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Foreign Exchange Products and Drawbacks and Limitations of the Markowitz Portfolio Theory

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This assignment is structured in two chapters. Firstly, a summary of foreign exchange products: FX forwards, FX futures, FX options and currency swaps. Secondly, drawbacks and limitations of the Markowitz portfolio theory.

The download includes the complete assignment in docx and pdf. The documents are well structured and correctly formatted.

  • Date: 2017-07-17
  • Author: Raúl Bartolomé Castro
  • Program: Distance Learning MBA
  • Module: International Financial Management

Description

Table of Contents

1 Foreign Exchange Products 3

1.1 FX Forwards 3

1.2 FX Futures 3

1.3 FX Options 3

1.1 Currency Swaps 3

1.2 Summary 4

2 Drawbacks and Limitations of the Markowitz Portfolio Theory 5

2.1 Improbable Events 5

2.2 Financial Markets Correlation 5

2.3 Transaction Cost 5

2.4 Investor Utility 5

2.5 Estimation Errors 5

2.6 Normal Distribution 6

2.7 Multi-period Framework 6

2.8 Other Views of Risk 6

2.9 Summary 7

3 References 8

4 Acronyms 10

5 Appendices 11

5.1 Introduction to Mean-Variance Portfolio Theory 11

List of Tables

Table 1 Summary of Foreign Exchange Products 4

Table 2 Summary of Drawbacks and Limitations of the Markowitz Portfolio Theory Foreign Exchange Products 7

Foreign Exchange Products

FX Forwards

FX forward are legally binding contracts, usually with a bank, to buy or sell an amount of foreign currency for a specific exchange rate at certain time in the future. They don’t require money up front. The closed of the contracts usually is settle on T+2 on cash or delivery basis. The contracts are over-the-counter (OTC) and do not trade on an Exchange (Gandolfo 2016, p. 22; Investopedia 2017; Societe Generale 2017).

FX Futures

FX futures are legally binding contracts to buy or sell a standard amount of foreign currency for a specific exchange rate at certain time in the future. The contracts are established with the Exchange, usually with a central counterparty clearing house (CCP) that assumes most of the credit risk. They don’t require money up front. The can be closed any time before expiration (Eiteman, et al. 2016, p. 202; Gandolfo 2016, p. 29; Investopedia 2017).

FX Options

FX options are legally binding contracts that can be sold or bought. Two types:

  • Call option that grants to the buyer (the holder of the option) the right to purchase a currency at specified price at expiration date or earlier[1].
  • Put option, the complementary to the call option, that grants to the buyer the right to sell a currency at specified price at expiration or earlier.

The buyer needs to put money up front to purchase the option, so called premium. The contracts usually are traded in an Exchange. They are regulated and standardized by strike price, maturity date of the underlying assets (Eiteman, et al. 2016, p. 205; Federici & Gandolfo 2016, p. 49).

Currency Swaps

Currency swaps are legally binding contracts between two companies to exchange cash flows in different currencies for an agreed period. The cash flow usually proceeds from a corporate loan, at the beginning of the currency swaps the counterparties exchange the principal of the loan. During the duration of the contract they exchange the interest payment. At maturity, they exchange back the principals to revert the initial transaction (Eiteman, et al., 2016, p. 247; Investopedia, 2017).

Summary

Table 1 presents a summary of previous discussion.

Table 1 Summary of Foreign Exchange Products

 

FX Forwards

FX Futures

FX Options

Currency Swaps

Money up front

No

No

Premium

Principal

Operations

Buy

Sell

Buy (long)

Sell (short)

Buy (long) call

Buy (long) put

Sell (short) call

Sell (short) put

Exchange of principals and interest

Traded

OTC (bank)

Exchange

Exchange or OTC

OTC (swap dealer)

Contract fees

Bank’ charges (bid/offer spread)

Broker’ charges

Broker’ charges

Swap dealer’s charges

Closing contract

Difficult (closed at expiration date)

Easy (can be closed prior to delivery)

Easy (can be closed prior to delivery)

Difficult (closed at expiration date)

Market

Opaque (private transaction)

Transparent (information publically available)

Transparent (information publically available)

Opaque (private transaction)

Customized contract

Yes (tailored to customer needs)

No (standardized contract)

No (standardized contract)

Yes (tailored to customer needs)

Regulation

Low

High

High

Low

Financial instrument

Derivative

Derivative

Derivative

Derivative

Underlying asset

Currency

Currency

Currency

Currency

Drawbacks and Limitations of the Markowitz Portfolio Theory

Improbable Events

Taleb (2001) defines the black swan theory. A black swan even is characterized by (i) rarity, a shocking event, (ii) extremeness, an event with mayor relevance and (iii) retrospective predictability, understanding the event after it happened, rationalized by hindsight.

He argues that modern portfolio theory (MVPT) is not better than its inputs, does not predict securities prices and only minimizes risk in terms of variance for an expected return. Taleb supports a portfolio where the investors protect the portfolio to extreme and improbable black swan evens rather than expected (Eiteman, et al., 2016, pp. 526-727).

Financial Markets Correlation

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