Important Concepts

Covered interestarbitrage:              Buying a country’scurrency spot and selling it forward to make a net profit off the combinationof higher interest rates in the country and/or any forward premium on itscurrency.

Covered interestparity:                   When theforward rate on a nation's currency exceeds the spot rate by the samepercentage that its interest rate is lower than the other country’s interestrate.

Coveredinternational investment: When the exchange rate at which anticipated foreigninvestment returns will be redeemed is locked in today through a forwardcontract. The agent is protected from exchange rate risk when “covered.”

Currency futures:                             Contracts to buy orsell 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. Thedifference lies in their form. While forward contracts are tailored to theneeds of the customer in terms of amount of funds, due-date of contract, and soon, futures contracts have standardized denominations and due dates. As aconsequence, they can be traded in organized markets such as the ChicagoMercantile Exchange. Almost anyone with some up‑front funds can enter into afutures contract; only very large firms get forward contracts from their banks.

Currency options:                             A currencyoptions contract gives parties the right (but not the requirement) to buy/sellforeign 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 theright to sell the currency at the “strike price.” A person expecting a foreigncurrency to become pricier in the future might buy a call option; a personexpecting the currency to fall in value might buy a put option.

Exchange raterisk:                          When thevalue of an economic agent’s income, wealth, or net worth changes as exchangerates change unpredictably in the future.

Future spot rate:                              The spot exchangerate that will end up prevailing at some date in the future.

Hedging:                                           Theact of exactly matching assets and liabilities, such as foreign currencies, soas to avoid exchange rate risk.

Long position:                                   A net assetposition (e.g., owning a foreign currency).

Short position:                                  A net liabilityposition (e.g., owing a foreign currency).

Speculation:                                      Deliberatelyassuming a net asset (long) position or net liability (short) position in anasset, such as a foreign currency, in the hope of profiting from price changes.

Uncoveredinterest parity:                When the expectedrate of appreciation of a currency equals the amount by which its interest rateis lower than the other country’s interest rate.

Uncovered international investment:When the exchange rate at which anticipatedforeign investment returns will be redeemed is not determined until the tradeoccurs at the future spot rate. The agent is exposed to exchange rate risk when“uncovered.”