International Economics: Pugel Ch. 18

Covered interest arbitrage

Buying a country's currency spot and selling it forward to make a net profit off the combination of higher interest rates in the country and/or any forward premium on its currency.

Covered interest parity

When the forward rate on a nation's currency exceeds the spot rate by the same percentage that its interest rate is lower than the other country's interest rate.

Covered international investment

When the exchange rate at which anticipated foreign investment returns will be redeemed is locked in today through a forward contract. The agent is protected from exchange rate risk when "covered."

Currency futures

Contracts to buy or sell a foreign currency on a specific date in the future at a price set today. In this sense, futures are exactly like forward exchange contracts. The difference lies in their form. While forward contracts are tailored to the needs of the customer in terms of amount of funds, due-date of contract, and so on, futures contracts have standardized denominations and due dates. As a consequence, they can be traded in organized markets such as the Chicago Mercantile Exchange. Almost anyone with some up front funds can enter into a futures contract; only very large firms get forward contracts from their banks.

Currency options

Gives parties the right (but not the requirement) to buy/sell foreign exchange in the future at a price set today. If someone purchases a "call option," she buys the right to obtain the currency at the "strike price" at a given date in the future. A person purchasing a "put option" buys the right to sell the currency at the "strike price." A person expecting a foreign currency to become pricier in the future might buy a call option; a person expecting the currency to fall in value might buy a put option.

Exchange rate risk

When the value of an economic agent's income, wealth, or net worth changes as exchange rates change unpredictably in the future.

Future spot rate

The spot exchange rate that will end up prevailing at some date in the future.

Hedging

The act of exactly matching assets and liabilities, such as foreign currencies, so as to avoid exchange rate risk.

Long position

A net asset position (e.g., owning a foreign currency).

Short position

A net liability position (e.g., owing a foreign currency).

Speculation

Deliberately assuming a net asset (long) position or net liability (short) position in an asset, such as a foreign currency, in the hope of profiting from exchange rate changes.

Uncovered interest parity

When the expected rate of appreciation of a currency equals the amount by which its interest rate is lower than the other country's interest rate.

Uncovered international investment

When the exchange rate at which anticipated foreign investment returns will be redeemed is not determined until the trade occurs at the future spot rate. The agent is exposed to exchange rate risk when "uncovered."

Exchange Rate Risk

A person holding a net asset position (a long position) or a net liability position (a short position) in a foreign currency is exposed to _____. The value of the person's income or net worth will change if the exchange rate changes in a way that the person does not expect.

Hedging

the act of balancing your assets and liabilities in a foreign currency to become immune to risk resulting from future changes in the value of foreign currency.

Speculating

taking a long or a short position in a foreign currency, thereby gambling on its future exchange value.

Forward Exchange Contract

an agreement to buy or sell a foreign currency for future delivery at a price (the forward exchange rate) set now. Useful because they provide a straightforward way to hedge an exposure to exchange rate risk or to speculate in an attempt to profit from future spot exchange rate values. An interesting hypothesis that emerges from the use of the forward market for speculation is that the forward exchange rate should equal the average expected value of the future spot rate.

covered international investment

If the rate at which the future sale of foreign currency will occur is locked in now through a forward exchange contract.

uncovered international investment

If the future sale of foreign currency will occur at the future spot rate, it is exposed to exchange rate risk and therefore speculative.