FINS1612 Exam Notes Understand the nature of global FX markets o Floating exchange rate regime the exchange rate

e for a country is allowed to move as factors of supply and demand o AUD, USD, GBP, JPY, EUR o Not controlled by government or central bank (though it can influence the exchange rate when there is rapid appreciation or depreciation i.e. slow it down) o Managed float regime allows currency to move within a defined range relative to another currency o Crawling peg regime allows the currency to appreciate gradually over time but within a range established by the government o Pegged rate currency directly linked to another country Discuss participants in the FX markets o FX dealers and brokers o Central banks influence exchange rate, change composition of holdings of foreign currencies in managing official reserve assets, purchase foreign currency to pay government imports and interest on or redeem government debt o Firms conducting international trade o Exporters sell foreign currency and buy AUD o Importers buy foreign currency and sell AUD o Investors and borrowers in the international money markets and capital markets investing overseas o Foreign currency speculators anticipate future rates to make a profit o Arbitrageurs no risk exposure; o Geographic taking advantage of when two dealers in different locations quote different rates on same currency o Triangular taking advantage of when 3 or more currencies are out of alignment Describe the functions and operations of FX markets o Operates 24 hrs a day o Typically the same rates globally (no arbitrage profits available) o Sophisticated global telecommunication systems utilised Outline instruments traded in FX markets o Spot transactions set an exchange rate today for delivery and settlement in 2 business days o Forward FX transactions set an exchange rate today for delivery and settlement in more than two days (standards are in months) Explain conventions for quotation and calculation of exchange rates and forward exchange rates, and complicating factors o Convention of quotations: Base Currency/Terms Currency [bid]-[offer] o buy/sell is from dealers point of view dealer buys low sells high o e.g. USD/AUD0.95-0.96 means 1 USD = 0.95(buy price] or 0.96[sell price] o Spread is calculated: (offer price bid price)/bid price x 100

FINS1612 Exam Notes o To transpose a spot quotation reverse then inverse e.g. Transpose USD/AUD0.95-96: 0.96)-1-(0.95)-1 = 1.042-53 AUD/USD1.04-05 o To calculate cross-rates: Direct (USD is base for both) base/term (term bid/base offer)-(term offer/base bid) Indirect (USD base for one) base/term (base bid x term bid)-(base offer x term offer) multiply bids, multiply offers 2 indirect base/term (base bid/term offer)-(base offer/term bid) o Forward exchange rates vary from spot exchange rates because of interest rate differences in every country. o Forward points are added if they are rising (i.e. smaller to larger) and subtracted if they are falling (i.e. larger to smaller) o If added the base currency is at a forward premium (base currency has lower interest rate) o if subtracted the base currency is at a forward discount (base currency has higher interest rate) o Forward points = Spot rate x o Complicating factors: o Two-way FX quotations: Bid forward points use above formula with terms bid interest rate and base offer interest rate Offer forward points use formula with terms offer interest rates and base bid interest rate Explain how supply and demand issues determine an equilibrium exchange rate o Demand is downward sloping (people buy more of it when its cheap so its no longer on the market) o Supply is upward sloping (as the value of currency increases people want to spend more on foreign currency and thus the quantity of it on the market increases) o Equilibrium rate the rate at which both demanders and suppliers are satisfied Consider mechanisms and relationships of factors influencing the exchange rate o Relative rates of inflation lowering of inflation (compared to another country or if the other country increases inflation) causes decrease in supply (shift left) and increase in demand (shift right) = net increase in value of currency ( inflation = currency value) o National income growth greater relative income growth causes increase in supply (shift right) due to higher demand for imports and an unchanged demand = net decrease in value of currency (income growth = currency value) *Note increased income growth may also increase foreign investments which would appreciate the currency o Relative interest rates increase of relative interest rates increases demand due to foreign investment while supply decreases as domestic investors also keep their investments in the country = net increase in currency value (income growth = currency value)

FINS1612 Exam Notes **If benefit from placing funds in the currency is lower than the depreciation expected during the time of investment the currency will depreciate **Also, the currency may only appreciate if the rise in nominal interest rates is due to an increase in the real rate of return (recall: i = r + p) o Exchange rate expectations based on expectations on all above issues. If currency is expected to depreciate, then residents will buy foreign currency, which shifts supply to the right, the demand for the currency will also decrease (shift left). Therefore currency depreciates as expected o Central bank or government intervention CB may intervene with international trade flows (subsidies, tariffs, quotas, embargo) and foreign investment flows (prohibition of outflow, penalty taxes) or directly with the FX market (smoothing or exchange rate targeting) Describe the macroeconomic context of interest rate determination o Monetary policies actions are directed at influencing interest rates o By increasing interest rates, the spending in interest-sensitive areas of the economy will slow to balance economys production and spending levels o Three main effects of changes in interest rates: o Liquidity effect o Income effect increased rates reduces spending and income levels o Inflation effect demands for loans slow o Economic indicators: o Leading change before business cycle changes o Coincidental change at the same time as the business cycle changes o Lagging change after the business cycle changes Explain the loanable funds approach to interest rate determination o Preferred method of forecasting interest rates o Loanable funds = funds available for lending o Increase interest rate = increase demand o Increase interest rate = decrease supply o Demand: o Business short term working capital, longer term investment o Government budgeted, independent of interest rate; vertical demand o Supply o Savings of household sector major source o Changes in money supply independent of interest rate; changes are represented parallel to savings and does not change slope o Dishoarding currency holding decreases as interest rates rise Understand yields, yield curves and term structures of interest rates, and apply the expectations theory, segmented markets theory and liquidity premium theory o Yield = total rate of return on an investment o Shapes of yield curves: o Normal/Positive (upwards) long term rates > short term rates o Inverse/Negative (downwards) short term rates > long term rates o Humped changes occur over time from normal to inverse, etc.

FINS1612 Exam Notes o Expectations theory longer term rates derived from average of expected short term rates: o If future short term rates > current short term rates normal o If current short term rates > future short term rates inverse o If future short-term rates are expected to rise and fall humped o Segmented markets theory - securities with different maturity ranges are viewed as imperfect substitutes by market participants: o If CB increases average maturity of bonds short term yields decrease, long term yields increase o Both theories above denies the existence of arbitrage opportunities and speculative profit o Liquidity premium theory assumes investors prefer short term over long term instruments; therefore requiring compensation for investing longer term Explain the risk structure of interest rates and the impact of default risk on interest rates o Default risk = borrower fail to meet interest payment obligations o Government bonds assumed to have zero default risk o Investors require compensation for bearing extra default risk Consider the nature and purpose of derivative products o Derivatives derive their price from an underlying physical product o Futures contract = right to buy or sell specific item at a specified future date at a price determined today o Two main types: Commodity (e.g. gold, cattle, wheat) and Financial (e.g. shares, money market instruments) o Hedging transferring risk of unanticipated changes in prices, interest rates or exchange rates to another party; off setting profit or loss from change in market price using futures contract Outline features of a futures transaction o Highly standardised but based on underlying commodities and financial instruments available in each country o Aus market bonds quoted on basis of yield to maturity o Orders specify: o Buy (bid) or sell (offer) o Type of contract o Delivery month o Price restrictions o Time limits o Quoted index figure = 100 yield o Profit made when dealer buys at lower index figure and sells at higher index figure o Long position = agreement to buy o Short position = agreement to sell o Both pay initial margin to ensure payments for losses incurred due to unfavourable price movements in the contract makes sure there is no default o Closing out a contract conducting an opposite futures contract transaction

FINS1612 Exam Notes o Most parties use future contracts to manage risk exposure or speculate and do not actually whish to receive or deliver the underlying commodity/instrument and close out before delivery date o Settlement with clearing house with standard delivery or cash settlement Review the types of futures contracts available through a futures exchange o Futures market can be established for any commodity or instrument that: o Is freely traded o Experiences considerable volatility o Can be graded according to a universally accepted standard o Is plentiful on supply or cash settlement is possible o Contract sizes: o 90-day bank accepted bills $1,000,000 FV o 10-Yr or 3-Yr treasury bonds - $100,000 (6% coupon) o S&P/ASX 200 Index Share price index x $25 o Listed company shares 1000 shares Identify why participants use derivative markets and how futures are used to hedge price risk o 4 main participants o Hedgers manage price risks o Speculators attempt to make a profit by purposely taking risks (that hedgers avoid) o Traders conduct transactions on their own account o Arbitragers take no risk; take advantage of out of equilibrium contracts o Borrowing hedge to lock in cost of funds for future borrowing, begin selling futures contract today and close out when time comes to sell bills (Recall: discount formula for bills =

Cost of funds = (Cost of bills futures profits)/(discounted value of bill + futures profits) x (365/days borrowing) o Investment hedge to lock in around current yield, buy futures contract today and close out when time comes to invest o Hedging foreign currency transaction to lock in exchange rate, sell a futures contract today and closeout at time of payment o Hedging value of share portfolio if share prices are forecast to fall, sell amount of futures contract equal to current market value/(25 x current index), close out when required Identify risks associated with using a futures contract hedging strategy o Standard contract size not always able to achieve perfect hedge for non-standard risk management needs; larger size of physical market exposure = less significant o Margin risk if maintenance margin calls are not met, clearing house will automatically close out strategy o Basis risk difference between price in physical market and futures market; beginning (initial) and at completion (final). Markets will also expect to change if you do and factor in fall/rise of rates

FINS1612 Exam Notes o Cross-commodity hedging often difficult to select a futures contract that are correlated to the underlying asset precisely in spread over time Explain and illustrate the use of an FRA for hedging interest rate risk o Over the counter product specifically managing interest rate risk exposure o No exchange of principal o Locks in interest rates for both borrower and lender o 3Mv9M 1.25 to 20 = cover six months rates starting in 3 months time, lend at 1.25 and borrow and 1.20 o Settlement amount paid in cash = FRA settlement rate FRA agreed rate

o FRA is tailor made; great flexibility with respect to contract period and amount Understand the structure and operation of option contracts and the types available o Asymetric cover protect one side o Limits effect of adverse price movements without reducing profits o Involve payment of premium to the writer o Will only be exercised in the holders best interest Explain the profit and loss payoff profiles of call and put option contracts o Long party buyer o Short party writer/seller o Call right to buy; in the money if S > X o Long call V = max(S-X, 0) P o Short call V = P max(S-X, 0) o Put right to sell; in the money if S < X o Long put V = max(X-S, 0) P o Short put V = P max(X-S, 0) o Profit for long party is unlimited, and loss is limited to premium paid o Profit for short party is limited to premium received and loss is unlimited o Counter this by being covered, either owning sufficient of the underlying asset or is a long call/put party of same asset with lower/higher exercise price Explain the factors affecting the price of options o Intrinsic value higher the market price = higher the premium o Time value longer until expiry = higher premium o Price volatility greater volatility higher premium o Interest rates for call options positive relationship (profit), for put potions negative relationship (loss due to OC of holding asset)

FINS1612 Exam Notes

Develop options strategies for hedging price risk o long asset (i.e. bought) and bearish (negative) about future asset price Strategy: limit downside risk by writing (selling) a call option, o short asset (i.e. sold) and bullish (positive) about future asset price Strategy: Buy a call in the underlying asset (i.e. take a long-call position) o very bullish about future price of the asset Strategy: Write (sell) a put option and earn a premium to benefit from fall in spot price. AND hold (buy) a call option with exercise price greater than written put o quite bullish, but with some risk of a price fall Strategy: Hold (buy) a call option to benefit from fall in spot price. And write (sell) a call option with a higher exercise price than the long call Discuss the advantages and disadvantages of option contracts in managing risk Describe the nature of a swap and explain the structure and operation of vanilla and basis interest rate swaps Understand the importance of the interest rate swap market