Using Derivatives to Hedge Foreign Exchange Risk and Maintain Stable Purchasing Power Parity

This report evaluates the use of derivatives contracts such as forward contract, future contract, call option and put options against the purchasing power parity and international fisher effect. Learn how to use these derivatives to hedge foreign exchange risk and maintain stable purchasing power parity.

RUNNING HEAD: International financial management
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Name of student
Topic- International financial management
University-

International financial management 2
Executive Summary
` In this report, evaluation of the different ways of derivatives has been taken into
consideration. There are several derivatives tools such as forward contract, future contract,
call option and put options. These derivatives tools are used to overcome the foreign
exchange risk and overcome the risk arise from the eexpected change among the exchange
rate of two currencies

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Table of Contents
Executive Summary...............................................................................................................................2
Introduction...........................................................................................................................................3
International fisher effect......................................................................................................................3
Purchasing power parity........................................................................................................................4
How derivatives could be used to protect against the failing of purchasing power parity and
International fisher effect......................................................................................................................4
Conclusion.............................................................................................................................................6
References.............................................................................................................................................7

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Introduction
This study is conducted with aim of using derivatives in the management in relation to
foreign exchange exposure and purchasing power parity of the people. In this report, use of
derivatives contracts such as forward contract, future contract, call option and put options
against the purchasing power parity and international fisher effect have been taken into
consideration.
International fisher effect
It is the economic theory that states that the expected changes among the exchange
rate of two currencies are equivalents to their countries’ nominal rates. It is observed that if
investors could eliminate these exchange change risk by entering into contract at the
stipulated rate. This theory focuses on the concept that real interest rates are independent of
other monetary variables such as changes in the particular nation’s monetary policy, better
indication of the health of the currency and lower interest rate. The IFE provides assumption
regarding the countries with the lower interest rates that if these countries have lower interest
rate than they will have lower interest rate and vice-versa (Wilmott, & Orrell, 2017).

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Purchasing power parity
The purchasing power parity could be defined as economic theory that reflects the
exchange rate between two countries which are equal to the ratio of currencies’ respective
purchasing power (Ghamami& Glasserman, 2017).
How derivatives could be used to protect against the
failing of purchasing power parity and International
fisher effect
It is observed that the currency derivatives are the financial derivatives whose payoffs
depend upon the foreign exchange rate of the two different countries. These derivatives could
be used to for the currency speculation arbitrage or hedging the foreign exchange risk. This
could be defined with the below example that if derivatives are used then investors could
easily eliminate the failing of International fisher effect and purchasing power parity of
country (Lin, Pantzalis, & Park, 2017).
Firstly, we have to take the assumption of Euro and Dollar impact. It is analysed by
undertaking the proper example of the EURO and Dollar currency exchange. It is observed
that if 100 quantity of the US is being purchased by the investors by using the forward
contract then they entered into foreign exchange transactions at the stipulated rate which will
assist them to save from the foreign exchange risk exposure (Hattori, 2017).

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This could be understood that due to the EURO financial crises the value of the
EURO went down and investors who were having the EURO in their account had to face the
decrease in their value investment while converting into other currency. On the contrary to
that the purchasing power parity of the Euro currency also went down which reflects that the
decreased value of the Euro on international level will also decrease the purchasing capacity
of the investors. Therefore, by using the derivatives contract like forward contract, future
contract, call option and put options, investors could lock the exchange rate at the stipulate
rate for their transaction. This will not only save investors from the changes in the foreign
exchange rate but also reduce the uncertainty of the business (Mururu, 2017).
On the contrary to that, International fisher effect shows that the expected changes
among the exchange rate of two currencies are equivalents to their countries’ nominal rates.
By using the derivatives contract like forward contract, future contract, call option and put
options, investors could easily enter into future contract at the spot foreign exchange rate. It
will not only reduce the uncertainty of the foreign exchange rate but also strengthen the
currency value of the country. Investor could use these contracts to enter into stipulate price
to avoid the possible ups and down in the currency value of the countries. This derivatives
contracts hedge their currency risk by creating shield for maintaining the stable purchasing
power parity (Gupta, 2017).

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Fair value hedge is another derivative contract which is undertaken by the investors to
make the interest rate swap in the interest rate of two countries. This will not only save the
international foreign risk exposure but also assists investors to create arbitrage profit. This is
the profit which is created by investors by investing in the two different securities and
establishes the swap between two currency values. This process is ideally used to hedge the
foreign exchange risk by entering into future and forward contract. This derivatives contract
allows investors to enter into the future transactions and book the exchange rate at the
stipulated rate irrespective of the changes in the foreign exchange rate of two currencies.
However, these derivatives contracts are mostly used by investors when they have prior
intuition that the currency value of other country will increase as compared to its base
currency value. This will not only save them from the possible investment risk but also assist
in creating the arbitrage profit when the currency exchange rate moves in the positive side
(Contreras, Rodríguez, & Sosa, 2017).,
Conclusion
Now in the end, it could be inferred that proper use of derivatives contracts could be
used to hedge foreign exchange risk, maintain the stable purchasing power parity of the
investors and results to arbitrage profit if all the foreign currency value factors are positive.

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References
Contreras, J., Rodríguez, Y. E., & Sosa, A. (2017). Construction of an efficient portfolio of
power purchase decisions based on risk-diversification tradeoff. Energy Economics, 64,
286-297.
Ghamami, S., & Glasserman, P. (2017). Does OTC derivatives reform incentivize central
clearing?. Journal of Financial Intermediation, 32, 76-87.
Gupta, S. L. (2017). Financial Derivatives: Theory, concepts and problems. PHI Learning
Pvt. Ltd..
Hattori, T. (2017). Does swap-covered interest parity hold in long-term capital markets after
the financial crisis?.
Lin, J. B., Pantzalis, C., & Park, J. C. (2017). Corporate derivatives use policy and
information environment. Review of Quantitative Finance and Accounting, 49(1), 159-
194.
Mururu, B. M. (2017). Hedging foreign exchange rate risk using currency futures: A case of
Kenyan multinational firms.
Wilmott, P., & Orrell, D. (2017). Deriving Derivatives. The Money Formula: Dodgy Finance,
Pseudo Science, and How Mathematicians Took Over the Markets, 83-107.