The Foreign Exchange Market

Conceptual Questions 1. Value Date: The settlement of a transaction takes place by transfers of deposits between two parties. The day on which these transfers are effected is called the Settlement Date or the Value Date. 2. Spot Rate: When the exchange of currencies takes place on the second working day after the date of the deal, it is called spot rate. 3. Forward Transactions: If the exchange of currencies takes place after a certain period from the date of the deal (more than 2 working days), it is called a forward rate. A trader may quote a forward transaction for any future date. It is a binding contract between a customer and dealer for the purchase or sale of a specific quantity of a stated foreign currency at the rate of exchange fixed at the time of making the contract. 4. Swap Transaction: A swap transaction in the foreign exchange market is combination of a spot and a forward in the opposite direction. Thus a bank will buy DEM spot against USD and simultaneously enter into a forward transaction with the same counter party to sell DEM against USD against the mark coupled with a 60- day forward sale of USD against the mark. As the term swap implies, it is a temporary exchange of one currency for another with an obligation to reverse it at a specific future date. 5. Bid Rate: The bid rate denotes the number of units of a currency a bank is willing to pay when it buys another currency. 6. Offer Rate: The offer rate denotes the number of units of a currency a bank will want to be paid when it sells a currency.

7. Bid - Offer Rate: The bid offer Rate is the rate which states both, the price which is the bank is willing to pay to buy other currencies and the price the bank expects when it sells the same currency. Bid and Ask will always be from a banks point of view. Thus (A/B)bid will denote the number of units of A the bank will pay when it buys one unit of B and (A/B)ask will mean the number of units of A the bank will want to be paid in order to sell one unit of B. 8. European Quote: The quotes are given as number of units of a currency per USD. Thus DEM1.5675/USD is a European quote. 9. American Quotes: American quotes are given as number of dollars per unit of a currency. Thus USD0.4575/DEM is an American quote. 10. Direct Quotes: in a country, direct quotes are those that give unit of the

currency of that country per unit of a foreign currency. Thus INR 35.00/USD is a direct quote in India. 11. Indirect Quote: Indirect or Reciprocal Quotes are stated as number of

units of a foreign currency per unit of the home currency. Thus USD 3.9560/INR 100 is an indirect quote in India. 12. Arbitrage: Arbitrage may be defined a san operation that consists in

deriving a profit without risk from a differential existing between different quoted rates. It may result from 2 currencies, also known as, geographical arbitrage or from 3 currencies, also known as, triangular currencies. II Descriptive questions 1. What is foreign exchange? In a business setting, there is a fundamental difference between making payment in the domestic market and making payment abroad. In a domestic transaction, only one currency is used while in a foreign transaction, two or more currencies maybe used.

Suppose an U.S importer has agreed to purchase a certain quantity of Indian spices and to pay the Indian exporter Rs. 1000000 for it. How would he go about doing this? He would have to pay the amount in dollars, which will be equivalent to its existing rate in rupees at a decided date. That is why the foreign exchange market comes into existence so that such transactions become possible and easier. The special checks and other instruments for making payment abroad are referred to collectively as foreign exchange. In other words, Foreign exchange includes currencies and other instruments of payment denominated in currencies. 2. What is foreign exchange market? Explain the functions. Answer: In a business setting, there is a fundamental difference between making payment in the domestic market and making payment abroad. In a domestic transaction, only one currency is used while in a foreign transaction, two or more currencies maybe used. The foreign exchange market is the market in which currencies are brought and sold against each other it is the largest market in the world. The foreign exchange market also known, as forex market is an over-the-counter market, this means that there is no single market place or an organized exchange like a stock exchange. The traders sit in the foreign exchange dealing room of major commercial banks around the world, they communicate with each other through telephone telex computer terminals and other electronic menace of communication. They are four main participants in the foreign exchange market. 1. Broker 2. Bankers 3. Corporations 4. Central bank. Bankers: large commercial banks operating either at retail level for individual exporters and corporations or at wholesale level in the InterBank market.

Central bank: central banks of various countries that intervene in order to maintain or to influence the exchange rate of their currencies within a certain range as also to execute the orders of government. Individual brokers or corporations: bank dealers often used brokers to stay anonymous since the identity of banks can influence short-term course. Foreign Exchange Flow

Exports

Corporations

Broker

Bank

Broker

Bank

Broker

Corporations

Imports

3. Elaborate the structure of the foreign exchange market and compare it with the foreign exchange of India Answer: The Foreign exchange market may be broadly classified into -: Wholesale market and Retail market .

I G

R M E A T RA

KI L E

M T

WHOLESALE MARKET (primary price maker) The wholesale market is also referred to as interbank market the average transaction size in this market is very small. Participants: Commercial banks, Corporations and Central bank Among these participants, primary price maker or professional dealer make a two way market to each other & their clients, i.e. on request they will quote a two-way price & be prepared to take either the buy or sell side .This group mainly include commercial bank but some large investment dealer & a few large corporation have also assumed the role of primary dealers. Primary price makers perform an important role in taking positions off the hands of another dealer or corporate customer & then offsetting these by doing an opposite deal with another entity which has a matching requirement.

Among primary price maker there is a kind of tiering

MULTINATIONAL BANK

(deal in large number of currencies & in large amount without using broker )

LARGE BANKS (deal in small number of currencies & use the services of broker ) LOCAL INSTITUTION (market in a small number currencies against home currency ) RETAIL MARKET (Secondary price maker ) It is the market in which travelers & tourists exchange one currency for another in the form of currency notes & travelers cheques. Total turnover & transaction size is very small. The bid-ask spread is large. The secondary price maker make foreign exchange prices but do not make a two way market . Foreign currency brokers Foreign currency brokers act as middlemen between two market makers. Their main function is to provide information to market making banks about prices at which there are firm buyers & sellers in a pair of currencies. The broker hunts around for an appropriate counterparty another bank - & collects commission on conclusion of deal. Banks may also use brokers to acquire information about the general state of the market even when they do not have a specific deal in mind. The important thing is brokers do not sell or buy on their own account. of major

Price takers Price takers are those take the prices quoted by primary price makers & buy or sell currencies for their own purposes but do not make a market themselves. Large corporations are the price taker who use the foreign exchange market for a variety of purposes related to their operations. They do not take active positions in the market to profit from exchange rate fluctuations. Central bank Central bank of various countries (such as RBI in India) intervene in the market from time to time to attempt to move exchange rates in a particular direction. In case of limited flexibility systems like EMS, these interventions are obligatory when interventions are reached. In other cases though there is no commitment to defend any particular rate, a central bank may still intervene to influence market sentiment. The structure of foreign exchange market in India The foreign exchange market in India may broadly said to have 3 segments or layers :First layer consists of the Central bank i.e. RBI & the Authorized dealers (ADs). ADs are mostly commercial banks &Financial institutions such as IDBI, ICICI & the travel agent like Thomas cook. Second layer is the inter bank segment in which ADs deal with each other. Third layer is in which ADs deal with their corporate customers . In retail market in addition to ADs there are moneychangers who are allowed to deal in foreign currencies. Full fledged money changers are allowed to buy & sell foreign currency & restricted money changers are allowed only to buy. The daily turn over in the foreign exchange market is currently estimated to be between US $ 1.5- 3 billion. The most important centre is Mumbai whereas other active centres are Delhi, Calcutta, Chennai, Cochin & Bangalore Indian market also has accredited brokers who match buyers & sellers. FEDAI i.e. Foreign Exchange Dealers Association of India has made it mandatory to route deals between two ADs through brokers .

4.Define the value date and classify the transactions into spot and forward transactions based on value date Answer: Value Date: A settlement of any transaction takes place by transfers of deposits between the two parties. The day on which these transactions are effected is called the settlement date or the value date. Settlement location: To effect the transfers, the banks in the countries of the two currencies involved must be open for business. The relevant countries are called settlement locations. Dealing locations: The location of the two banks involved in the trade is dealing locations, which need not be the same as the settlement locations. Classification of transaction based on value date

Types of transaction

Cash T + 0

Tom T +1

Spot T + 2

Forward T+3

Where T represents the current day when trading takes place and n represents number of days. Cash Cash rate or Ready rate is the rate when the exchange of currencies takes place on the date of the deal itself. There is no delay in payment at all, therefore represented by T + 0. When the delivery is made on the day of the contract is booked, it is called a Telegraphic Transfer or cash or value day deal. Tom It stands for tomorrow rate, which indicates that the exchange of currencies takes place on the next working day after the date of the deal, and therefore represented by T+ 1. Spot When the exchange of currencies takes place on the second day after the date of the deal (T+2), it is called as spot rate. The spot rate is the rate

Cash

quoted for current foreign currency transactions. It applies to interbank transactions that require delivery on the purchased currency within two business days in exchange for immediate cash payment for that currency. For e. g. a London bank sells yen against dollar to a Paris bank on Monday, 1st march, the London bank will turn over yen deposit in Japan to the Paris bank on Wednesday and the Paris bank will turn over $ deposit in US to the London bank on same day i. e. 3rd march, Wednesday. If the 3rd march is holiday in any bank in dealing location or settlement location deposit will takes place on next business day. Forward The forward rate is a contractual rate between a foreign exchange trader and the traders client for delivery of foreign currency sometime in the future. Here rate of transaction is fixed on transaction date for transactions in future. Standard forward contract maturities are 1,2,3,6, 9, and 12 months. e. g. 1 month forward purchase of pounds against dollars on 1st Jan. Value date is arrived as follows: Value date for spot transaction: 3rd Jan. Value date for forward transaction: 3rd Jan + 1 calendar month = 3rd Feb If the 3rd Feb. is holiday in any bank in dealing location or settlement location deposit will takes place on next business date. But this must not take you for next month, for e. g. if value date is Feb 28 is value date and it is ineligible your cannot shift it to 1 st March it must be rolled back to Feb 27. Swap: A swap transactions in the foreign exchange market is combination of spot and forward transaction. Thus a bank will buy deutchemarks spot against US dollar and simultaneously enter into forward transaction with the same counterparty to sell deutchemarks against US dollar. 5. Elaborate the structure of the foreign exchange market and compare it with the foreign exchange of India

The major participants in the foreign exchange markets are commercial banks; foreign exchange brokers and other authorized dealers, and the monetary authorities. It is necessary to understand that the commercial banks operate at retail level for individual exporters and corporations as well as at wholesale levels in the inter bank market. The foreign exchange brokers involve either individual brokers or corporations. Bank dealers often use brokers to stay anonymous since the identity of banks can influence short term quotes. The monetary authorities mainly involve the central banks of various countries, which intervene in order to maintain or influence the exchange rate of their currencies within a certain range and also to execute the orders of the government. It is important to recognize that, although the participants themselves may be based within the individual countries, and countries may have their own trading centers, the market itself is world wide. The trading centers are in close and continuous contact with one another, and participants will deal in more than one market. Primarily, exchange markets function through telephone and telex. Also, it is important to note that currencies with limited convertibility play a minor role in the exchange market. Besides this, only a small number of countries have established their full convertibility of their currencies for full transactions. The foreign exchange market in India consists of 3 segments or tires. The first consists of transactions between the RBI and the authorized dealers. The latter are mostly commercial banks. The second segment is the interbank market in which the ADs deal with each other. And the third segment consists of transactions between ADs and their corporate customers. The retail market in currency notes and travelers cheques caters to tourists. In the retail segment in addition to the ADs there are moneychangers, who are allowed to deal in foreign currencies. The Indian market started acquiring some depth and features of well functioning market e.g. active market makers prepared to quote twoway rates only around 1985. Even then 2 - way forward quotes were generally not available. In the interbank market, forward quotes were even in the form of near term swaps mainly for ADs to adjust their positions in various currencies. Apart from the ADs currency brokers engage in the business of matching sellers with buyers. In the interbank market collecting a commission from both.

FEDAI rules required that deals between ADs in the same market centers must be effected through accredited brokers. 6. Write a note on Inter bank dealing Primary dealers quote two way prices and are willing to deal either side, i.e. they buy and sell the base currency up to conventional amounts at those prices. However, in interbank markets this is a matter of mutual accommodation. A dealer will be shown a two-way quote only if he / she extends the privilege to fellow dealers when they call for a quote. Communications between dealers tend to be very terse. A typical spot transaction would be dealt as follows: BANK A : Bank A calling. Your price on mark dollar please. BANK B : Forty forty eight. BANK A : Ten dollars mine at forty eight. Bank A dealer identifies and asks himself for Bs DEM/USD. Bank A is dealing at 1.4540/1.4548. The first of these, 1.4540, is bank Bs price for buying USD against DEM or its bid for USD; it will pay DEM 1.4540 for every USD it buys. The second 1.4548, is its selling or offer price for USD, also called ask price; it will charge DEM 1.4548 for very USD it sells. The difference between the two, 0.0008 or 8 points is bank Bs bid offer or bid ask spread. It compensates the bank for costs of performing the market making function including some profit. Between dealers it is assumed that the caller knows the big figure, viz. 1.45. Bank B dealer therefore quotes the last two digits (points) in her bid offer quote viz. 40 48. Bank A dealer whishes to buy dollars against marks and he conveys this in the third line which really means I buy ten million dollars at your offer price of DEM 1.4548per US dollar. Bank B is said to have been hit on its offer side. If the bank A dealer wanted to sell say 5 million dollars, he would instead said Five dollars yours at forty. Bank B would have been hit on its bid side. When a dealer A calls another dealer B and asks for a quote between a pair of currencies, dealer B may or may not wish to take on the resulting position on his books. If he does, he will quote a price based on his information about the current

market and the anticipated trends and take the deal on his books. This is known as warehousing the deal. If he does not wish to warehouse the deal, he will immediately call a dealer C, get his quote and show that quote to A. If A does a deal, B will immediately offset it with C. This is known as back-to-back dealing. Normally, back-to-back deals are done when the client asks for a quote on a currency, which a dealer does not actively trade. In the interbank market deals are done on the telephone. Suppose bank A wishes to buy the British pound sterling against the USD. A trader in bank A might call his counterpart in bank B and asks for a price quotation. If the price is acceptable they will agree to do the deal and both will enter the details- the amount bought/sold, the price, the identity of the counter party, etc.-in their respective banks computerized record systems and go to the next transaction. Subsequently, written confirmations will be sent containing all the details. On the day of the settlement, bank A will turn over a US dollar deposit to bank B and B will turn over a sterling deposit to A. The traders are out of the picture once the deal is agreed upon and entered in the record systems. This enables them to do deals very rapidly. In a normal two-way market, a trader expects to be hit on both sides of his quote amounts. That is in the pound dollar case above. On a normal business day the trader expects to buy and sell roughly equal amounts of pounds / dollars. The bank margin would then be the bid ask spread. But suppose in the course of trading the trader finds that he is being hit on one side of hiss quote much more often than the other side. In the pound dollar example this means that he is buying many more pounds that he selling or vie versa. This leads to a trader building up a position. If he has sold / bough t more pounds than he has bought/ sold he is said to have a net short position / long position in pounds. Given the variability of exchange rates, maintaining a large net short or long position in pounds of 1000000. The pound suddenly appreciates from say $1.7500 to $1.7520. This implies that the banks liability increases by $2000 ($0.0020 per pound for 1 million pounds. Of course pound depreciation would have resulted in a gain. Similarly a net long position leads to a loss if it has to be covered at a lower price and a gain if at a higher price. (By covering a position we mean undertaking transactions that will reduce the net position to zero. A trader net long in pounds must sell pounds to cover a net short must buy pounds. A potential gain or loss from a position depends upon the size of the position and the variability of exchange

rates.

Building and carrying such net positions for a long duration would be

equivalent to speculation and banks exercise tight control over their traders to prevent such activity. This is done by prescribing the maximum size of net positions a trader can build up during a trading day and how much can be carried overnight. When a trader realizes that he is building up an undesirable net position he will adjust his bid ask quotes in a manner designed to discourage on type of deal and encourage the opposite deal. For instance a trader who has overbought say DEM against USD, will want to discourage further sellers of marks and encourage buyers. If his initial quote was say DEM/USD 1.7500 1.7510 he might move it to 1.7508 1.7518 i.e offer more marks per USD sold to the bank and charge more marks per dollar bought from the bank. Since most of the trading takes place between market making banks, it is a zero sum game, i.e. gains made by one trader are reflected in losses made by another. However when central banks intervene, it is possible for banks as a group to gain or lose at the expense of the central bank. Bulk of the trading of the convertible currencies. Takes place against the US dollar. Thus quotations for Deutschemarks, Swiss Francs, yen, pound sterling etc will be commonly given against the US dollar. If a corporate customer wants to buy or sell yen against the DEM, a cross rate will be worked out from the DEM/USD and JPY/USD quotation. One reason for using a common currency (called the vehicle currency) for all quotations is to economize on the number of exchange rates. With 10 currencies 54 two-way quotes will be needed. By using a common currency to quote against, the number is reduced to 9 or in general n 1ss. Also by this means the possibility of triangular arbitrage is minimized. However some banks specialize in giving these so called cross rates.

7. Define arbitrage and explain the different types of arbitrage. Sometimes companies deal in foreign exchange to make a profit, even though the transaction is not connected to any other business purpose, such as trade flows or investment flows. Usually, however, this type of foreign exchange activities is

more likely to be persuaded by foreign exchange traders and investors. One type of profit seeking activity is arbitrage, which is the purchase of foreign currency on one market for immediate resale on another market (in a different country) in order to profit from a price discrepancy. Hence, arbitrage may be defined as an operation that consists in deriving a profit without risk from a differential existing between different quoted rates. It may result from two currencies (also known as geographical arbitrage) or from three currencies (also known as triangular arbitrage). Interest arbitrage involves investing in foreign bearing instruments in foreign exchange in an effort to earn a profit due to interest rates differentials. For example, a trader may invest $ 1000 in the United States for ninety days or convert $1000 into British pounds, invest the money in the United Kingdom for ninety days and then convert the pounds back into dollars. The investor would try to pick the alternative that would be the highest yielding at the end of ninety days. But Speculation is the buying or the selling of the commodity i.e. foreign currency, where the activity contains both the element of risk and the chances of a greater profit. Speculators are important in the foreign exchange market because they spot trends and try to take advantage of them. Thus they can be a valuable source of both supply and demand for a currency. As a protection against risk, foreign exchange transactions can be used to hedge against a potential loss due to an exchange rate change.

Spot Quotations: Arbitraging between Banks: Though one hears the term market rate, it is not true that all banks will have identical quotes for a given pair of currencies at a given point of time. The rates will be close to each other but it may be possible for a corporate customer to save some money by shopping around.

Inverse quotes and 2 point arbitrage: The arbitrage transaction that involve buying a currency in one market and selling it at a higher price in another market is called Two point Arbitrage. Foreign exchange markets quickly eliminate two point arbitrage opportunities if and when they arise.

Cross rates and 3 point arbitrage: The term three point arbitrage refers to the kind of transaction where one starts with currency A, sell it for B, sell B for C and finally sell C back for A ending up with more A than one began with. Efficient foreign exchange markets do not permit risk - less arbitrage profit of this kind.

Numerical Examples 1. An Arbitrage between two Currencies. Suppose two traders A and B are quoting the following rates: Trader A (Paris) Trader B (New York) FFr 5.5012/US$ US $ 0.1817/FFr We assume that the buying and selling rates for these traders are the same. We find out the reciprocal rate of the quote given by the trader B, which is FFr 5.5036 / US $ (= 1/0.1817) .A combiste buys, say, US $ 10,000 from the trader A by paying FFr 55,012. Then he sells these US $ to trader B and receives FFr 55,036. in the process he gains FFr 24 (=55,036 - 55,012).

Since, in practice buying and selling rates are likely to be different, so the quotation is likely to be as follows: Trader A Trader B FFr 5.4500/US $ - FFr 5.5012 US $ US $ 0.1785/FFr - US $ 0.1817/ FFr

These rates mean that trader A would be willing to buy one unit of US dollar by paying FFr 5.45 while he would sell one US dollar for FFr 5.501. The same holds true for the corresponding figures of trader B. But this process would tend to increase the selling rate at the trader A because of the increase in demand of US dollars and the reverse would happen at the trader B because of increased supply of US dollars. This would lead to an equilibrium after some time. 2.An Arbitrage between three currencies Suppose two traders, both located at New York are quoting as follows: Trader A Trader B $ 0.60/SF $ 0.60/SFr $ 0.51 DM $ 0.52 DM Since three currencies are involved here, we find the cross rates between SFr and DM as well. These are: SFr 0.85/DM (= 0.51/0.60) at the trader A and SFr 0.867/DM (= 0.52/0.60) at the trader B. Thus, the situation looks like as follows: Trader A Trader B $ 0.60/SFr $ 0.60/SFr $ 0.51/DM $ 0.52/DM SFr 0.85/DM SFr 0.867/ DM Hence what are the arbitrage possibilities? There is no arbitrage gain possible between the US $ and the Swiss franc.

The following two arbitrages are, however possible. a. Deutschmarks against the US $ is being quoted at the trader B. So buy DMs from the trader A and sell them to trader B. b. Buy DMs against SFrs from the trader A and sell them to the trader B. 8. Examine clearly the different types of forward transactions and describe discount and premium evaluation in forward quotations. Outright forward quotation: Some of the major currencies quoted in the forward market are Deutschmarks, Pound sterling, Japanese yen, Swiss franc, Canadian dollar etc. they are generally quoted in terms of US dollars. Currencies may be quoted in terms of one, three, six months and one year forward. But enterprises may obtain form banks quotations for different periods. As mentioned earlier, the spot market is for foreign exchange transactions within two business days. However, some transactions maybe entered into on one day but not completed until after two business days. For example, a French exporter of perfume might sell perfume to an US importer with immediate delivery but payment not required for thirty days. The US importer is obligated to pay in francs in thirty days and may enter into a contract with a trader to deliver francs in thirty days at a forward rate, a rate today for future delivery. Thus the forward rate is the rate quoted by foreign exchange traders for the purchase or sale of foreign exchange in the future. The difference between the spot and the forward rates is known as either the forward discount or the forward premium on the contract. If the domestic currency is quoted on a direct basis and the forward rate is greater than the spot rate, the foreign currency is selling at a premium. It is calculated as follows: Forward discount/ premium = Forward mid Spot mid * 12/n * 100 Spot mid Where n indicates the number of months forward.

When Fwd rate > Spot rate, it implies premium. Fwd rate < Spot rate, it implies discount. In the case of forward market, the arbitrage operates in the differential of interest rates and the premium or discount on exchange rates. Numerical problems 1. Spot 1-month 3-months 6-months (FFr/US$) 5.2321/2340 25/20 40/32 20/26 In outright terms these quotes would be expressed as below: Maturity Bid/Buy Sell/Offer/Ask Spread Spot FFr 5.2321 per US $ FFr 5.2340 per US $ 0.0019 1-month FFr 5.2296 per US $ FFr 5.2320 per US $ 0.0024 3-months FFr 5.2281 per US $ FFr 5.2308 per US $ 0.0027 6-months FFr 5.2341 per US $ FFr 5.2366 per US $ 0.0025 It may be noted that in the forward deals of one month and 3 months, US $ is at discount against the French franc while 6 months forward is at a premium. The first figure is greater than the second both in one month and three months forward quotes. Therefore, these quotes are at a discount and accordingly these points have been subtracted from the spot rates to arrive at outright rates. The reverse is the case for 6 months forward. 2. We take an example of a quotation for the US $ against Rupees, given by a trader in New Delhi. Spot 1-month 3-months 6-months Rs 32.1010-Rs32.1100 225/275 300/350 375/455

Spread 0.0090 0.0050 0.0050 0.0080 The outright rates from these quotations will be as follows: Maturity Bid/Buy Sell/Offer/Ask Spread Spot Rs 32.1010 per US $ Rs 32.1100 per US $ 0.0090 1-month Rs 32.1235 per US $ Rs 32.1375 per US$ 0.0140 3-months Rs 32.1310 per US $ Rs 32.1450 per US $ 0.0140 6-months Rs 32.1385 per US $ Rs 32.1555 per US $ 0.0170 Here we notice that the US $ is at a premium for all three forward periods. Also, it should be noted that the spreads in forward rates are always equal to the sum of the spread of the spot rate and that of the corresponding forward points. Numerical problems and solutions 1. On a particular date the following DEM/$ spot quote is obtained from a bank: -1.6225/35 a) Explain this quotation. question, the initial figure i.e. 1.6225 being the bid rate and the latter being the ask rate. Also it shows the number of DEM used to buy or sell one US dollar i.e. the bank will pay 1.6225 DEM for each US dollar it buys and will want to be paid 1.6235 DEM for each US dollar it sells. b) Compute implied inverse quote. $/DEM becomes 0.6159/63 (1/1.6235 = 0.6159 and 1/ 1.6225 = 0.6163) Ans. The above quotation shows the bid rate and the ask rate of the currencies in

Ans. When DEM/$ is 1.6225/35, the implied inverse quote is:

c)

Another bank quoted $/DEM 0.6154/59. Is there an arbitrage? If so how would it work?

Ans. Suppose Bank A quotes $/DEM 0.6154/59 and Bank B quotes $/DEM 0.6159/63. There is no arbitrage opportunity since the main purpose of doing an arbitrage is making a profit without any risk or commitment of capital. This doesnt exist in the given case as a potential buyer would end up buying a DEM at 0.6159 $ from Bank A and would have to sell it to Bank B at the same price since that would be the only way of not making any losses. It is clear form the diagram shows that shows no arbitrage is possible: $/DEM 0.6154 Bank A 59 Bank B 63

2. The following quotes are obtained from the banks: Bank A FFr/$ spot i. 4.9570/80 Bank B 4.9578/90

Is there an arbitrage opportunities be represented

Ans. There is no arbitrage opportunity in this case. This can diagrammatically as: FFr/$ 4.9570 78 80 90

Bank A Bank B

The quotes are overlapping each other hence preventing an arbitrage. The buyer will go into a loss if he buys from bank A at 4.9580 FFr since he would have to sell it to bank B for 4.9578 FFr undergoing a loss of 0.0002 FFr.

b) What kind of market will it result into? Ans. This will result into a one way market. c) What might be the reason for this? Ans. A one way market may be created when a bank wants to either encourage the seller of dollars and discourage buyers or vice versa. In this case, Bank A wants to encourage buyers of dollars and discourage sellers of the same thus creating a net long positioning dollars. At the same time Bank B wants to encourage the sellers of dollars and discourage buyers thus creating a net short position in dollars. Hence the outcome would be that Bank A will be confronted largely with buyers of US dollars and few sellers while for Bank B the reverse case will hold true. Eventually, it would mean that regular clients of Bank B wanting to buy dollars can save some money by going to Bank A and vice versa. 3. In London a dealer quotes: DEM/ GPB spot 3.5250/55 JPY/ GPB spot 180.0080/181.0030 a) What do you expect the JPY/ DEM rate to be in Frankfurt? JPY/ GPB spot 180.0080/181.0030 Therefore, JPY/ DEM = B1 A1 A2 [where B1 - 180.0080 B2 A1 181.0030 B2 - 3.5250 A2 3.5255] = 180.0080 3.5255 181.0030 3.5250 Ans. In London: DEM/ GPB spot 3.5250/55

= 51.0588 / 51.3483 JPY/ DEM It is assumed that the JPY/ DEM rate in Frankfurt will also approximately be the same as in London. Therefore, the JPY/ DEM rate in Frankfurt is 51.0588 / 51.3483.

b)

Suppose that in Frankfurt you get a quote: JPY/ 51.2250. Is there an arbitrage opportunity?

DEM spot 51.1530/

Ans.

When in London: JPY/ DEM 51.0588 / 51.3483 and In Frankfurt: JPY/ DEM 51.1530/ 51.2250 There is no arbitrage opportunity as the quotes overlap each other and the buyer will stand to make a loss. If he buys in Frankfurt where 1 DEM is 51.2250 JPY and sells it in London for 51.0588 JPY, he makes a loss of 0.1662JPY. Diagrammatically it can be represented as:

JPY/ DEM 51.0588 Frankfurt London

.1530

.2250

.3483

4. The following quotes are obtained in New York: DEM/$ spot 1.5880/ 90 1- month forward 10/ 5 2- month forward 20/ 10 3- month forward 30/ 15 Calculate the outright forward rates. Ans. While observing the forward quotations, it is clear that the US dollar is at discount in the forward market since the points corresponding to the bid price are higher than those corresponding to the ask price. Therefore, the forward points will be subtracted form the spot rate figure. Thus, the outright rates are: DEM/$ spot - 1.5880/ 90 1 month forward - 1.5870/ 85 2 month forward - 1.5860/ 80 3 month forward - 1.5850/ 75

Text Book Questions The Foreign Exchange Market I. Explain the following terms: 1. Bid rate: The bid rate denotes the number of units of a currency a bank is willing to pay when it buys another currency. 2. Offer rate: The offer rate denotes the number of units of a currency a bank will want to be paid when it sells a currency 3. Bid offer spread: The difference between the ask and bid rates. E.g. [(DEM/USD)ask (DEM/USD)bid] 4. Value date: The settlement of a transaction takes place by transfers of deposits between two parties. The day on which these transfers are effected is called the Settlement Date or the Value Date. 5. Swap transaction: A swap transaction in the foreign exchange market is combination of a spot and a forward in the opposite direction. Thus a bank will buy DEM spot against USD and simultaneously enter into a forward transaction with the same counter party to sell DEM against USD against the mark coupled with a 60- day forward sale of USD against the mark. As the term swap implies, it is a temporary exchange of one currency for another with an obligation to reverse it at a specific future date. II Explain the terms: a) European quotes: The quotes are given as number of units of a currency per USD. Thus DEM1.5675/USD is a European quote. b) American quotes: American quotes are given as number of dollars per unit of a currency. Thus USD0.4575/DEM is an American quote

c)

Direct quotes: In a country, direct quotes are those that give unit of the

currency of that country per unit of a foreign currency. Thus INR 35.00/USD is a direct quote in India. d) Indirect quotes: Indirect or Reciprocal Quotes are stated as number of units

of a foreign currency per unit of the home currency. Thus USD 3.9560/INR 100 is an indirect quote in India. e) On a particular day at 11.00 am, the following DEM/$ spot quote is obtained from a bank 1.6225/35. a). Explain this quotation. Ans. The above quotation shows the bid rate and the ask rate of the currencies in question, the initial figure i.e. 1.6225 being the bid rate and the latter being the ask rate. Also it shows the number of DEM used to buy or sell one US dollar i.e. the bank will pay 1.6225 DEM for each US dollar it buys and will want to be paid 1.6235 DEM for each US dollar it sells. b) Compute implied inverse quote. Ans. When DEM/$ is 1.6225/35, the implied inverse quote is: $/DEM becomes 0.6159/63 (1/1.6235 = 0.6159 and 1/ 1.6225 = 0.6163) c). Another bank quoted $/DEM 0.6154/59. Is there an arbitrage? If so how would it work? Ans. Suppose Bank A quotes $/DEM 0.6154/59 and Bank B quotes $/DEM 0.6159/63. There is no arbitrage opportunity since the main purpose of doing an arbitrage is making a profit without any risk or commitment of capital. This doesnt exist in the given case as a potential buyer would end up buying a DEM at 0.6159 $ from Bank A and would have to sell it to Bank B at the same price since that would be the only way of not making any losses. It is clear form the diagram shown below that shows no arbitrage is possible: $/DEM 0.6154 Bank A 59 Bank B 63

III. The following quotes are obtained from the banks: Bank A FFr/$ spot 4.9570/80 Bank B 4.9578/90

a) Is there an arbitrage opportunities Ans. There is no arbitrage opportunity in this case. This can be represented diagrammatically as: FFr/$ 4.9570 Bank A Bank B The quotes are overlapping each other hence preventing an arbitrage. The buyer will go into a loss if he buys from bank A at 4.9580 FFr since he would have to sell it to bank B for 4.9578 FFr undergoing a loss of 0.0002 FFr. b) What kind of market will it result into? Ans. This will result into a one way market. c) What might be the reason for this? Ans. A one way market may be created when a bank wants to either encourage the seller of dollars and discourage buyers or vice versa. In this case, Bank A wants to encourage buyers of dollars and discourage sellers of the same thus creating a net long positioning dollars. At the same time Bank B wants to encourage the sellers of dollars and discourage buyers thus creating a net short position in dollars. Hence the outcome would be that Bank A will be confronted largely with buyers of US dollars and few sellers while for Bank B the reverse case will hold true. Eventually, it would mean that regular clients of Bank B wanting to buy dollars can save some money by going to Bank A and vice versa. 78 80 90

IV. The buyer rate for SFr spot in New York is $ 0.5910. A corporate treasurer is going to buy SFr in Zurich at SFr/$ 1.6650 and sell them in New York. Will he make a profit? If yes, then how much? Ans. The steps involved in this process are as follows: i. Buys 1.6650SFr at Zurich by paying 1$ ii. Sells 1.6650 SFr at New York and gets 0.9840$ [0.5910*1.6650] Thus, gives 1$ and gets 0.9840$. Therefore loss inculcated is $0.016. V. In London a dealer quotes: DEM/ GPB spot 3.5250/55 JPY/ GPB spot 180.80/181. 30 a) What do you expect the JPY/ DEM rate to be in Frankfurt? Ans. In London: DEM/ GPB spot 3.5250/55 JPY/ GPB spot 180.80/181.30 Therefore, JPY/ DEM = B1 A2 A1 B2 [where B1 - 180.80 A1 181.30 B2 - 3.5250 A2 3.5255] = 180.80 3.5255 181.30 3.5250

= 51.2835/ 51.4326 JPY/ DEM It is assumed that the JPY/ DEM rate in Frankfurt will also approximately be the same as in London. Therefore, the JPY/ DEM rate in Frankfurt is 51.2835/ 51.4326 b) Suppose that in Frankfurt you get a quote: JPY/ DEM spot 51.1530/ 51.2250. Is there an arbitrage opportunity? Ans. When in London A: JPY/ DEM 51. 2835/ 51.4326 and In Frankfurt B: JPY/ DEM 51.1530/ 51.2250 There exist an arbitrage opportunity, buy from the dealer from Frankfurt at 51.2550JPY and sell it to the dealer in London at 51.2835JPY making a profit of 0.0285JPY/DEM without any risk of commitment of capital. It can be shown as : At B + DEM -51.2550 JPY

At A -DEM

+51.2835 JPY

i. +0.0285JPY Another arbitrage that is possible is shown as under: At A buy DEM i.e. DEM At B +x +51.2835 JPY -51.2550 JPY

X = 51.2835/51.2550 = 1.0006 DEM Therefore, arbitrage of 0.0006 DEM is possible. VI. The following quotes are obtained in New York: $/GPB = 1.5275/85 SFr/ $ = 1.5530/35 a. what rates do you expect for SFr/ GPB spot in London? Ans. In New York $/GPB = 1.5275/85 And Therefore Also in New York: SFr/GPB =B1 A2 0.6547 1. Therefore SFr/GPB = 2.3720/2.3746 It is assumed that the spot rate in London will approximately same as that in New York. Therefore, in London SFr/GPB spot is assumed to be 2.3720/2.3746. b. If a London bank quotes 2.3730/40, can you make arbitrage profits? If so, then how? Ans. In London SFr/GPB 2.3730/40 B2 A1 1.5285 0.6542 SFr/$ =1.5530/35 GPB/$ =0.6542/0.6547

=1.5275

In New York SFr/GPB 2.3720/2.3746 In this case, an arbitrage opportunity does not exist. It is clearly seen below in the diagram:

SFr/GPB

2.3720

3730

3740

3746 London

New York VII. The following quotes are obtained in New York: DEM/$ spot 1.5880/ 90 1- month forward 10/ 5 2- month forward 20/ 10 3- month forward 30/ 15 Calculate the outright forward rates. Ans. While observing the forward quotations, it is clear that the US dollar is at discount in the forward market since the points corresponding to the bid price are higher than VIII The following quotes are available in Amsterdam: $/DG spot 1- month fwd 2-month fwd 3- month fwd :0.5875/85 :12/18 :15/25 :20/30

Calculate the outright forward. Ans. An observation of the figures indicates that the first figure is lower than the second in all the three forward quotes, implying DG is quoted at premium in the forward market. Thus, the points will be added to the corresponding spot rates. The rates are calculated as shown: $/DG spot 1-month fwd 2-month fwd 3-month fwd :0.5875/58 :0.5887/0.5903 :0.5890/0.5910 :0.5895/0.5915

those corresponding to the ask price. Therefore, the forward points will be subtracted form the spot rate figure. Thus, the outright rates are:

DEM/$ spot - 1.5880/ 90 1 month forward - 1.5870/ 85 2 month forward - 1.5860/ 80 3 month forward - 1.5850/ 75