
33
Hedging Contingent Exposures
• SOLUTION 3: Buy a put option on the € with contract size

equal to the total price of the airplanes.
• Why it works:
– If Boeing wins the contract and the € depreciates, it can exercise the
put option whose payoff offsets the loss on its €-receivables.
– If Boeing wins the contract and the € does not depreciate, then the
revenues of the sale after being converted into $ will cover production
costs.
– If Boeing does not win the contract and the € depreciates, it can still
exercise the option and make a profit.
– If Boeing does not win the contract and the € appreciates it won’t
exercise the option.
• You see that Boeing is insured against a depreciation of the €.
Remember this insurance is costly (option premium). 34
Appendix
• Hedging Recurrent Exposure with Swaps
43
Hedging Recurrent Exposure with Swaps
• Swap contracts can be viewed as an exchange of a

bond denominated in one currency for another bond
denominated in another currency.
• Firms that have recurrent exposure can very likely
hedge their exchange risk at a lower cost with swaps
than with a program of hedging each exposure as it
comes along.
• It is also the case that swaps are available in longer-
terms than futures and forwards.
44
Illustrating Example
• The German plant building company Siemens VAI Metals

Technologies has just secured a deal to build a large car
assembly plant in the US.
– Payment details: $225m split into four $15m payments over the next
four years and $165m in the fifth year.
• Siemens VAI requires financing.
• If Siemens VAI issued a 5-year USD-bond, it could use the
payments from the deal to pay the coupon due on this bond.
• However, Siemens VAI might find it cheaper to raise money in
the German debt market since it is a company with high
reputation in Germany but maybe not well known in the US.
• Possible Solution: Issue a bond in Germany and swap the
payments due in euro to payments due in USD. 45
The Starting Point: USD receivable and EUR-
denominated debt
• Siemens VAI has issued a bond denominated in EUR and
expects a payment stream from a USD-receivable.
• It is exposed to exchange rate risk as the future USD/EUR rate
is uncertain.
200
Cashflows from USD receivable and EUR debt
150
100
50
0
0 1 2 3 4 5
-50
years to payment
-100
-150
EUR debt USD receivable 46
Swapping USD for EUR
• Siemens would like to convert its EUR debt into USD debt.
• Suppose a bank offers the following swap contract:
– Exchange a USD bond with 10% coupon and notional of $150 for a EUR bond
with 8% coupon and notional of €100 both with 5 year maturity.
• Siemens would use the EUR inflow to pay for its EUR denominated bond.
200
Swap Payments
150
100
50
0
-50 0 1 2 3 4 5
-100 years until payment
-150
-200
EUR inflow USD outflow 47
The Effect of the Swap
• Siemens would use the EUR inflow resulting from the swap to pay for its
EUR denominated bond. Thus, adding the swap contract to the EUR debt
creates a synthetic USD bond.
• The USD proceeds from the receivable are used to pay for this synthetic
USD bond. In net, Siemens VAI receives an inflow of USD today which it
can immediately convert into EUR and has thus eliminated the FX-rate risk.
200
100
0
0 1 2 3 4 5
years until payment
-100
-200
synthetic USD debt USD receivable Net Exposure 48
Summarizing Table
USD EUR swap Synthetic Total Net

receivable debt EUR USD USD debt Exposure
year inflow outflow
0 100 -100 150 -150 150
1 15 -8 8 -15 15 0
2 15 -8 8 -15 15 0
3 15 -8 8 -15 15 0
4 15 -8 8 -15 15 0
5 165 -108 108 -165 165 0
The exchange rate exposure was eliminated as no future cashflow

is affected by an uncertain future FX-rate.
49
Lecture 9
Hedging Economic Exposure
1
Lecture 9: Hedging Economic Exposure
Economic Exposure
– Definition
– Components
– Determinants
How to measure economic exposure
– Linear
– Non-linear
Hedging Economic Exposure
– Operational hedging
– Financial hedging
2
Economic Exposure
• Refers to the effect of changes in the exchange rate on the

future cash flows of the firm through the effect on future
operational or strategic decisions. (e.g., exchange rate
changes affect the firm’s future competitive position).
• Identifying economic exposure requires comprehensive

thinking:
– Changes in exchange rates can affect not only firms that are directly
engaged in international trade but also purely domestic firms.
– Consider a U.S. bicycle manufacturer which sources and sells only in
the U.S.
– Since the firm’s product competes against imported bicycles it is
subject to foreign exchange exposure.
3
Channels of Economic Exposure
Asset exposure Home currency

value of assets
and liabilities
Exchange rate
Firm Value
fluctuations
Operating exposure Future operating

cash flows
4
How to Measure Economic Exposure
• Economic exposure is the sensitivity of the future home

currency value of the firm’s assets and liabilities and the firm’s
operating cash flow to random changes in exchange rates.
– How do the future values of assets/liabilities and cash flows of the firm
change given a unit change in the FX-rate?
• When a MNC wants to hedge economic exposure it needs to
know how much of a hedging instrument it has to buy. The
economic exposure provides this number.
• The MNC has to project how future cash flows will look like for
different exchange rates by taking the economic environment
into account.
• It could also look at the past and calculate how past cash flows
were affected by past exchange rates.
5
How to Measure Economic Exposure
• Economic exposure can be divided into

– Asset exposure
– Operating exposure
• We will start with measuring asset exposure.
• Measuring operating exposure is very similar.
• A reoccurring example:
– We use the example of a NOR AS from Norway.
– NOR AS sells its product at home and in Canada.
– NOR AS also owns a subsidiary and property in Canada.
6
How To Measure Economic Exposure
A Simple Example
• NOR AS owns assets in Canada in a well located commercial
area and wants to analyze how exchange rate changes affect
the NOK-value of its assets.
• It considers 3 different exchange rate scenarios:
S(NOK/CAD) = 5, 5.5, or 6 which it considers equally likely
• Its Canadian subsidiary is asked to project asset values given
the projected exchange rates.
– Exemplary relationship: If the CAD rises, more firms want to export to
Canada and build local subsidiaries there. This higher demand for land
in the Canadian commercial area raises property prices.
• Using this information, the financial department has to
calculate the economic exposure and hedge accordingly.
7
Projected Asset Values
(asset values are in 1000)
3
𝑁𝑂𝐾 1
𝑆ҧ = ෍ 𝑝𝑖 𝑆𝑖 = 5 + 5.5 + 6 = 5.5
𝐶𝐴𝐷 3
Projected CAD-value of the assets 𝑖=1
state 1 state 2 state 3 mean variance

Probability 1/3 1/3 1/3
S(NOK/CAD) 5 5.5 6 5.5 0.167
Local Asset Value (CAD) 980 1000 1070 1016.7
Asset Value (NOK) 4900 5500 6420 5606.7 390755.6
= 𝐿𝑜𝑐𝑎𝑙 𝐴𝑠𝑠𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 × 𝑆(𝑁𝑂𝐾/𝐶𝐴𝐷) 3
𝑉𝑎𝑟 𝑆 = ෍ 𝑝𝑖 (𝑆𝑖 −𝑆)ҧ 2

𝑖=1
1 2 2 2
= 5 − 5.5 + 5.5 − 5.5 + 6 − 5.5 = 0.167
3
8
The Effect Of FX-Rate Changes On Asset
Values
Remark: Every FX-rate realization has the same probability in this example.
Illustrating the FX-exposure with such a scatter plot makes only sense if this
is the case or if you use historical data instead of forecasts. 9
The Effect Of FX-Rate Changes On The Asset
Value
• We have fitted a line through the FX-rate – asset value
combinations:
𝐴𝑠𝑠𝑒𝑡 𝑉𝑎𝑙𝑢𝑒𝑖 = −2753.3 + 1520 𝑆𝑖
𝐸𝐶𝑂𝑁𝑂𝑀𝐼𝐶 𝐸𝑋𝑃𝑂𝑆𝑈𝑅𝐸
• Economic Exposure = Slope Coefficient

it tells us by how much the asset value changes if the
exchange rate changes by one unit.
• The CAD exposure is CAD1.52 million (remember everything
was in 1000).
• If the FX-rate increases by 1, say from NOK 5/CAD to NOK
6/CAD, then the expected asset value increases by NOK 1.52
m.
10
How to Measure Economic (Asset) Exposure
• Thus, in order to determine economic exposure we can run

the following regression:
𝑉𝑖 (𝑇, 𝐷𝐶) = 𝑎 + ณ
𝑏 × 𝑆𝑖 (𝑇, 𝐷𝐶/𝐹𝐶) + 𝜀𝑖
• 𝑉𝑖 (𝑇) is the future asset value in scenario i which is exposed

to FX-risk.
• 𝑏 = 𝐶𝑜𝑣[𝑉 𝑇, 𝐷𝐶 , 𝑆 𝑇 ] is the FC-value, that is
𝑉𝑎𝑟[𝑆(𝑇)]
exposed to FX-rate risk (the economic exposure). If b = 0,
there is no (linear) FX-risk exposure.
• 𝑎 + 𝜀𝑖 is the part of the asset value (in DC-terms) not
linearly related to the exchange rate.
11
Calculating The Economic Exposure
3
ത 𝑖 −𝑆)ҧ
𝐶𝑜𝑣 𝑉, 𝑆 = ෍ 𝑝𝑖 (𝑉𝑖 −𝑉)(𝑆
𝐶𝑜𝑣(𝑉, 𝑆) 253.3
𝑖=1 𝑏= =
1 𝑉𝑎𝑟(𝑆) 0.167
= [ 4900 − 5606.7 5 − 5.5 + 5500 − 5606.7 5.5 − 5.5
3

S(NOK/CAD) 5 5.5 6 5.5 0.167
Asset Value (NOK) (= V) 4900 5500 6420 5606.7 390755.6
Covariance Economic Exposure (b) Intercept(a) 𝑎 = 𝑉ത − 𝑏 × 𝑆ҧ
253.3 1520 -2753.3 = 5606.7 − 1520 × 5.5
Residual (ε) 53.33 -106.67 53.33 0 5688.9
𝜀1 = 𝑉1 − 𝑎 − 𝑏 × 𝑆1
= 4900 − −2753.3 − 1520 × 5 = 53.33
12
How To Hedge This Exposure?
• b is the FC-value that is exposed to FX-rate risk. If we want to

hedge FX-rate risk, we need to obtain protection that has an
exposure of -b.
• E.g., sell CAD forward in the amount of b in FC units.
• Are we hedged? – Yes:
𝑽𝒊,𝒉𝒆𝒅𝒈𝒆𝒅 𝑻, 𝑫𝑪 = 𝑉𝑖 𝑇, 𝐷𝐶 +𝑏 𝐹 𝑇 − 𝑆𝑖 𝑇
𝐹𝑜𝑟𝑤𝑎𝑟𝑑 𝑆𝑎𝑙𝑒
= 𝑎 + 𝑏𝑆𝑖 𝑇 + 𝜀𝑖 +𝑏 𝐹 𝑇 − 𝑆𝑖 𝑇
= 𝒂 + 𝒃 × 𝑭 𝑻 + 𝜺𝒊
• The future asset value is not (linearly) affected by the future
FX-rate! The hedge is not perfect because our exposure was
13
not exactly linear!
• In the previous example the exposure was CAD 1.52m.

• The appropriate hedging strategy is to sell CAD 1.52m
forward (like hedging a FC receivable).
𝑽𝒊,𝒉𝒆𝒅𝒈𝒆𝒅 𝑻, 𝑫𝑪 = 𝑉𝑖 𝑇, 𝐷𝐶 + 1520 𝐹 𝑇 − 𝑆𝑖 𝑇
= −2753.3 + 1520𝑆𝑖 𝑇 + 𝜀𝑖 +1520 𝐹 𝑇 − 𝑆𝑖 𝑇

= −𝟐𝟕𝟓𝟑. 𝟑 + 𝟏𝟓𝟐𝟎 × 𝑭 𝑻 + 𝜺𝒊
• The hedged asset value is not affected by the uncertain future

FX-rate anymore.
• (The hedge is not perfect since the exposure was not perfectly
linear.) 14
15
Does The Hedge Work?
Suppose the forward rate (F(T)) is NOK 5.6/CAD
S(NOK/CAD) 5 5.5 6 5.5 0.167
Asset Value (NOK) (= V) 4900 5500 6420 5606.7 390755.6
Covariance Economic Exposure (b) Intercept (a)
253.3 1520 -2753.3 𝑏(𝐹 − 𝑆3 ) = 1520(5.6 − 6)
Forward Sale 912 152 -608

Total Value (Vhedged) 5812 5652 5812 5758.7 5688.9
𝑉1,ℎ𝑒𝑑𝑔𝑒𝑑 𝑇, 𝐷𝐶
= 𝑉1 𝑇, 𝐷𝐶 + 1520 𝐹 𝑇 − 𝑆1 𝑇 = 4900 + 912
𝑉𝑎𝑟(𝑉ℎ𝑒𝑑𝑔𝑒𝑑 𝑇, 𝐷𝐶 ) = 𝑉𝑎𝑟(𝜀)
= 𝑎 + 𝑏 × 𝐹 𝑇 + 𝜀1 = −2753.3 + 1520 × 5.6 + 53.3
16
What is Operating Exposure
• Definition: the extent to which the firm’s operating cash

flows (in DC-terms) are affected by the exchange rate.
• It measures how changes in the FX rate affect the firm’s
cash flows through its impact on the sales volume,
price, competition, production costs,… of the firm.
• The effect of random changes in exchange rates on the
firm’s competitive position, which is not readily
measurable.
• A firm’s operating exposure may be considerably larger
than its transaction exposure.
17
Operating Exposure is Measured in the Same Way
as Asset Exposure
• In order to determine operational exposure we can run the
following regression:
𝑐𝑎𝑠ℎ𝑓𝑙𝑜𝑤𝑖 (𝑇, 𝐷𝐶) = 𝑎 + ณ
𝑏 × 𝑆𝑖 (𝑇, 𝐷𝐶/𝐹𝐶) + 𝜀𝑖
• 𝐶𝑎𝑠ℎ𝑓𝑙𝑜𝑤𝑖 (𝑇) is the future cash flow in scenario i which is

exposed to FX-risk.
• 𝑏 = 𝐶𝑜𝑣[𝑐𝑎𝑠ℎ𝑓𝑙𝑜𝑤 𝑇, 𝐷𝐶 , 𝑆 𝑇 ] is the FC-value, that is
exposed to FX-rate risk (the economic exposure). If b = 0,
there is no (linear) FX-risk exposure.
• 𝑎 + 𝜀𝑖 is the portion of cash flows (in DC-terms) not affected
by the exchange rate.
18
• b is the FC-value that is exposed to FX-rate risk. If we want to

hedge FX-rate risk, we need to obtain protection protection
that has an exposure of -b.
• E.g., sell the FC forward in the amount of b FC units.
• Are we hedged? – Yes:
𝒄𝒂𝒔𝒉𝒇𝒍𝒐𝒘𝒊,𝒉𝒆𝒅𝒈𝒆𝒅 𝑻, 𝑫𝑪 = 𝑐𝑎𝑠ℎ𝑓𝑙𝑜𝑤𝑖 𝑇, 𝐷𝐶 +𝑏 𝐹 𝑇 − 𝑆𝑖 𝑇
𝐹𝑜𝑟𝑤𝑎𝑟𝑑 𝑆𝑎𝑙𝑒
= 𝑎 + 𝑏𝑆𝑖 𝑇 + 𝜀𝑖 +𝑏 𝐹 𝑇 − 𝑆𝑖 𝑇
= 𝒂 + 𝒃 × 𝑭 𝑻 + 𝜺𝒊
• The expected cash flow is not (linearly) affected by the future
FX-rate! The hedge is not perfect because our exposure was
19
not exactly linear!
Determinants of Operating Exposure
• Recall that operating exposure cannot be readily

determined from the firm’s accounting statements as
can transaction exposure.
• OE is determined by:
 The market structure of inputs and products: how
competitive or how monopolistic are the markets which the
firm is facing.
 The firm’s ability to adjust its markets, product mix, and
sourcing in response to exchange rate changes.
20
Determining a Firm’s Operating Exposure
Our Example Again
1 S(NOK/CAD) 5 We consider again NOR AS.
2 Units sold (in 1000) 20
3 Price per unit (CAD) 100 Projections for the next quarter:
4 Sales (CAD) 2000 = (2) x (3) • At the moment, NOR AS sells its
5 Sales(NOK) 10000 = (4) x (1)
product for CAD 100.
• The current FX-rate is NOK 5/CAD.
• If nothing changes, the firm is
6 Unit Costs (NOK) 200
expected to sell 20,000 units.
7 Fixed Costs (NOK) 5100 • Given the unit and fixed costs, the net
8 Total Cost (NOK) 9100 = (6) x (2) + (8) profit before tax is NOK 200,000.
9 Depreciation (NOK) 700 • The resulting operating cash flow is
NOK 900,000.
10 Net Profit before tax (NOK) 200 = (5) – (8) – (9) • Simplification to save space: corporate
11 Add back depreciation 700 tax is 0. In reality, calculate net profit
after taxes (line 10 minus taxes and
12 Operating cash flow (NOK) 900 = (10) + (11)
then add back depreciation to arrive at
operating cash flow. 21
Our Example Again
1 S(NOK/CAD) 5
2 Units sold (in 1000) 20
3 Price per unit (CAD) 100
4 Sales (CAD) 2000 = (2) x (3)
5 Sales(NOK) 10000 = (4) x (1)
6 Unit Costs (NOK) 200

7 Fixed Costs (NOK) 5100
8 Total Cost (NOK) 9100 = (6) x (2) + (8)
9 Depreciation (NOK) 700
How things change with a positive tax
10 Net Profit before tax (NOK) 200 = (5) – (8) – (9) rate:
10’ Net Profit after tax (NOK) 140 = (10)x(1 – 0.3) • Suppose the corporate tax is 30%.
11 Add back depreciation 700
12 Operating cash flow (NOK) 840 = (10’) + (11)
22
Different Channels
1 S(NOK/CAD) 5
The FX-rate can affect operating cash
2 Units sold (in 1000) 20 flow through different effects:
3 Price per unit (CAD) 100
4 Sales (CAD) 2000 = (2) x (3) 1. The Conversion Effect:
5 Sales(NOK) 10000 = (4) x (1) • (line 5)
2. The Competitive Effect via
6 Unit Costs (NOK) 200 • units sold (line 2)
7 Fixed Costs (NOK) 5100 • prices (line 3)
8 Total Cost (NOK) 9100 = (6) x (2) + (8) • unit costs (line 6)
9 Depreciation (NOK) 700
10 Net Profit before tax (NOK) 200 = (5) – (8) – (9)

11 Add back depreciation 700
12 Operating cash flow (NOK) 900 = (10) + (11)
23
Economic Environment and Operating
Exposure – Five Different Cases
• We will analyze five different cases:
– Case 1: The firm is a price-taker and cannot adjust its retail price in
CAD. The FX-rate has no effect on costs.
– Case 2: The firm has market power and can entirely pass on the FX-
rate change to its retail price in CAD.
– Case 3: The firm is a price-taker and cannot adjust its retail price but
the PPP holds.
– Case 4: The firm can only partly pass on the FX-rate change to its retail
price in CAD.
– Case 5: The firm is a price-taker and cannot adjust its retail price in
CAD but unit costs are affected by the FX-rate.
• It considers 3 different exchange rate scenarios:

S(NOK/CAD) = 5, 5.5, or 6 which it considers equally likely. 24
Case 1: The firm is a price-taker and cannot
adjust its retail price in CAD.
1 S(NOK/CAD) 4.5 5 5.5
2 Units sold (in 1000) 20 20 20
3 Price per unit (CAD) 100 100 100
4 Sales (CAD) 2000 2000 2000
5 Sales(NOK) 9000 10000 11000
6 Unit Costs (NOK) 200 200 200

7 Fixed Costs (NOK) 5100 5100 5100
8 Total Cost (NOK) 9100 9100 9100 Operating Exposure:
9 Depreciation (NOK) 700 700 700 𝐶𝑜𝑣[𝐶𝐹 𝑇 , 𝑆 𝑇 ]
𝑏=
10 Net Profit before tax (NOK) -800 200 1200 = 2000
11 Add back depreciation 700 700 700
12 Operating cash flow (NOK) -100 900 1900 Is that surprising?
25
Case 2: The firm can entirely pass on the FX-
rate change to its retail price in CAD.
1 S(NOK/CAD) 4.5 5 5.5 Set price per unit such that
2 Units sold (in 1000) 20 20 20 the NOK price per unit is
3 Price per unit (CAD) 111.11 100 90.91 constant:𝑃 𝐶𝐴𝐷 𝑖 𝑆𝑖 = 𝑁𝑂𝐾500
4 Sales (CAD) 2222.222 2000 1818.182
5 Sales(NOK) 10000 10000 10000

7 Fixed Costs (NOK) 5100 5100 5100
8 Total Cost (NOK) 9100 9100 9100
9 Depreciation (NOK) 700 700 700
Operating Exposure:
10 Net Profit before tax (NOK) 200 200 200 𝐶𝑜𝑣[𝐶𝐹 𝑇 , 𝑆 𝑇 ]
11 Add back depreciation 700 700 700 𝑏=
12 Operating cash flow (NOK) 900 900 900 =0
Remark: In scenario 3 with S=5.5 the firm would probably not decrease its
price as long as there is no threat of competitors entering the market. 26
Case 3: The firm is a price-taker and cannot
adjust its retail price but the PPP holds.
Suppose the PPP holds and we
1 S(NOK/CAD) 4.5 5 5.5
had zero inflation in Norway. FX-
2 Units sold (in 1000) 20 20 20 rates are then derived from the
3 Price per unit (CAD) 111.11 100 90.91 PPP:
1 + 𝜋(𝑁𝑂𝐾)
4 Sales (CAD) 2222.22 2000 1818.18 𝑆𝑖 = 𝑆0
1 + 𝜋𝑖 (𝐶𝐴𝐷)
5 Sales(NOK) 10000 10000 10000
Inflation scenarios for Canada:
𝜋1 𝐶𝐴𝐷 = 11.11%
𝜋2 𝐶𝐴𝐷 = 0
7 Fixed Costs (NOK) 5100 5100 5100 𝜋3 𝐶𝐴𝐷 = −9.09%
8 Total Cost (NOK) 9100 9100 9100
Net Profit before tax

10 (NOK) 200 200 200
Operating cash flow
12 (NOK) 900 900 900 27
Case 4: The firm can only partly pass on the
FX-rate change to its retail price in CAD.
1 S(NOK/CAD) 4.5 5 5.5 The price change affects demand.
2 Units sold (in 1000) 19 20 21
4 Sales (CAD) 2052 2000 1932
Test Your Intuition
5 Sales(NOK) 9234 10000 10626
6 Unit Costs (NOK) 200 200 200 • Calculate the operating

7 Fixed Costs (NOK) 5100 5100 5100 exposure in this case.
8 Total Cost (NOK) 8900 9100 9300 • How would you hedge it?
Var(S) = 0.1667
10 Net Profit before tax (NOK) -366 200 626 Var(Sales(NOK)) = 324033
11 Add back depreciation 700 700 700 Var(CF) = 165099.6
12 Operating cash flow (NOK) 334 900 1326 Cov(S,Sales(NOK))=232
Cov(S,CF) = 165.33
Cov(Sales(NOK),CF)= 231233
28
Case 4: The firm can only partly pass on the
FX-rate change to its retail price in CAD.
1 S(NOK/CAD) 4.5 5 5.5 The price change affects demand.
2 Units sold (in 1000) 19 20 21
4 Sales (CAD) 2052 2000 1932
5 Sales(NOK) 9234 10000 10626

7 Fixed Costs (NOK) 5100 5100 5100
8 Total Cost (NOK) 8900 9100 9300
Operating Exposure:
𝐶𝑜𝑣[𝐶𝐹 𝑇 , 𝑆 𝑇 ]
𝑏=
10 Net Profit before tax (NOK) -366 200 626 𝑉𝑎𝑟[𝑆(𝑇)]
11 Add back depreciation 700 700 700 = 992
12 Operating cash flow (NOK) 334 900 1326 Hedge: Sell 992.000 CAD
forward.
Remark: The operational exposure is considerably smaller than under case
1 with b=2000 where the firm has no ability to pass on FX-rate changes. 29
Case 5: The firm is a price-taker but unit
costs are affected.
1 S(NOK/CAD) 4.5 5 5.5
2 Units sold (in 1000) 20 20 20
4 Sales (CAD) 2000 2000 2000
5 Sales(NOK) 9000 10000 11000

7 Fixed Costs (NOK) 5100 5100 5100
8 Total Cost (NOK) 8200 9100 10000 Operating Exposure:
9 Depreciation (NOK) 700 700 700 𝐶𝑜𝑣[𝐶𝐹 𝑇 , 𝑆 𝑇 ]
𝑏=
10 Net Profit before tax (NOK) 100 200 300 = 200
12 Operating cash flow (NOK) 800 900 1000
Remark: The operational exposure is now very low. Why? 30
Wrap-Up
• High operating exposure if either costs or revenues

(both in DC units) are sensitive to FX-rate changes.
• Low operating exposure if both costs and revenues
(both in DC units) are sensitive/insensitive to FX-rate
changes.
• Moderate operating exposure if the firm has some
ability to pass on exchange rate changes.
31
Non-Linear Exposure
The Setup
Suppose that the current FX-rate is NOK 5/CAD. Every scenario is equally likely.
1 S(NOK/CAD) 3.5 4 4.5 5 5.5 6

2 Units sold (in 1000) 17.2 18.2 19 20 20 20 NOR AS is not able to
benefit from a NOK
3 Price per unit (CAD) 142.86 125.00 111.11 100 90.91 83.33
depreciation because
4 Sales (CAD) 2457 2275 2111 2000 1818 1667 of competitors cutting
5 Sales(NOK) 8600 9100 9500 10000 10000 10000 their price, as well.
6 Unit Costs (NOK) 200 200 200 200 200 200 If the NOK strengthens,
NOR AS passes on the
7 Fixed Costs (NOK) 5100 5100 5100 5100 5100 5100
appreciation to cover
8 Total Cost (NOK) 8540 8740 8900 9100 9100 9100 costs at the expense of
9 Depreciation (NOK) 700 700 700 700 700 700 market share losses.
10 Net Profit before tax (NOK)

-640 -340 -100 200 200 200
11 Add back depreciation 700 700 700 700 700 700
12 Operating cash flow (NOK) 60 360 600 900 900 900 This creates non-linear
exposure.
36
Non-linear Exposure
A straight line yields

a bad fit because the
exposure of NOR AS
is not linear in the
FX-rate.
37
Non-Linear Exposure
• How can NOR AS hedge against this non-linear FX-risk?

– A linear contract (forward, future, money-market hedge) is clearly sub-
optimal because NOR AS is not exposed to FX-risk above NOK 5/CAD.
If it bought a linear contract (e.g., sold CAD forward) to match the
exposure below NOK5/CAD it would create additional FX-exposure
above NOK5/CAD!
– Solution: Buy a put-option on the CAD with strike price NOK 5/CAD.
• How much to buy?
– Find the slope in the range of the possible FX-rate realizations where
the cashflows of NOR AS are affected by FX-rate changes.
38
Non-Linear Exposure
39
Non-Linear Exposure
• The hedge does work:

– The exposure is CAD 552,000.
– Suppose the put option costs NOK 0.45 per CAD 1.
Then, NOR AS has to pay 0.45 x 552,000 = NOK 248,400 in total for the
protection.
– The hedged position consists of the original cash flow from the exports
and the put payoff/profit (put payoff minus put price).
1 S(NOK/CAD) 3.5 4 4.5 5 5.5 6
12 Operating cash flow (NOK) 60 360 600 900 900 900
13 Put Payoff (NOK) 828 552 276 0 0 0 = Max(K-S,0) x 552
14 Put profit (NOK) 580 304 28 -248 -248 -248 = Max(K-S,0) x 552 + 248
15 Hedged cashflow (w/o costs) 888 912 876 900 900 900 = (12) + (13)
16 Hedged cashflow (w costs) 640 664 628 652 652 652 = (12) + (14)
Remark: We assume that the put is paid in the accounting period of the cashflow.
40
Non-Linear Exposure
41
Lecture 10
Country And Political Risk
1
Lecture 10: Country And Political Risk
• What Is Country and Political Risk?
• How Does Country/Political Risk Affect The Firm’s

Capital Budgeting Decision?
• Where Do You Get The Information On A Country’s

Riskiness From?
• How To Deal With Country Risk

2
Country Risk Versus Political Risk
• Political Risk is the risk that a government action will

negatively affect a company’s cashflow.
– (Sovereign governments have the right to regulate the
movement of goods, capital, and people across their
borders. These laws sometimes change in unexpected
ways.)
• Country Risk comprises political risk and adverse
changes in a country’s economic and financial
environment (e.g. sovereign default).
3
Sovereign Risk
• Sovereign Risk: Risk that a government defaults on its bond

payments.
• Why is sovereign credit risk different?
– Can’t take a country to bankruptcy court
– Still, there are consequences
• Assets may be seized
• Country won’t be able to borrow so easily going forward
• International trade could be impacted
• Default could make economic crises worse
• When a government decides on whether to default it weighs
those consequences against the immediate gain through
lower interest and redemption payments.
4
Sovereign Risk
• If the bond is denominated in the domestic currency the

government can always repay the debt by printing money.
This action increases inflation and depreciates the currency. It
is effectively equivalent to partial default.
• Many emerging countries issue bonds denominated in USD or
EUR.
– This eliminates the possibility of partial default because the real value
of the coupon and principal of the bond cannot be affected by the
country’s monetary policy.
• BUT: In case of terrible economic conditions, on which kind of
debt will politicians decide to default first, government debt
denominated in the DC and mostly held by residents or FC-
debt mostly held by foreigners?
5
Sovereign Risk
• Remark: The lack of willingness to pay even though a

government could is a form of political risk.
• The ability to pay for FC-debt is closely connected to a
country’s ability to generate inflows of foreign exchange.
• Financial and economic risk factors
– Ratio of a country’s external debt to its GDP
– Ratio of a country’s debt service payments to its exports
– Ratio of a country’s imports to its official international reserves
– A country’s terms of trade (export prices/import prices)
– A country’s current account deficit
• Sovereign Ceiling: The credit rating of a private company
generally is hardly ever better than the credit rating of its
country’s government debt. 6
Political Risk
• Political risk factors

– Expropriation/nationalization – worst-case scenario
– Contract repudiation
– Taxes and regulation (i.e., hiring/firing, environmental
standards, repatriation of funds)
– Exchange controls (e.g., Argentina in 2002)
– Corruption and legal inefficiency
• Transparency International Corruption Perceptions Index for more
than 150 countries
– Ethnic violence, political unrest, and terrorism
– Home-country restriction
7
Expropriations 1960 to 1979
8
Source: Hajzler 2010: Expropriation of FDIs: Sectorial Patterns from 1993 to 2006, Univ of Otago Discussion Paper
Expropriations 1980 to 2006
9
Source: Hajzler 2010: Expropriation of FDIs: Sectorial Patterns from 1993 to 2006, Univ of Otago Discussion Paper
Review of Capital Budgeting
Standard NPV Rule
The basic net present value equation is
T
E[CFt ] E[TVT ]
NPV0 = ∑ + − I0
t =1 (1 + r ) (1 + r )
t T
Where:
CFt = incremental after-tax cash flow in year t,
TVT = after tax terminal value including return of net working capital,
(the terminal value could be 0).
I0 = initial investment at inception,
r = appropriate discount rate,
T = economic life of the project in years (could be infinite).
Note, in general: NPV=PV(benefits)-PV(costs)

10
Standard NPV Rule
The NPV rule is to accept a project if NPV ≥ 0

T
E[CFt ] E[TVT ]
NPV0 = ∑ + − I0 ≥ 0
t =1 (1 + r ) (1 + r )
t T
and to reject a project if NPV ≤ 0

T
E[CFt ] E[TVT ]
NPV0 = ∑ + − I 0 ≤ 0.
t =1 (1 + r ) (1 + r )
t T
11
Example
• Example: Oconoc’s Project in Zuenvela
– Oconoc, an American oil company wants to do a joint project with
Atauz Petrol, an oil company in Zuenvela
– Oconoc’s investment amounts to $75m.
– Without political risk, the expected cashflow is $50m in year 1 and
year 2.
– Oconoc‘s discount rate is 10%.
• Should Oconoc undertake this project?
– The NPV of the project is positive:
$50 $50
𝑁𝑁𝑁𝑁𝑁𝑁 = −$75𝑚𝑚 + + = −$75𝑚𝑚 + $86.78𝑚𝑚 = $11.78𝑚𝑚
1.1 1.12
• How do things change in the presence of political risk?
12
Incorporating Political Risk in Capital
Budgeting
Expected Return/Cost of Capital of a MNC:
– A MNC generally has globally well diversified shareholders.
– For them systematic risk is represented by the covariation of the MNC‘s
return with the world market return.
Consequences of Political Risk For Capital Budgeting
1. Expected Cashflows: Take into account the probabilities and
consequences of political risk.
2. Discount Rate: Only if the political risk is systematically correlated with
the world market return then the discount rate should be adjusted.
– The evidence so far is that political risk in emerging markets is uncorrelated
with the global market return, i.e. it is country-specific (idiosyncratic) and
should not be priced.
– BUT: Emerging markets are still not fully integrated with global financial
markets. Therefore, it is possible that the standard CAPM does not capture all
systematic risk.
13
Budgeting
• Onoco‘s investment decision with political risk:
– Suppose that the political risk is idiosyncratic (non-systematic), as
many studies find.
– The probability of an expropriation is 12% in year 1 and (if none
happened in year 1) also in year 2.
– If expropriation happens, the expected cashflow is 0.
• Consequences for Onoco’s Capital Budgeting Decision:

– Adjust expected cash flows for political risk: Consider the possible
consequences of expropriation risk and their probabilities for each
future period.
– Compute discount rate as usual (i.e., without expropriation risk since it
this is non-systematic).
14
Adjusting the MNC’s Cash Flows for Political Risk
year 0 year 1 year 2
Prob = 1
Cash Flow = 0
PV no exprop exprop y1 exprop y2

cashfl. prob cashfl. prob cashfl. prob
Year 1 $40m $50m 0.88 $0 0.12
Year 2 $32m $50m 0.882 $0 0.12 $0 0.88x0.12
0.88 × $50 + 0.12 × $0 0.882 × $50 + 0.88 × 0.12 × $0 + 0.12 × $0

𝑁𝑁𝑁𝑁𝑁𝑁 = −$75𝑚𝑚 + +
1.1 1.12
= −$75𝑚𝑚 + $72𝑚𝑚 = −$3𝑚𝑚
15
Budgeting – General Formula
• If expropriation risk is idiosyncratic, capital budgeting analysis must be
adjusted for political risk as follows:
– Step1: Compute the discount rate, r, and the future expected cashflows for
period t, E[CF(t)], as usual, without expropriation risk.
– Step2: Compute a series of expropriation probabilities, p(t), for each period.
p(t) could change from period to period.
– Step 3: Compute the probability that there has been no expropriation until
(and including) time t 𝑡𝑡−1
1 − 𝑝𝑝 1 × 1 − 𝑝𝑝 2 × ⋯ × (1 − 𝑝𝑝 𝑡𝑡 ) = �(1 − 𝑝𝑝 𝑡𝑡 − 𝑛𝑛 )
𝑛𝑛=0
• The NPV for an investment I is give by:
𝑇𝑇
𝐸𝐸[𝐶𝐶 𝑡𝑡 ] × ∏𝑡𝑡−1
𝑛𝑛=0(1 − 𝑝𝑝 𝑡𝑡 − 𝑛𝑛 )
𝑁𝑁𝑁𝑁𝑁𝑁 = −𝐼𝐼 + �
1 + 𝑟𝑟 𝑡𝑡
𝑡𝑡=1
– Here we assume total expropriation. If this is not the case, we can simply
include the expected value of compensation payments. 16
Managing Political Risk
• Insurance
– Coverage
• Currency inconvertibility and non-transferability
• Expropriation
• War and political violence Political risk insurance for U.S.
Companies
• Overseas private investment corporation (OPIC)
– Political risk insurance in emerging and transitioning
economy
• Multilateral investment guarantee agency (MIGA)
– Public versus private insurance
• Private - more important as time goes on
• Public – may deter rogue nations 24
Political Risk Insurance and Capital
Budgeting
Example cont‘d:
• Suppose Oconoc can buy political risk insurance.
• The insurer offers to cover up to $50m for an
insurance premium of $1.7m per year.
• How do the expected cashflows change?
• What is the NPV of the project if Oconoc buys this
insurance?
25
Political Risk Insurance and Capital Budgeting
year 0 year 1 year 2
Prob = 1
Cash Flow = 0
PV no exprop exprop y1 exprop y2
cashfl. prop cashfl. prob cashfl. prob
Year 1 $40m $48.3m 0.88 $48.3 0.12
Year 2 $32m $48.3m 0.882 $0 0.12 $48.3 0.88x0.12
0.88 × $48.3 + 0.12 × $48.3 0.882 × $48.3 + 0.88 × 0.12 × $48.3 + 0.12 × $0
𝑁𝑁𝑁𝑁𝑁𝑁 = −$75𝑚𝑚 + +
1.1 1.12
= −$75𝑚𝑚 + $79.04𝑚𝑚 = $4.04𝑚𝑚
26
• Project Finance
– Two Main Characteristics:
• The financing is project specific.
• The return to fund providers is primarily generated by the project.
• Project finance can be used to break the debt ceiling
imposed by the country’s credit rating (see next
slide).
• Famous examples:
– $16 billion Channel Tunnel
– $4.4 billion Berlin-Brandenburg International Airport
(now $5.9 billion)
27
• A Project Finance Example: Petrozuata

– Petrozuata was a joint venture between Venezuela’s government-owned oil company,
Petroleos de Venezuela S. A. (PDVSA), and ConocoPhillips, a U.S. oil company.
– Petrozuata was established in 1997 to develop the Orinoco oil belt.
– Project financing was used on a stand-alone non-recourse basis. Moreover, the deal
contained a special feature called a “cash waterfall.”
– The cash waterfall worked like this: Petrozuata’s customers would deposit their dollar-
denominated funds from the purchase of oil into an offshore account maintained by
Bankers Trust, a U.S.–based bank. Bankers Trust would then disburse the cash
according to a payment hierarchy, ensuring that the project debt would be serviced
before money would be transferred to Venezuela to pay off the project’s equity
holders.
– This structure reduced political risk and Petrozuata received a higher credit rating
than Venezuela.
– But some political risk remained: Expropriation was still possible. And on May 1, 2007,
President Chavez announced that Venezuela was taking over control of all oil-
production projects in the Orinoco belt. 28
Lecture 11
International Capital Budgeting
1
Course Outline
1. Introduction: Globalization and the MNC International Economics:

2. The International Monetary System • Institutional setup
3. Foreign Exchange Market • Determination of the
exchange rate
4. Forward Markets • Exchange rate
5. Parity Relationships forecasting
6. Forecasting Exchange Rates
7. Currency Futures and Options Risk Management and Hedging
• Pricing of FX-rate derivatives
8. Transaction (contractual) Exposure
• Hedging
9. Operating Exposure
10. Foreign Direct Investment, Political and Country Risks
11. International Capital Budgeting
Capital Budgeting and Valuation of a MNC

• Investment Decision
2
• Valuation and Gains to Hedging
Lecture 11: International Capital Budgeting
• Review of Domestic Capital Budgeting

– Net Present Value
• Adjusted Net Present Value
– Purpose: Develop a framework to evaluate projects on a uniform
basis.
• How is international capital budgeting different from domestic
capital budgeting?
• Case Study: IWPI-US wants to set up a subsidiary in Spain.
• Does Hedging Add Value? – When Should a Firm Hedge?
3
Standard NPV Rule
The basic net present value equation is
T
E[CFt ] E[TVT ]
NPV0 = ∑ + − I0
t =1 (1 + r ) (1 + r )
t T
Where:
CFt = incremental after-tax cash flow in year t,
TVT = after tax terminal value including return of net working capital,
(the terminal value could be 0).
I0 = initial investment at inception (we could have expenditures also in the future),
r = appropriate discount rate,
T = economic life of the project in years (could be infinite).
Note: the general definition is: NPV=PV(benefits)-PV(costs)

4
Standard NPV Rule
The NPV rule is to accept a project if NPV ≥ 0

T
E[CFt ] E[TVT ]
NPV0 = ∑ + − I0 ≥ 0
t =1 (1 + r ) (1 + r )
t T
and to reject a project if NPV ≤ 0

T
E[CFt ] E[TVT ]
NPV0 = ∑ + − I 0 ≤ 0.
t =1 (1 + r ) (1 + r )
t T
5
Review of Domestic Capital Budgeting
Standard NPV Rule
Suppose the Vincenzo Uno has a project with the following expected yearly cash flows for
an unlimited amount of time:
Annual revenue €1,000,000
Annual cost -600,000
Operating income 400,000
Corporate tax (.34 tax rate) 134,000
After-tax profits €264,000
If the discount rate for this project is 10%, the present value of these perpetual expected
profits is as follows:
€264,000 €264,000 €264,000 €264,000

+ + + ⋯ = = €2,640,000
1.10 1.102 1.103 0.10
Suppose that the initial investment required to generate these cash flows is
€2,750,000. Then, the NPV of this project to Vincenzo Uno is negative:
€2,640,000 - €2,750,000 = -€110,000
Since the NPV is negative, we would reject the project. 6
Adjusted NPV
For our purposes it is necessary to extend the NPV calculation.
1. We are interested in the incremental profit of the project
represented by free cash flow:
𝐹𝐹𝐹𝐹𝐹𝐹𝑡𝑡 = 𝑅𝑅𝑡𝑡 − 𝐶𝐶𝐶𝐶𝐶𝐶𝑆𝑆𝑡𝑡 − 𝑆𝑆𝑆𝑆𝐴𝐴𝑡𝑡 − 𝐷𝐷𝐷𝐷𝐷𝐷𝑟𝑟𝑡𝑡 (1 − 𝜏𝜏) + 𝐷𝐷𝐷𝐷𝐷𝐷𝑟𝑟𝑡𝑡 −∆𝑁𝑁𝑁𝑁𝐶𝐶𝑡𝑡 − 𝐶𝐶𝐶𝐶𝐶𝐶𝑋𝑋𝑡𝑡
𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁=𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸−𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑜𝑜𝑜𝑜 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖
Rt is incremental revenue ΔNWCt is incremental change in net working

capital
COGSt is incremental cost of goods sold
CAPXt is incremental capital expenditure
SGAt is incremental selling and general
administrative expenses τ is the marginal tax rate
Deprt is incremental accounting depreciation NOPLAT is net operating profits less adjusted
taxes
EBIT is earnings before interest and taxes
7
Adjusted NPV
2. We need to consider financial side effects

– Issuance costs
– Tax shield (tax paid on interest payments is deductible)
– Costs of financial distress
– Subsidized financing
8
Adjusted NPV
2. We need to consider financial side effects

3. We include any real options
– Real options involve the ability to adjust the scale of a project in
response to future information (also includes shutting down).
– Think of a sequel to a movie (if the first Pirates of the Caribbean is a
success, produce one or more sequels otherwise not).
– Think of Twitter and other internet IPOs which have negative cash
flows now and in the near future but positive (and very large) equity 9
values. Their value is derived largely from real options.
Adjusted NPV
Adjusted Net Present Value is our appropriate decision tool
• Components:
1. Discounted free-cash flows of the all-equity firm (NPV)
• Only incremental, after-tax cash flows (same currency!)
2. Value of the financial side effects (NPVF)
• Examples: costs of issuing securities; tax implications of financing; costs of
financial distress ; subsidized financing from governments
3. Value the growth options (RO)
• Adjusted Net Present Value is the sum of these three things:
ANPV = NPV + NPVF + RO

• Decision rule: accept only positive ANPV projects
10
Elements of the Adjusted NPV
Deriving the NPV of Free Cash Flows
• Incremental profits - flows that result from the project alone
• Revenues - forecasts depend on future economic
environment
• Costs - measures cost of goods sold
• Depreciation – legal tax shield; subtracted out before taxes
are calculated
• Capital expenses – money spent on property, plant and
equipment (PPE)
• Net working capital – inventory and cash on hand to run
business
11
Deriving the NPV of Free Cash Flows from the Income
Statement and Balance Sheet:
Step 1: Subtract costs from revenues
Revenue – Costs = Earnings before interest and taxes (EBIT)
Step 2: Subtract taxes on earnings:
EBIT-Taxes on EBIT = Net operating profit less adjusted taxes (NOPLAT)
Step 3: Add back non-cash costs
NOPLAT + Accounting depreciation = Gross cash flow (GCF)
Step 4: Subtract investments made to increase future profitability
GCF – Change in net working capital (ΔNWC) – Capital expenditures (CAPX)
= Free cash flow (FCF)
𝐹𝐹𝐹𝐹𝐹𝐹𝑡𝑡 = 𝑅𝑅𝑡𝑡 − 𝐶𝐶𝐶𝐶𝐶𝐶𝑆𝑆𝑡𝑡 − 𝑆𝑆𝑆𝑆𝐴𝐴 𝑇𝑇 − 𝐷𝐷𝐷𝐷𝐷𝐷𝑟𝑟𝑡𝑡 (1 − 𝜏𝜏) +𝐷𝐷𝐷𝐷𝐷𝐷𝑟𝑟𝑡𝑡 −∆𝑁𝑁𝑁𝑁𝐶𝐶𝑡𝑡 − 𝐶𝐶𝐶𝐶𝐶𝐶𝑋𝑋𝑡𝑡
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖
𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁=𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸−𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑜𝑜𝑜𝑜 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 12
Deriving the NPV of Free Cash Flows
– Present value of infinite sum of free cash flows
∞ 𝑇𝑇 ∞
𝐸𝐸0 [𝐹𝐹𝐹𝐹𝐹𝐹𝑡𝑡 ] 𝐸𝐸0 [𝐹𝐹𝐹𝐹𝐹𝐹𝑡𝑡 ] 𝐸𝐸0 [𝐹𝐹𝐹𝐹𝐹𝐹𝑡𝑡 ]
𝑁𝑁𝑁𝑁𝑁𝑁 0 = � =� + �
1 + 𝑟𝑟 𝑡𝑡 1 + 𝑟𝑟 𝑡𝑡 1 + 𝑟𝑟 𝑡𝑡
𝑡𝑡=0 𝑡𝑡=0 𝑡𝑡=𝑇𝑇+1
• r = discount rate of an all-equity firm (could depend on the time-horizon)

– Present value when we have specific free cash flow ∞
𝐸𝐸0 [𝐹𝐹𝐹𝐹𝐹𝐹𝑡𝑡 ]
�
forecasts only until period T. 𝑡𝑡=𝑇𝑇+1
1 + 𝑟𝑟 𝑡𝑡
∞
𝑇𝑇 1 𝐸𝐸0 [𝐹𝐹𝐹𝐹𝐹𝐹𝑡𝑡 ]
𝐸𝐸0 [𝐹𝐹𝐹𝐹𝐹𝐹𝑡𝑡 ] 𝑇𝑇𝑉𝑉𝑇𝑇 =
1 + 𝑟𝑟 𝑇𝑇
�
1 + 𝑟𝑟 𝑡𝑡−𝑇𝑇
𝑁𝑁𝑁𝑁𝑁𝑁 0 = � + 𝑡𝑡=𝑇𝑇+1
1 + 𝑟𝑟 𝑡𝑡 1 + 𝑟𝑟 𝑇𝑇 𝑇𝑇𝑉𝑉𝑇𝑇
𝑡𝑡=0
– Calculating the terminal value (TV) of a project
• At some point the project’s growth potential will be met.
• If no new capital expenditures are planned and replacement CAPX is not
more productive it is reasonable to assume that the cash flows grow with
the expected inflation rate. 13
Financial Side Effects
1. The costs of issuing securities
– Monetary fee (legal, auditing, printing,…)
– Underwriting discount
• The spread between what the firm
receives from issuing securities and
what the public pays for the
securities
– Lee, Lockhead, Ritter and Zhao (1996):
• Initial public offerings (IPOs) of
equity: 11% From Lee, Lockhead, Ritter and Zhao (1996): The cost of
raising capital.
• Seasoned equity offerings (SEOs) of
equity: 7.1%
• Convertible bonds: 3.8%
• Straight bonds: 2.2%
• They find economies of scale. 14
2. Tax shield: is the value of the ability to deduct interest expense
for tax purposes.
– Example: 2-year corporate bond with face value D and yearly coupon
coupon payment of c% of the face value. Suppose the required interest
rate (risk-free rate plus credit spread) on this corporate bond is rD. Then
the present value of the tax shield is given by
𝜏𝜏𝜏𝜏𝜏𝜏 𝜏𝜏𝜏𝜏𝜏𝜏
+
1 + 𝑟𝑟𝐷𝐷 (1 + 𝑟𝑟𝐷𝐷 )2
• Normally, c = rD when the firm issues debt. However, when using the adjusted
NPV method to value to entire company we might have to consider existing
debt issued with some coupon c that equaled the required interest rate at the
issuance time which might not be equal to the current required rate (the
interest rate and/or the credit spread might have changed).
• If the tax shield is as volatile as the cash flow, the discount rate is equal to
15
r (the discount rate of an all-equity firm).
3. Costs of financial distress:
– If these costs didn’t exist, firms would have mostly (maybe 100%) debt
in their capital structure because of the interest tax shield.
– The direct costs of financial distress, e.g., legal consulting, and
accounting fees ≈ 3% of the firm value in default.
– The indirect costs of financial distress – loss of value due to the
expectation of failure.
• Customers not wanting to buy because they won’t be able to get after-
sales service or creditors unwilling to extend more credit
• Inability to attract and keep high-quality, skilled labor
• Indirect costs can be much larger than the direct costs. Studies find that
for small firms the entire value of the firm in default is used up to cover
costs of financial distress.
(Bris et al 2006: The Costs of Bankruptcy: Chapter 7 Liquidation versus Chapter 11 Reorganization, Journal of
Finance, Vol 61, Nr 3.) 16
4. Subsidized financing
– Adds value to the project
– Appropriate discount rate is the market’s required rate of return on
the debt since the firm is just as likely to default on a subsidized loan
The proper discount rate to value financial side effects:
– The discount rate should reflect the riskiness and timing of the cash flows
generated by the financial side effects. If the financial-side-effect cash-flow is…
– … as risky as the free cash flows => r (discount rate used for the free cash
flows).
– … constant (like the interest payment itself) and paid as long as the firm
doesn’t default => rD (approximation b/c of different treatment in bankruptcy)
– … paid only if the firm goes bankrupt => use derivative pricing
17
Suppose the Vincenzo Uno issues debt to finance the project. It issues €500,000 of debt
with a coupon (c) of 6% p.a. with infinite maturity (this is a consol bond). Issuance cost
amount to one percent of the face value of debt (€ 5,000). The yearly tax shield is τcD.
For a corporate tax rate of 34% the yearly tax savings amount to €10,200. The value of the
tax shield is given by
𝜏𝜏𝜏𝜏𝜏𝜏 𝜏𝜏𝜏𝜏𝜏𝜏 𝜏𝜏𝜏𝜏𝜏𝜏 𝜏𝜏𝜏𝜏𝜏𝜏
+ + + ⋯ =
1 + 𝑟𝑟𝐷𝐷 (1 + 𝑟𝑟𝐷𝐷 )2 (1 + 𝑟𝑟𝐷𝐷 )3 𝑟𝑟𝐷𝐷
If the required interest rate for Vincenzo Uno’s debt is 8%, the present value of the tax
shield is
0.34 × 0.06 × €500,000 €10,200
= = €127,500
0.08 0.08
Normally 6%. It differs here to
The adjusted net present value becomes positive: show the calculation.
€2,640,000 − €2,750,000 + €127,500 − €5,000 = €12,500

𝑁𝑁𝑁𝑁𝑁𝑁 𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁=𝑡𝑡𝑡𝑡𝑡𝑡 𝑠𝑠ℎ𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 − 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐
and the project is worthwhile undertaking! 18

How is International Capital Budgeting
Different?
• Additional sources of risk
– Currency risk
– Country and political risk
• Cash flows accrued to a subsidiary can differ substantially
from those finally accruing to its parent:
– foreign exchange controls
– taxes on dividends paid to parent
– royalty payments
– licensing agreements
– overhead management fees
– profits from intermediate goods sold to subsidiary
• Financing choice: at home or abroad?
19
Parent Versus Subsidiary Cash Flows
• A three-step approach to determining the value of a

foreign subsidiary (i.e., from the perspective of parent
company)
– Step One: NPV cash flow analysis of the foreign subsidiary as
if it were independent of the parent
– Step Two: Cash flow from parent’s perspective
• After-withholding-tax dividends which the project will yield to parent
• After-tax value of royalty payments, licensing/management fees,
sales of intermediate goods
• Watch for cannibalization of exports
– Step Three: Adjust the value of the project for the NPV of
financial side effects and possible growth options
20

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Financial Strategy in a Global Economy

1. Final Exam: 70%

• If there is a homework, the assignment will be posted on Tuesday around 2.30pm on

1. Introduction International Economics:

9. Foreign Direct Investment, Political and Country Risks

• What’s Special about “International” Finance?

• Goals for International Financial Management

• Globalization of the World Economy – Major Trends

• Other Global Players You Should Know

• Globalization of Capital Flows and the Last Financial Crisis

– Suppose the textbook for this

– Foreign Exchange Risk:

• Purpose of International Finance:

• Purpose of International Finance

• Country Risk comprises political risk and adverse changes in a country’s

• Nestlé used to issue two different classes of common

• Following this, the price spread between the two types of

• Emergence of Globalized Financial Markets

• Emergence of the Euro as a Global Currency

• Trade Liberalization and Economic Integration

• Deregulation of Financial Markets

Rank Country GDP (PPP) $Billions

93% increase of the

The Foreign Exchange Market

ForEx (or FX)

Most trades are $1M

Electronic Conversations per Hour

1. Interbank Market (Wholesale)

• Exchange rate – price of one currency in terms of

JPY and USD are the ISO (Intern. Organization for

• Direct and indirect are inverse: Direct = 1/Indirect

For a US-resident, Relationship between direct and indirect quote:

• Vehicle currency – a currency that is actively used in many

The implied S(¥/£) cross rate is

E.g., for an US investor

1. Sell $100,000 for £ at S(£/$) = 1.50 receive £150,000

profit per round trip = $106,250 – $100,000 = $6,250

It doesn’t matter where we start,

If we went “counter clockwise” we would be the source of arbitrage profits,

USD 1.1202 /EUR

JPY 121.23 /USD

USD 1.5366 /GBP

Trick: Selling GBP to the bank and getting paid in USD

• How Forward Contracts Work

Fundamental Questions for FF:

$-Value in 90 Unhedged Position

-$1.65m FC liability: £1m x S($/£, 90d)

– If you sell one unit of FC forward (short position)

Long FC: S(t+90d)-F(t,90d)

$1.53/£ $1.65/£ S(t+90d) in [$/£]

Short FC: F(t,90d)-S(t+90d)

Example cont’d: bank A quotes a forward rate of $1.53/£.

$-Value in 90 Hedged FC Liability

FC liability hedged $-value of FC liability Forward Purchase

• Hedging export receipts

• Forward contract maturities and value dates

• Forward premium - occurs when the forward price of a

• What does that mean?

Arbitrage Strategy using £ 1M:

£9,411.76 (Step 4 – Step 1) profit for every £1M that is

International Monetary System

• The Balance of Payments and Supply and Demand in