Intro
Hedging
Speculating
Forward Premium
The forward point premium is the additional value of a given currency against another, when the forward and spot rates are compared. For example, if spot JPY-USD is 0.009189 and the corresponding 180-day forward rate is 0.009360, JPY trades at a 171-point premium.
The forward premium can also be calculated in percentage terms. In this case, the annualised 180-day JPY premium is 3.72% = [(9360-9189)/9189] x 360/180. The forward premium reflects the interest rate differential between USD and JPY.
In this example, short-term interest rates are lower in JPY than in USD, which explains the forward premium of JPY. The forward rate makes it impossible for arbitrageurs to take advantage of interest rates differentials without risk.
Risk Premia
The difference between the expected return on a security or portfolio and the "riskless rate of interest" (the certain return on a riskless security) is often termed its risk premium. Underlying the terminology is the notion that there should be a premium (higher expected return) for bearing risk. As we will see, however, there is no reason why such premia should be associated with all types of risk.
An equivalent definition of a risk premium is: the expected excess return on a security or portfolio, where excess return is the difference between an actual return and that of a riskless security.
International investment without cover
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Covered interest parity
Covered interest rate parity (CIRP) is a theoretical financial condition that defines the relationship between interest rates and the spot and forward currency rates of two countries. It establishes the fact that there is no opportunity for arbitrage using forward contracts, which are often used to make loose profits by exploiting the difference in interest rates. It holds that the difference in interest rates should equal the forward and spot exchange rates.
Eurocurrency
Eurocurrency is currency held on deposit by governments or corporations operating outside of their home market. For example, a deposit of U.S. dollars (USD) held in a British bank would be considered eurocurrency, as would a deposit of British Pounds (GBP) made in the United States.
Purchasing power parity
PPPs are the rates of currency conversion that equalize the purchasing power of different currencies by eliminating the differences in price levels between countries. In their simplest form, PPPs are simply price relative that show the ratio of the prices in national currencies of the same good or service in different countries. PPPs are also calculated for product groups and for each of the various levels of aggregation up to and including GDP.
Relative PPP
Relative Purchasing Power Parity (RPPP) is an expansion of the traditional purchasing power parity (PPP) theory to include changes in inflation over time. Purchasing power is the power of money expressed by the number of goods or services that one unit can buy, and which can be reduced by inflation. RPPP suggests that countries with higher rates of inflation will have a devalued currency.
Bandwagon effect
The bandwagon effect is the tendency of people to take certain actions or arrive at a conclusion primarily because other people are doing so. The phenomenon is observed in various fields, such as economics, politics, and psychology. Financial markets are no different.
Overshooting
In economics, overshooting, also known as the exchange rate overshooting hypothesis, is a way to think about and explain high levels of volatility in currency exchange rates using the concept of price stickiness.
- The overshooting model establishes a relationship between sticky prices and volatile exchange rates.
- The model's main thesis is that prices of goods in an economy do not immediately react to a change in foreign exchange rates.
- Instead, a domino effect first impacts other factors—such as financial markets, money markets, derivatives markets, and bond markets—which then transfers its influence onto the prices of goods.