AFMP4
Syllabus E. Treasury And Advanced Risk Management Techniques E2. The use of financial derivatives to hedge against forex risk

E2b. Predicting Exchange Rates 2 / 13

Syllabus E2b)

b) Evaluate, for a given hedging requirement, which of the following is the most appropriate strategy, given the nature of the underlying position and the risk exposure:

i) The use of the forward exchange market and the creation of a money market hedge

Purchasing Power Parity (PPP theory)

Why do exchange rates fluctuate?

“The law of one price”

Illustration

Item costs $1,000
$2:€ (base)
However inflation in US is 5% and Europe is 3%

According to law of one price what is the predicted exchange rate in 1 year?

  • Solution

    So next year - Item in US costs $1,050 and in Europe €515
    “The law of one price” = $1,050 = €515

    So, forward exchange rate = 1,050 / 515 = $2.039:€1

    PPPT “High inflation leads to depreciation of currency”

  • Another way of calculating this is as follows:

    Exchange rate now (counter) x (1+ Inf (counter) / 1 + inf (base))

    2 x 1.05 / 1.03 = 2.039

Limitations

  1. Future inflation is an estimate

  2. Market is ruled by speculative not trade transactions

  3. Governments often intervene

Interest Rate Parity (IRP theory)

Why do exchange rates fluctuate? 
An investor will get the same amount of money back no matter where he deposits his money

Illustration

US Interest rate = 10%
European Interest rate = 8%
Exchange rate = $2:€

Investor has $1,000 to invest for 1 year

What is the future exchange rate as predicted by IRPT?

  • Solution

    In US he will receive $1,100 in one years time
    In Europe he will receive €540
    Forward rate will therefore be 1,100 / 540 = $2.037:€

    IRPT “High interest rates leads to depreciation of currency”

  • Another way of calculating this is as follows:

    Exchange rate now x (1+ Int (counter) / 1 + int (base))

    2 x 1.10 / 1.08 = 2.037

Limitations

  1. Government intervention

  2. Controls on currency trading