1) Define spot, forward, and swap transactions in the foreign exchange market and give an example...
1) Define spot, forward, and swap transactions in the foreign exchange market and give an example of how each could be used.
2) The Big Mac is considered a good candidate for the application of the law of one price and measurement of under or overvaluation of a currency. Develop an argument as to why this is a good idea.
3) Does foreign currency exchange hedging both reduce risk and increase expected value? Explain, and list several arguments in favor of currency risk management and several against.
Homework Answers
1]
A spot transation in the foreign exchange market is where one currency is exchanged for another at the prevailing spot (current) exchange rate.
This could be used by a tourist who needs currency of the country to which they are travelling. For example, a US tourist travelling to Europe could exchange US dollars for Euros at the spot exchange rate.
2]
A forward transation in the foreign exchange market is where a specified quantity of one currency is exchanged for another at a specified exchange rate on a specified future date.
For example, a US company which needs to pay 10,000 Euros to a supplier after 6 months could enter into a forward contract to exchange its US dollars for Euros after 6 months at the specified forward exchange rate.
3]
A swap transation in the foreign exchange market is where two parties exchange the notional principal (each denominated in different currencies) and each party pays interest to the other party on the notional principal.
For example, a US company which has a Euro-denominated loan could enter into a swap transaction with a swap dealer such that its Euro-denominated loan is effectively converted into a dollar-denominated loan, thus hedging the company's foreign exchange risk
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