International Finance Lecture 9 – Currency Derivatives – 1

The lecture is presented to Donghua University CIP students. Subject: International Finance

Hello dear class and welcome to our ninth lecture series on international finance and i’m your instructor jamal hyder so before starting the new chapter i’m gonna be you know uh playing this video and this is the debt crisis of united states of america and it is explained in a very simple way so let’s watch that i’m gonna be turning off my video hurry meet uncle

Sam he has a lot of bills to pay almost four trillion dollars worth every year uncle sam’s income is a little over two trillion dollars per year to make up the difference the deficit he does what most americans do he borrows money when uncle sam takes out a loan he calls it a bond bonds can be held by banks investors or even foreign governments uncle sam has to

Promise to pay interest on these bonds just as you do on any loan you take out ever think about paying your mortgage with your credit card that’s exactly what uncle sam does he takes out new loans new bonds so that he can make payments on the old ones all those loans and especially all that interest adds up right now uncle sam owes about 14 trillion dollars to put

That in perspective 14 trillion is about the same as the national gdp the total value of all the goods and services produced by the american economy in an entire year it’s such a huge amount of money that uncle sam is starting to run out of people to borrow from and he’s having trouble just paying the interest on his loans the obvious solution would be to either

Cut spending or increase taxes but if he cuts spending the people that he’s spending money on would complain that they don’t have money to spend and that he was hurting the economy if he tried to raise taxes enough to close this gap not only would people definitely have less money to spend he’d probably have riots on his hands so uncle sam chooses the easy way

To make money just make it he calls up the federal reserve which is our central bank and like magic dollars are created and deposited in banks all around america the problem is that the more of something there is the less it’s worth same goes for the us dollar the more dollars there are the less each one will buy that’s why commodities like gasoline food and

Gold become more expensive when uncle sam does his money making magic the commodities aren’t really worth more your money is just worth less that’s called inflation remember the foreign governments that lent money to uncle sam when they lent money to the american government something interesting happened it made the us look richer and their countries look

Poorer when a country looks poor compared to america one dollar of our money buys a lot of their money so they can pay their workers only a few pennies a day with such low labor costs they can sell their products in america for lower prices than any american manufacturer can the easiest way for american companies to compete is to move their factories overseas

And pay their workers a few pennies a day too this contributes to a recession americans lose their jobs stop paying taxes and start collecting government benefits like medicaid and unemployment this means that uncle sam has even less income and even more expenses at the same time the people who still have jobs are desperate to keep them so they tend to do more

Work but not to get paid anymore when your dollars are worth less and you’re not earning more of them that’s called stagflation and this is why uncle sam is in a catch-22 he can’t raise taxes or cut spending without making the recession worse and he can’t have the federal reserve create more money without making inflation worse for now he can keep borrowing

Money but since he can’t even pay the interest on the loans he already has it just makes his inevitable bankruptcy even worse whether it’s in two months or two years the day will come when uncle sam can no longer pay his bills when that happens the banks investors and foreign governments who are counting on that money won’t be able to pay their bills you see

Just like uncle sam governments banks and corporations don’t actually have much money mostly all they have is debt to each other if one link in the debt chain stops paying defaults the whole thing falls apart if investors can’t pay their bills corporations won’t be able to pay their employees if banks can’t pay their bills you won’t be able to take out a loan

Use a credit card or even withdraw your savings if foreign governments can’t pay their bills their own banks and corporations will have the same problems that’s called a global economic collapse it’s never happened before so nobody really knows how bad it will be how long it will last or even how we’ll eventually get out of it the house of cards has already been

Built there’s no painless way to dismantle it now all we can do is to educate each other about what’s actually going on and to prepare for what may be very extraordinary circumstances okay today we will start chapter number five which is currency derivatives and we’ll try to cover this two learning objectives number one explain how power contracts are used to

Hedge based on the anticipated exchange rate movements and then describe how currency futures contracts are used to speculate or hedge based on anticipated exchange rate movements so we are not going to spend more time on what are the con forward contracts and what are the future contracts we already studied that so the real crux of this chapter is to find out

How we are going to use and let me remind you one thing this is a little bit advanced finance that you are studying right now so feel you know yourself that you are mastering something because this is a real knowledge and if you go for professional studies like like cfa or cpa or ca so there you will learn these as well so also if you go to some master degree

In in finance or financial economics you will also study this concept over there so i’m gonna be explaining explaining all these in a very nice slow and very detailed explanation so that you can understand so don’t worry about that that’s my job to make you understand so let’s move there we go yes so what are the currency derivatives let me just repeat one more

Time and that is a currency derivative is a contract whose price is derived from the value of underlying accuracy it means the value of the contract depends on some other things if this is currency then value depends on currency if that is stock derivative then it then the value depends on stock price since we are learning currency derivatives we’ll talk about

The derivatives in terms of currencies so examples there are three types of derivatives forward future contracts and options contract and how we are going to use the derivative first of all we can use it for speculation and we can use for hedging our exposure against currency movement or exchange rate risk so are we clear on these definitions right yes yes

Pretty much the the previous one isn’t it which one yeah we already studied about basic definitions of currency derivatives future forward and options but this lecture in the indeed in this chapter as well we are talking about how we are going to use that okay so that’s why i spent a lot of time on that lecture to make you understand that because in this lecture

We will talk about a lot of numericals like that so let’s talk about the number one that is forward market a forward contract or forward market contract is an agreement between a corporation and a financial institutions it can also be between individual for example currency dealers and all the stuff we can be using for like speculation purposes okay number one

How it works to exchange specific amount of money amount of currency at a specified exchange rate we call that power rate and on a specified time period so it means a forward contract is for a time period with agreed upon the forward rate in the contract and it must have specified the currency right dollars euro yen qn right pound it’s like that plus it is

The agreement it means agreement is obligatory it’s not the optional agreement it is agreement you must obligate this contract so how a company or wealthy individuals they can use the forward contracts first of all hedge means reduce the risk they hatch their imports by locking in a rate at which they can obtain currency so this is very fancy words locking up

It means they are just entering into a contract we call that locking right because when you enter into a contract and you cannot back off it means you are locked so that’s why this is a financial terminology you are locked in a contract okay and why they use that because of bit express is wider for less liquid currencies if you want to do for mexican peso and

You want to do transaction of mild manual pieces

Transcribed from video
International Finance Lecture 9 – Currency Derivatives – 1 By Dr Jamal Naqvi