Capital Market and Derivatives - Assignment Example

CAPITAL MARKET AND DERIVATIVES WORK CAPITAL MARKET AND DERIVATIVES WORK Question one The concept of forward exchange rates The forward exchange rate is a rate of exchange at which a certain bank agrees to change one currency into another currency at a particular future date by which it enters into a contract with an investor. Usually in business, banks or multinational corporations do enter into a forward contract to take an advantage of the forward rate for the purposes of hedging. The forward exchange rate is by a relationship that exists between the spot exchange rate and interest rate differential between the two countries. The relationship typically indicates equilibrium in the foreign exchange market under which arbitrage opportunities are. When it is in equilibrium and when the rates of interest differ across two countries. The condition of the party requires that the forward exchange rate include a discount or a premium reflecting a difference in the interest rate. The forward interest rates are crucial in and have theoretical implications for forecasting future spot exchange rates. For this reason, financial economists have come up with a hypothesis that the forward exchange rate predicts accurately the future spot rate, by which the empirical evidence is mixed (Gandolfo, 2004). In considering the bonds, forward rates are calculated to determine future values. An example is where an investor can buy a one-year Treasury bill or buy a 5-month bill and roll it into another five-month bill once it matures. The investor will be indifferent if they both produce similar results. The investor will be aware of the spot rate for the six-month bill and the bond of one year. However, he will be conscious of a five-month bond bought five months from now (Gandolfo, 2004). The role of forward exchange rates in financial markets The forward exchange rates play the following roles in financial markets; · To convert the currency of one country to the currency of another country. · It enhances the analysis of expectations of the asset price. The forward exchange rate in financial markets is critical in determining favorable asset prices. · It fully reflects the available information concerning the exchange rate expectations. Since one larger view of the market, efficiency is that the current prices reflect all information that is available. When the view is to the foreign exchange market, it will imply that expectations of economic agents about future values of the exchange rate determinants are fully reflected in the forward rates. · To give some insurance against the foreign exchange risk that is the adverse consequences of unpredictable changes in exchange rates (Gandolfo, 2004). Currency Conversion Companies use the forward exchange rates: · to change payments it gets for its exports, the income it generates from investments that are, or the income it generates from licensing agreements with foreign companies · when they must pay a firm that is external for its products or services in its country’s currency · when they have idle money that they want to invest for short terms in money markets · for the speculation of currency - the movement of funds that is short term from one currency to another in the effort of profiting from shifts in exchange rates (Gandolfo, 2004). Insuring Against Foreign Exchange Risk Another function of the forward exchange rate is to provide insurance to protect it against the expected dangerous consequences of unknown changes in exchange rates or foreign exchange risk. · The spot exchange rate is the known rate at by which a foreign currency investor converts one currency to another currency on a particular day. · A forward exchange is experienced when two parties agree to exchange currency and execute the agreement at some particular date in the future. A forward exchange rate is when two parties agree to exchange the money and complete the transaction at a forthcoming date. · A currency swap is the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates. Swaps are between businesses that are international and their banks, between the banks, and between governments. When it is very desirable to move out o one currency into another for a limited period without incurring foreign exchange rate risk (Gandolfo, 2004). Question two The no-arbitrage condition in the foreign exchange market is as the covered interest rate parity. The covered interest rate parity depends on the forward market. The one-month forward exchange rate can be determined by rearranging the covered interest rate parity that will give the forward exchange rate as a function of the other variables. As a result, it will mean that the one-month forward exchange rate depends on three known variables, the domestic interest rate, the spot exchange rate, and the foreign interest rate. Thus, the forward rate is the price of a forward contract that gets its value from spot contracts pricing and the addition of information on interest rates that are available (Gandolfo, 2004). The below equation represents the covered interest rate parity, a condition by which investors eliminate the exposure to foreign exchange rate risks (the anticipated changes in the exchange rates). There is the use of a forward contract where the exchange rate is. Under the condition, a domestic investor will earn returns that are equal from investing in assets that are household or converting his currency at the prevailing spot exchange rate. Also investing in currency assets that are foreign with an interest rate that is foreign and exchanging the currency for domestic currency at a negotiated exchange rate. Investors will be different in interest rates on deposits with the countries due to equilibrium resulting from the forward exchange rate. The condition will allow for no arbitrage opportunities since the return on domestic deposits is equal to the return on foreign deposits. If the two returns were equalized by the use of a forward contract, there would be a potential arbitrage opportunity, where an investor could borrow currency in the country with a lower interest rate. He will then converts into the foreign currency at the current spot exchange rate and invest in the country with the higher rate of interest. Such investiment will allow one to obtain some higher returns (Gandolfo, 2004). The following symbols represent; F represents a forward exchange rate S entails the current spot exchange rate id involves domestic currency rate of interest, base currency if entails foreign exchange rate of interest, quoted currency, The equation may be rearranged to enable us find the forward interest rates Question three Taking the US dollar as the investing currency and the Japanese yen as the funding currency the excess return of borrowing Japanese yen and investing in US dollars can be calculated by the following equation: (1) Whereby,  Represent a spot price of the dollar per unit of Japanese yen at the time represented by t  Involves one-time forward exchange rate at the time  Is the one-period risk-free interest rate at the time for US dollar (Gandolfo, 2004).  is the one-period risk-free interest rate at time  for US dollar (Gandolfo, 2004). Equation 1 indicates that the excess return of borrowing Japanese yen and lending US dollar can be as the interest rate differential between the two currencies minus the appreciation of Japanese yen in the next period. Further, this is equivalent to the one-period forward rate minus the spot exchange rate of the next time given no-arbitrage condition holds. For this reason, if both spot and one-period forward exchange rates are, the excess return of the dollar-yen carry trade can be calculated (Gandolfo, 2004) The Historical Excess Returns of the Carry Trade Strategy could be calculated as described below; The first thing is to compare the dollars spot price with Japanese Yen to ensure that there is efficiency and effectiveness in the conversion process. The scond thing that should be taken into consideration is the one period exchange rate, risk free rate and finally one period risk free interest rate. The Japanese YEN to United States dollars US $ (BBI) - EXCHANGE RATE RATE  RATES BBJPYSP BBJPY1F ln(s) ln(f) 232.125 231.655 5.447276 5.445249 231.6 230.865 5.445012 5.441833 234.7 234.065 5.458308 5.455599 233.35 232.715 5.452539 5.449815 224.4 223.585 5.41343 5.409792 226.85 225.89 5.424289 5.420048 231.55 230.615 5.444796 5.44075 237.425 236.255 5.469852 5.464912 245.25 244.035 5.502278 5.497312 241.495 240.415 5.486849 5.482367 246.75 245.695 5.508376 5.504091 245.9 245.135 5.504925 5.501809 247.4 246.91 5.511006 5.509024 251.55 250.625 5.527642 5.523958 254.8 254.345 5.540479 5.538692 259.45 258.935 5.558564 5.556577 250.65 250.715 5.524058 5.524317 251.6 251.09 5.527841 5.525811 251.025 250.74 5.525553 5.524417 248.45 248.125 5.515242 5.513933 236.575 236.21 5.466265 5.464721 238.9 238.605 5.476045 5.474809 216.15 215.775 5.375973 5.374236 211.375 211.495 5.353634 5.354201 202.075 202.06 5.308639 5.308565 200.1 199.935 5.298817 5.297992 192.75 192.485 5.261394 5.260018 180.2 179.975 5.194067 5.192818 179.45 179.115 5.189897 5.188028 167.45 167.15 5.120685 5.118892 174.4 174.055 5.161352 5.159371 163.75 163.385 5.098341 5.096109 153.95 153.725 5.036628 5.035165 154.7 154.605 5.041488 5.040873 154.4 154.225 5.039547 5.038413 163.4 163.165 5.096201 5.094762 161.9 161.66 5.086979 5.085495 158.1 157.775 5.063228 5.06117 153.675 153.48 5.03484 5.03357 153.2 152.99 5.031744 5.030373 145.85 145.49 4.982579 4.980107 140.65 140.285 4.946275 4.943676 144.05 143.45 4.97016 4.965987 146.9 146.475 4.989752 4.986855 149.85 149.435 5.009635 5.006862 142.2 141.82 4.957235 4.954559 146.4 145.945 4.986343 4.98323 138.275 137.92 4.929244 4.926674  (1) C= (232-24)-(232-231) = (208)-(1) = $207 (Gandolfo, 2004).  Table 1. Descriptive Statistics, 2002-2009 Mean median Standard deviation Sharpe ratio 2002 EPS -1.060     1.178 1.248**   0.157 EPS -1.949     2.324 1.365* 0.378 0.153 PER 36.484* -195.280**         0.123 PER 34.906*   -117.333**       0.109 2003 EPS -0.690   14.569*       0.187 EPS -3.052*     6.374 2.877*   0.511 EPS -4.597*     8.432 2.908* 0.888 0.516 SR 0.175***     -0.034 0.050 -0.130** 0.189 0.009     -0.004 0.002 -0.007** 0.128 2004 EPS -1.440*     3.965 1.502*   0.617 EPS -2.093*     4.626 1.395* 0.457 0.637 PER 31.128* -209.927**         0.180 PER 32.849*   -153.424*       0.219 PER 34.330*     -174.166** -4.242   0.102 PER 38.593**     -178.486** -3.539 -2.984 0.072 2005 EPS -1.670 48.704**         0.152 EPS -3.313*   48.678*       0.576 EPS -14.757*     49.340** 2.286 6.683* 0.294 PER 40.916* -260.872*         0.346 PER 37.288*   -129.134*       0.266 PER 51.586*     -291.625* -8.022   0.300 PER 58.872*     -299.296* -7.157 -4.874 0.282 2006 EPS 0.272   2.286***       0.086 EPS -2.066*     6.444* -0.190 1.241* 0.493 PER 146.474***     -552.522*** -59.052   0.060 PER 211.304**     -649.906** -45.176 -39.255 0.065 SR -0.039     0.668*** 0.048   0.050 SR -0.050     0.684*** 0.046 0.007 0.013 5.277**     -5.261 -6.474*   0.202 4.267     -3.744 -6.690* 0.612 0.181 2007 PER 97.586*   -472.048*       0.261 PER 160.906*     -466.381* -81.263**   0.281 PER 221.881*     -543.151* -70.960** -37.016** 0.369 SR -0.064   1.486*       0.321 SR -0.094     1.239** 0.065   0.154 SR 0.001     1.119** 0.081 -0.058 0.155 -0.007***     0.053* 0.008   0.211 -0.009     0.056* 0.008*** 0.001 0.190 2008 EPS -0.028 4.057*         0.380 EPS -0.069   3.316*       0.476 EPS -0.225     1.539 0.353**   0.232 EPS -0.044     1.232 0.382** -0.119 0.215 PER 63.434* -461.163**         0.117 PER 67.230*   -364.892**       0.141 PER 110.783*     -396.000** -53.578**   0.231 PER 149.560**     -461.498** -47.378*** -25.518 0.220 -0.571     3.690 -2.882*   0.239 0.488     1.902 -2.712** -0.697 0.215 2009 EPS 0.021 1.364**         0.140 Note: *, ** and *** denote significance at 1%, 5% and 10% level, respectively. (Gandolfo, 2004). The profitability of the carry trade strategy has a very low rising speed, and it might not be for a very longer period. Therefore, it is imperative to try other strategies that would improve the profitability of the exercise. The strategies could be; the Momentum strategy, which shorts past losers and buys past winners. In addition, the Value, which shorts overvalued currencies and buys undervalued currencies relative to the purchasing power parity (Gandolfo, 2004). Question 4 Until currently, economists have had a thought that the currency trading was a zero sum game. They thought that the currency speculation to the expected return was zero. However, recent research has demonstrated that simple, rules-based currency trading strategies have shown to be profitable over the past thirty years. The strategies could be below; · the carry trade, which borrows in the low-interest rate currencies and invests in the high-interest-rate currencies. · Momentum, which shorts past losers and buys past winners. · Value, which shorts overvalued currencies and buys undervalued currencies relative to the purchasing power parity (Gandolfo, 2004). The profitability of the naive, zero-cost trading strategies poses a challenge to the theory of finance. It also contradicts both the efficient market hypothesis and the uncovered interest parity condition. Also from previous research, the carry trade strategy generated an annualized mean of 10.11 % (Gandolfo, 2004). In addition, the naive carry trade has experienced high returns for long periods followed by great crashes where large depreciations of the high yield currencies cause enormous loss. For this reason basing on low Sharpe ratios and negative skew, the trades may appear unattractive even if they are across many currencies. The fact that if an informed and expert trader will fail to match returns to the naive carry trade strategy he will further underscore the puzzling nature of the other strategies. There is also evidence that the excess returns to the carry trade strategy would present a reward to investors for their being exposed to the considered macroeconomic volatility of the 1920s and 1930s (Gandolfo, 2004). Conclusion The forward exchange rate is a rate of exchange at which a certain bank comes into consent of converting one currency to another at a particular future date by which it enters into a contract with an investor. Usually in business, banks or multinational corporations do enter into a forward contract to take an advantage of the forward rate for the purposes of hedging. The forward exchange rate is by a relationship that exists between the spot exchange rate and interest rate differential between the two countries. The forward interest rates are crucial in and have theoretical implications for forecasting future spot exchange rates. As a result, financial economists have come up with a hypothesis that the forward exchange rate predicts accurately the future spot rate, by which the empirical evidence is mixed. The no-arbitrage condition in the foreign currency market is as the covered interest rate parity (Gandolfo, 2004). The covered interest rate parity depends on the forward market. The one-month forward exchange rate can be determined by rearranging the covered interest rate parity that will give the forward exchange rate as a function of the other variables. As a result, it will mean that the one-month forward exchange rate depends on three known variables, the domestic interest rate, the spot exchange rate, and the foreign interest rate. Thus, the forward rate is the price of a forward contract that gets its value from the spot contracts pricing and the addition of information on interest rates that are available. The profitability of the naive, zero-cost trading strategies poses a challenge to the theory of finance. It also contradicts both the efficient market hypothesis and the uncovered interest parity condition. Also from previous research, the carry trade strategy generated an annualized mean of 10.11 %. For this reason basing on low Sharpe ratios and negative skew, the businesses may appear unattractive even if they are across many currencies. The fact that if an informed and expert trader will fail to match returns to the naive carry trade strategy he will further underscore the puzzling nature of the other strategies (Gandolfo, 2004). Reference List Gandolfo, G. (2004). Elements of international economics: with ... 9 tables. Berlin [u.a.], Springer. Read More