foreign exchanges

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Chapter 2
The Foreign
Exchange Market
www.themegallery.com
Learning Objectives
Summarize the fundamental
underpinnings of the foreign exchange
market.
Explain the distinctions between
various measures of the exchange rate.
Differentiate the roles of hedging,
arbitrage, and speculation in foreign
exchange markets.
Describe the links between the current
spot rate and contracts to buy or sell
foreign exchange in the future.
Foreign Exchange Market
A market where “foreign exchanges”
are bought and sold against one
another.
 Foreign exchanges include foreign
currencies and interbank deposits
denominated in various currencies.
FX rates determine the price of each
(domestic) currency in terms of other
(foreign) currencies.
The Function and Structure of the
FX Market
Introduction
 FX markets comprise all financial
transactions denominated in foreign
currency;
 Facilitate exchange of value from one
currency to another;
 Internationally adopted FX market
conventions to improve market
functionality.
The Function and Structure of the
FX Market
Transfer of purchasing power due to
international trade and capital
transactions;
Provide financial services to support
international trade;
Provide hedging facilities for
managing foreign exchange risk.
The Function and Structure of
the FX Market
The FX market is extremely
competitive, worldwide in scope and
the trading of currencies is
unrestricted (due to the abolition of
capital control).
 FX is needed because every international
transaction requires a foreign exchange
transaction.
 Largest and most perfect market.
 It is an over-the-counter (OTC) market as
participants rarely meet and actual currencies
are rarely delivered physically.
Participants in the FX market
Four board categories can be summarized:
Banks and foreign exchange dealers:
• Operate in interbank and client market
• Market makers
Individuals and firms:
• Individual, commercial or investment
transactions
• hedging exchange rate risk
Participants in the FX market
Include those who buy and sell foreign
exchanges directly or indirectly.
Arbitragers exploit exchange rate anomalies in
an attempt to reap profits
 Buy at a low price and sell at a high price
Hedgers enter the market to cover open
positions
 They protect against possible exchange rate risk
Speculators take open positions
 They deliberately bear the risk to make a profit
Banks play a very important role in the market.
Participants in the FX market
Central banks and treasuries
 acts as bankers for their government.
 Use the market to acquire or spend their
country’s foreign reserves to influence
the exchange rate.
 Profitability is not the priority here.
FX Market Participants
The FX market is a two-tiered market:
 Interbank Market (Wholesale)
• About 700 banks worldwide stand ready to
make a market in foreign exchange.
• Nonbank dealers account for about 20% of
the market.
• There are FX brokers who match buy and
sell orders but do not carry inventory and
FX specialists.
 Client Market (Retail)
Market participants include international banks,
their customers, nonbank dealers, FX brokers,
and central banks.
BIS: Triennial Central Bank Survey
(April 2010)
 Size: Average daily turnover of USD 4.0 trillion
 Activity: Cross-border transactions represent 65%
of trading activity while local transactions account
for 35%.
 FX market turnover: UK 36.7%; United States 18%;
 Japan 6%; Singapore 5%; Switzerland 5%; Hong
Kong SAR 5%; and Australia 4%.
 Currency: USD 85%; Euro 39%; Yen19%; GBP 13%
 Currency pairs: USD/EUR 28%; USD/JPY 14%;
USD/GBP 9%
Global foreign exchange market turnover by instrument
Average daily turnover in April, in billions of US dollars
Instrument
1998
Foreign exchange instruments
2001
2004
2007
2010
1,527
1,239
1,934
3,324
3,981
Spot transactions²
568
386
631
1,005
1,490
Outright forwards²
128
130
209
362
475
Foreign exchange swaps²
734
656
954
1,714
1,765
10
7
21
31
43
87
60
119
212
207
1,705
1,505
2,040
3,370
3,981
11
12
26
80
166
Currency swaps
Options and other products³
Memo:
Turnover at April 2010 exchange rates 4
Exchange-traded derivatives
5
Currency distribution of global foreign exchange market turnover
Percentage shares of average daily turnover in April 2010
Currency
US dollar
Euro
Deutsche mark
French franc
ECU and other EMS currencies
Slovak koruna2
Japanese yen
Pound sterling
Australian dollar
Swiss franc
Canadian dollar
1998
2001
86.8
...
30.5
5.0
16.8
...
21.7
11.0
3.0
7.1
3.5
2004
89.9
37.9
...
...
...
0.0
23.5
13.0
4.3
6.0
4.5
2007
88.0
37.4
...
...
...
0.0
20.8
16.5
6.0
6.0
4.2
2010
85.6
37.0
...
...
...
0.1
17.2
14.9
6.6
6.8
4.3
84.9
39.1
...
...
...
...
19.0
12.9
7.6
6.4
5.3
Global foreign exchange market turnover by currency pair
Daily averages in April, in billions of US dollars and percentages
1998
2001
2004
2007
2010
Currency pair
Amount
USD/EUR
USD/DEM
USD/FRF
USD/XEU
USD/OthEMS
USD/JPY
USD/Oth
USD/GBP
USD/AUD
USD/CAD
USD/CHF
EUR/JPY
EUR/GBP
EUR/Oth
.
309
60
17
178
292
140
122
44
52
82
.
.
.
%
.
20
4
1
12
19
9
8
3
3
5
.
.
.
Amount
372
.
.
.
.
250
152
129
51
54
59
36
27
17
%
30
.
.
.
.
20
12
10
4
4
5
3
2
1
Amount
541
.
.
.
.
328
251
259
107
77
83
61
47
35
%
28
.
.
.
.
17
13
13
6
4
4
3
2
2
Amount
892
.
.
.
.
438
498
384
185
126
151
86
69
83
%
27
.
.
.
.
13
15
12
6
4
5
3
2
2
Amount
1,101
.
.
.
.
568
445
360
249
182
168
111
109
102
%
28
.
.
.
.
14
11
9
6
5
4
3
3
3
Correspondent Banking
Relationships
Large commercial banks maintain
demand deposit accounts with one
another which facilitates the efficient
functioning of the FX market.
Correspondent Banking
Relationships
Bank A is in London, Bank B is in New York.
The current exchange rate is £1.00 = $2.00.
A currency trader employed at Bank A buys
£100m from a currency trader at Bank B for
$200m settled using its correspondent
relationship.
Bank A
London
$200m
£100m
Bank B
NYC
Correspondent Banking
Relationships
Bank A
London
Assets
$200m
£ deposit at B £300m B’s Deposit $1,000m
£400m
$1,200m
$ deposit at B $800m B’s Deposit £200m
$600m
Other Assets £600m Other L&E
NYC
£100m
Liabilities
£100m
£600m
Total Assets £1,300m Total L&E £1,300m
Bank B
Assets
Liabilities
£100m
A’s Deposit £300m
£400m
A’s Deposit $800m
$600m
$800m
Other L&E $800m
Total Assets $2,200m
Total L&E $2,200m
$ deposit at A $1000m
$1200m
£ deposit at A £200m
Other Assets
The Foreign Exchange Rate
and the Market for Foreign
Exchange
Foreign exchange rate: the price
of one currency in terms of
another.
•e.g., US$/€ or €/US$
The foreign exchange rate is
determined by the interaction of
demand for and supply of foreign
exchange.
The foreign exchange market is
the worldwide network of markets
and institutions that exchange
currencies
The Market for Foreign
Exchange
S€
$/€
Initially, Qeq euros are
traded, and the
equilibrium price is eeq.
eeq
D€
Qeq
Euros (€)
The Market for Foreign
Exchange
S€
$/€
An increase in U.S.
demand for euros
causes an appreciation
of the euro.
e'eq
eeq
D€
Qeq Q'eq
D'€
Euros (€)
The Market for Foreign
Exchange
S€ S'€
$/€
An increase in the
supply of euros
causes a depreciation
of the euro.
eeq
e'eq
D€
Qeq Q'eq
Euros (€)
The Market for Foreign Exchange:
Demand
wishing to buy goods
and services from or
send gifts or payments
to another country.
wishing to profit
from exchange rate
changes
(speculation).
Foreign
exchange is
demanded
by those
wishing to purchase
financial assets in a
nother country.
wishing to
minimize risk from
exchange rate
changes
(hedging).
The Market for Foreign Exchange:
Supply
selling goods and
services to or receiving
gifts or payments from
another country.
wishing to profit
from exchange rate
changes
(speculation).
Foreign
exchange is
supplied by
those
in other countries w
ho wish to purchase
financial assets in t
he home country.
wishing to
minimize risk from
exchange rate
changes
(hedging).
The Market for Foreign
Exchange: Supply
The total supply and demand for
foreign exchange includes two
components.
One is related
to current
account
transaction.
The other is
related to
financial
flows,
including
speculation
and hedging.
The Market for Foreign
Exchange
SG&S
STotal
$/€
The total equilibrium
exchange rate will
only be the same as
the one for G&S if
the current account is
exactly in balance.
eeq
DG&S
Qeq
DTotal
Euros (€)
Transactions
in the foreign exchange Market
The Spot Market
The spot market involves almost the
immediate purchase or sale of foreign
exchange.
 have maturity date two business days after the
FX contract is entered into
Cash transaction e.g. exchange of AUD100
for US$ at a moneychanger.
The Spot Transactions
A Spot transaction in the foreign
exchange market is the purchase of
foreign exchange, with delivery and
payment is normally on the second
following business day.
The date of settlement is referred to as
the value date.
value date has three types: Value
Spot/VAL SP; Value Tomorrow/VAL TOM;
Value Today/VAL TOD.
Spot transaction
Procedure of Spot transaction
― Inquiry
When a bank needs to transact foreign exchange with
other banks, trader should firstly inquire to other banks by
telephones, telex
― Quotation
quotation is the linchpin segment of forex, because it
relates to whether the forex could be bought or sold.
― Making
a deal
when quotation banks report the price, enquiry banks
should give the reply whether to buy or sell, and the quantity.
― Confirmation
If the reply is “OK, Done”, The two parties also should
confirm the sort of currencies, exchange rate, quantity, value
date and settlement methods etc.
― Delivery
Spot transaction example
Bank A:HI BANK OF A CALLING SPOT
GBP AGAINST USD PLS
Bank B:65/95
Bank A:MINE USD3
Bank B:OK DONE WE SELL USD3AGAINST
GBP AT 1.6765 VALUE 16/2/06 GBP
TO BKL BK FOR OUR A/C 123456
Bank A:USD TO KKY BK FOR OUR A/C 654321
Spot Rate Quotations
Like the price of any commodity, the
exchange rate is an expression of the value
of one unit of a currency (the commodity) in
terms of another currency (the unit of
account).
S(x/y) is the price (in terms of x) of one unit
of y
1
S (x y ) =
S ( y x)
Spot Rate Quotations
Direct quotation refers to the
domestic currency price of one unit
of the foreign currency (normal or
price quotation) (AUD/USD = 1.25).
Indirect quotation refers to the
foreign currency price of one unit of
the domestic currency (quantity or
volume quotation) (USD/AUD = 0.80).
A quote that is direct to one country
is indirect to another.
Currency Conversion
To convert from y to x, multiply by the
exchange rate.
To convert from x to y, divide by the
exchange rate.
Examples – given S(USD/AUD) = 0.80
+ To convert AUD100 into USD, we get:
AUD100 * 0.80 = USD80
+ To convert USD100 into AUD, we get
USD100/0.80 = AUD125
Exchange Rate Changes
 When the exchange rate changes between 2 points
in time from S0(x/y) to S1(x/y), the % change in the
exchange rate (change in the value of y) is
measured as:


S
x
y
1
S  x y  
-1
S0  x y 
S  y x  
1
-1
1  S  x y 
 To express as a percentage, we then multiply by 100
Example (direct quotations)
Suppose that the exchange rate between
the Australian dollar and British pound
stands at S(AUD/GBP) = 3.57, and then
falls to S(AUD/GBP) = 3.52.
As such, S0(AUD/GBP) = 3.57 and
S1(AUD/GBP) = 3.52, implying that the AUD
has appreciated
 We can calculate the percentage
depreciation in the British pound as
( AUD / GBP)
S
3.52
1
S (AUD GBP)=
-1 =
- 1 = -0.0140
S0 ( AUD / GBP)
3.57
Example (indirect quotations)
Suppose that the exchange rate between
the Australian dollar and British pound
stands at S(GBP/AUD) = 0.2801, and then
rises to S(GBP/AUD) = 0.2840.
Again, it implies that the AUD has
appreciated
 We can calculate the percentage
appreciation in the AUD as
SGBP AUD  S1 GBP / AUD - 1  0.2840- 1  0.0140
S0 GBP / AUD
0.2801
The Bid-Ask (offer) Spread
When dealers attempt to strike a deal,
they quote exchange rates in terms of
two numbers, known as the two-way
quote.
 The bid rate is the rate at which the
quoting dealer is willing to buy.
 The ask rate is the rate at which the
quoting dealer is willing to sell.
The Bid-Ask Spread
A dealer could offer
 bid price of $1.25 per €
 ask price of $1.26 per €
 While there are a variety of ways to
quote that,
The bid-ask spread represents the
dealer’s expected profit.
The Bid-Ask Spread
big
figure
small figure
Bid
Ask
S(£/$)
1.9072
1.9077
S($/£)
.5242
.5243
A dealer would likely quote these
prices as 72-77.
It is presumed that anyone trading
$10m already knows the “big figure”.
Points and Pips
Exchange rate quotations are measured in
points and pips
A point is one-hundredth of a cent (or a
penny)
 0.01/100 = 0.0001 (i.e. the fourth decimal place)
 In the previous example, the spread is 0.0003, or
3 points
The bid and ask rates may be quoted as the
number of points only (the last 2 decimals)
 In the previous example, 1.2078-81.
A pip is one-tenth of a point
 0.0001/10 = 0.00001 (i.e. the fifth decimal place).
How the media report
exchange rates
In its issue of the 17 March 2009, The
Age reported the following exchange
rates provided by the Westpac
Banking Corporation on 16 March
2009:
buy
sell
USD 0.6649 0.6451
EURO 0.5179 0.4987
Yen 65.71
63.10
How the media report exchange
rates
This is very confusing. Maybe the
officer was drunk when he made the
decision.
But why the bid rates are higher than
the offer rates?
Surely a market maker such as
Westpac wants to buy low and sell high.
How the media report exchange
rates
The clarify this, we have to determine how the
exchanges rates are expressed and to which
currency the words “buy” and “sell” refer.
The exchange rates are obviously expressed
as the price of one Australia Dollar, but the
“buy” and “sell” rates refer to the other
currency, and this is the source of confusion.
Thus, the 0.6649/0.6451 means that Westpac
is willing to buy the USD at the reciprocal of
0.6649 and sell it at the reciprocal of 0.6451.
How the media report
exchange rates
The confusion would certainly disappear if the
exchange rates were expressed as S(X/AUD),
which gives the following:
buy
sell
USD 1.5309 1.5501
EURO 1.9308 2.0052
Yen 0.0152 0.0158
Represent the buying and selling rates of one
unit of the foreign currency in terms of the
Australian dollar.
Now the bid rates are lower than the offer rate
How the media report exchange
rates
Alternatively, the exchanges can be left as
they appear in the first table, provided that the
words “buy” and “sell” are switched around.
It will be useful if it said “sell/buy (AUD)”, so
that there is non confusion about the rates
representing the prices of one Australian
dollar.
buy
sell
USD 0.6649 0.6451
EURO 0.5179 0.4987
Yen 65.71
63.10
Cross Exchange Rates
A cross exchange rate is the exchange
rate between two currencies derived from
their exchange rates against another
currency.
S ( x / z)
S ( x / y) =
S ( y / z)
In practice, z is normally the US dollar,
and x, and y involve currencies that are
not heavily traded.
Cross-rate Calculation
The calculation depends on the quote
style
USD/EUR 0.8130-40
USD/JPY 110.40-50
EUR/JPY 110.40/0.8140 -110.50/0.8130
AUD/USD 0.8560-70
GBP/USD 1.8270-80
AUD/GBP 0.8560/1.8280-0.8570/1.8270
exercise
USD/JPY=120.10/120.30
USD/HKD=7.7820/7.7840
AUD/USD=0.7350/0.7360
NZD/USD=0.6030/0.6040
USD/HKD=7.7820/7.7830
GBP/USD=1.6910/1.6920
Transactions
in the foreign exchange Market
 An outright forward transaction (usually called just
“forward”) requires delivery at a future value date of
a specified amount of one currency for a specified
amount of another currency.
 The exchange rate is established at the time of the
agreement, but payment and delivery are not
required until maturity.
 Forward exchange rates are usually quoted for value
dates of one, two, three, six and twelve months.
 Buying Forward and Selling Forward describe the
same transaction (the only difference is the order in
which currencies are referenced.)
Forward transaction
and Quotes
Forward rates are typically quoted in
terms of points.
A forward quotation which is expressed
in points is not a foreign exchange rate
as such.
Rather, it is the difference between the
forward rate and the spot rate.
Forward transaction
and Quotes
Forward quotations may also be
expressed as the percent deviation
from the spot rate.
This method of quotation facilitates
comparing premiums or discounts in
the forward market with interest rate
differentials.
Example
 In the New York forex market, the
spot rate of USD/JPY is 130.47/57,
the points of 1-month USD is 40/50.
And the spot rate of EUR/USD is
1.8252/62, the points of 1-month EUR
is 30/20. What are the forward rate of
USD/JPY and EUR/USD?
Answer
1-month forward rate of USD/JPY is
the bid=130.47+0.40=130.87
the ask=130.57+0.50=131.07
1-month forward rate of EUR/ USDis
the bid=1.8252-0.0030=1.8222
the ask=1.8262-0.0020=1.8240
Forward transaction
and Quotes
Conclusion :
the points is quoted as “smaller~bigger”,
the forward rate equals to spot rate plus
the points.
―If the points is quoted as “bigger~smaller”,
the forward rate equals to spot rate minus
the points.
―If
Exercise
PLS calculate the forward cross rate of
GBP/AUD
spot rate:GBP/USD=1.5630/40
6-month points:318/315
spot rate:AUD/USD=0.6870/80
6-month points:157/154
Forward transaction example
A:
B:
A:
B:
GBP 0.5 Mio
GBP 1.8920/25
MINE, Pls adjust to 1 Month
OK Done Spot/1 month 93/89 at 1.8836 We
sell GBP 0.5 Mio Val October/25/06 USD to
My NY
A: OK All agreed, My GBP to My London Tks,BI
B: OK, BI and Tks
The application of forward transaction
Forward transaction for value-keeping the
dealers are risk-averse and wish to hedge against
an unfavorable change in the exchange rate.
Ways:
the selling sum=uncovered foreign exchange
assets
the buying sum=uncovered foreign exchange
liabilities
Case 1
An USA merchant exports some goods to
UK and the sum of 1,000,000 pounds is
appointed to be paid after 3 months. To
avoid the depreciation of GBP, American
exporter decides to do a 3-month forward
transaction. Assumed that GBP/USD spot
exchange rate is 1.6750/60. When the
contract is signed, 3-month forward spread
of GBP is 30/20, and the market rate is
1.6250/60 on value date. If the exporter
doesn’t make the forward transaction,
what’s the influence?
The answer:
Under the forward transaction
Exporter can receive:
1,000,000*(1.6750-0.0030)=$1,672,000
If he sell the spot GBP on value date,
the exporter can receive:
1,000,000*1.6250=$1,625,000
So the spread=1,672,0001,625,000=$47,000
The application of forward
transaction
Forward transaction for speculation
speculators who believe the spot rate in
the future will differ with the current
forward rate would take part in the forward
transaction in order to make the profits.
the speculation has two forms:
 Buy long
The speculators anticipate that the spot
exchange rate in the future will increase, so
they will buy the forward exchange.
Case 2
On a certain day, USD/JPY 6-month
forward exchange rate in the Tokyo
foreign exchange market is 126.00/10.
A Japanese speculator believes that
the spot rate of USD/JPY will be
130.20/30 half a year later. If the
anticipation is right, and the
speculator brought 6-month forward
USD valued in $1,000,000, what’s the
sum of profit?
The answer:
When buying USD, the Japanese
speculator should pay:
1,000,000*126.10=126,100,000JPY
 Half a year later, when selling the USD,
the speculator would receive:
1,000,000*130.20=130,200,000JPY
The spread revenue:
130,200,000-126,100,000=4,100,000JPY
Forward transaction for
speculation
 Sell short
The speculators anticipate that the
spot exchange rate in the future will
decrease, so they will sell the forward
exchange.
Arbitrage Transaction

Arbitrage refers to the process that an
individual purchases foreign exchange in a
low-priced market for resale in a high-priced
market for the purpose of making the profits.
The forms of Arbitrage
Time arbitrage
Arbitrage
Space arbitrage
Interest arbitrage
Arbitrage
Time arbitrage
Space arbitrage
Interest arbitrage
Arbitrage
Time arbitrage

It is also called swap transaction. In this
situation, there exists exchange rate
discrepancy on different delivery term. When
buying or selling some certain currency, the
dealers also sell or buy the same sum of the
same currency.
A swap transaction is the simultaneous
purchase and sale of a given amount of
foreign exchange for two different value
dates.
Both purchase and sale are conducted with
the same counterparty.
 spot-forward, one-day, forward-forward
swap transaction
A: DEM Swap
USD 10 Mio AG DEM Spot/1 Month
B: DEM Spot/1 Month 85/86
A: 85 Pls
My USD To A NY My DEM To A Frankfurt
B: OK Done We Sell/Buy USD 10 Mio AG
DEM May 20/June 22, Rate at 1.6120 AG
1.6205 USD To My B Frankfurt Tks For
Deal, BI
A: OK, ALL agreed BI
Case 3
A corporation will accept £1,000,000
in 1 month, and pay £1,000,000 in 3
months. Supposed the 1-month
forward rate of £/$ is 1.6868/80, 3month forward rate of £/$ is 1.6729/42.
PLS analyze the situation of forwardforward swap.
Answer:
Sell 1-month forward GBP valued
£1,000,000
£1,000,000*1.6868=$1,686,800
Buy 3-month forward GBP of the volume of
£1,000,000
£1,000,000*1.6742=$1,674,200
The spread revenue:
$1,686,800 -$1,674,200= $12,600
Space Arbitrage

Transaction are taken place to make profits
because for exchange rate’s differences
between different foreign markets.
 In general, Arbitrage is referred to as space
arbitrage. The specific operation is as
follows:
 some currency is bought at a low-priced
market, and sold at a high-priced market to
gain the spread revenue.
 Example:
London:
GBP1=USD1.7200/10
New York:
GBP1=USD1.7310/20
Space Arbitrage
Forms
Direct Arbitrage
It’s also called Two-point arbitrage.
That is , The same exchange rate has
two different prices in two different
markets. The investors take advantage
of this difference to make the profits.
Case 4
The spot rate of GBP/USD in the
London foreign exchange market is
1.6850/60. and the spot rate of
GBP/USD in the New York is 1.6880/90.
How to do a direct arbitrage?
Answer:
It indicated that the price of GBP in
London is lower than that in New York,
and the price of USD in London is higher
than that in New York.
The investor can buy USD and sell
GBP at the price of $1.6860 in the London
market, and sell USD and buy GBP at the
price of $1.6880 in the New York market.
Assuming that transaction fee doesn’t
exist, He can gain the spread revenue of
$0.002 on each pound.
Space Arbitrage
 Indirect Arbitrage
We also call it Three-point arbitrage.
The transactions take place in the
three or more than three foreign
exchange markets. It is more complex
than direct arbitrage.
Exhibit 4.9A Triangular Arbitrage
Citibank
End with $1,014,533
(6) Receive $1,014,533
Dresdner Bank
Start with $1,000,000
(1)
Sell $1,000,000 to
Barclays Bank at $1.4443/£
Barclays Bank
(5) Sell €1,121,651 to
Citibank at $0.9045/€
(2) Receive £692,377
(4) Receive €1,121,651
(3) Sell £692,377 to Dresnder Bank
at €1.6200/£
75
Case 5
On a certain day, USD/EU ‘s spot rate is
1.8600/25 in the New York foreign
exchange market, and the spot rate of
GBP/USD in the London market is
1.6850/70, the spot rate of GBP/EU is
3.0340/50 in the Frankfort. Is there any
chance to arbitrage?
Answer:
Supposed the USD is the arbitrage
currency, and convert USD into EU in
the New York market, and sell EU to
buy GBP in the Frankfort, at last
convert GBP into USD in the London
market.
Then we can get an equation:
1*1.8600*(1/3.0350)*1.6850=1.0327
If the answer is 1,that means there isn’t
any difference between rates, so there
isn’t any chance for arbitrage.
If the answer doesn’t equal to 1, There is a
chance for arbitrage.
>1 the transaction sequences are right
<1 the transaction sequences are wrong
Since the answer is 1.0327, so the
order is right for arbitrage. If the
investor uses $1,000,000 to do so,
at last he can get $1,032,652, that
is , the profit is $32,652.
Exercises
1、suppose in the Canadian forex market,
$1=C$1.1320/30 , in the USA market,$1=C$1.1332/40
How to do a direct arbitrage?
2、suppose in the NewYork forex market,
$1=FF7.0800/15
in the Paris forex market, £1=FF9.6530/40
in the London forex market, £1= $1.4325/35
How to do an indirect arbitrage?
Interest Arbitrage

Interest Arbitrage: According to the differences
between the rates of two markets, investors
make the fund flow from the lower rate country
to the higher rate country to gain the profit.

The forms
Uncovered Interest Arbitrage
When the fund flows to the higher rate country,
the investors don’t cover the assets which
have the exchange rate risks.
―Covered Interest Arbitrage
When changing the fund’s flow, the investors
also take transactions to keep the value.
―
Interest Arbitrage
The premise of Interest Arbitrage is that the
authorities don’t restrict the capital flow
and the convertibility of the currencies.
The differences of rates exist in the same
sort of financial instruments of the different
countries.
The term of interest arbitrage is always
within one year.
Doing covered interest arbitrage also
concerns with some certain transaction
costs.
Because of the political risks, the investors
always hold the cautious attitude .
Interest Arbitrage
Feasibility analysis of Interest Arbitrage
Assumed in the USA money market the time deposit rate
of 3-month is 8%, and that of UK market is 12%. The spot
rate is that GBP1=USD1.5828, the discount point of 3month is GBP1=USD0.0100.
discount(premium) 12
thediscount/premium rate 

 100%
spot rate
m onth
Interest Arbitrage
The rate=(0.01/1.5828)*(12/3)=2.53%<4%
So it is feasible to do the interest arbitrage.
We can borrow the USD from the USA
market with the rate of 8%, then transfer
USD into GBP and deposit it in the UK
market with the rate of 12%, and also sell
the 3-month GBP forward. In this
transaction we can obtain the profits of USD
0.0034/USD1.
Case 6
Assuming that the rate of Japanese
market is 3%, the rate of American
market is 6%, the spot rate of USD/JPY is
129.50/00. A Japanese investor wants to
invest J¥130,000,000 to USA for a year.
And the exchange rate of USD/JPY won’t
change, that is 129.50/00. What about the
revenue under the interest arbitrage and
without arbitrage.
Answers:
(1) Interest Arbitrage
J¥130,000,000/130.00=$1,000,000
J¥130,000,000 equals to 1,000,000 USD
After one year, Principal and interest of
USD investment is
1,000,000*(1+6%)=$1,060,000
$1,060,000 equals to
$1,060,000*129.50=J¥137,270,000
(2) Without Interest Arbitrage
J¥130,000,000*(1+3%)=J¥133,900,000
The difference is
J¥137,270,000-J¥133,900,000=3,370,000
Case 7
Other assumptions are the same to the
case 6. but we don’t know the spot rate
of USD/JPY in the future, what we know
is the forward rate of USD/JPY in a year
is 127.00/50.
Answer:
(1) Interest Arbitrage
sell J¥130,000,000,then have
J¥130,000,000/130.00=$1,000,000
Principal and interest of USD
investment is
1,000,000*(1+6%)=$1,060,000
Since knowing the forward rate, we
can sell the forward USD, and get
$1,060,000*127.00=J¥134,620,000
(2) Without Interest Arbitrage
Principal and interest of JPY is
J¥130,000,000*(1+3%)=J¥133,900,000
The difference is
J¥134,620,000-J¥133,900,000=720,000
Exercise
Assuming that the rate of USA
market is 8%, the rate of UK
market is 6%, the spot rate in the
UK market is that
GBP1=USD1.6025/35. the
discount point of 3-month is
30/40. A investor wants to invest
£100,000. Please arrange the
interest arbitrage.
Future Transaction


Foreign Exchange Future Transaction
is the trade on standard foreign
exchange future contract in the
exchange.
Standard foreign exchange future
contract
―
the kinds of currency
Each foreign exchange stipulates the specific
futures on certain currencies.
―
contract denomination
each foreign exchange has its own regulations
on contract denomination, and the volume of
transaction should be a round figure multiple of
contract denomination.
Standard foreign exchange
future contract
―delivery
date
it is commonly 3-month, 6-month, 9month, and 12-month in most future
exchange.
―price
fluctuation
Each future contract also fixes the floor
of price fluctuation and the ceiling of daily
price fluctuation.
Future Transaction
 in the future transaction, the margin system is
adopted. and it has two functional mechanism.
 One is Marking to Market system. After the
investors paying the initial margin, the brokers
adjust the capital of margin account according to
the current price fluctuation.
 The other is Maintenance Margin system. When
the prices have the unfavorable change, and
cause the margin blow the maintenance margin,
the investors would receive the margin call and
have to add the margin, otherwise the contracts
would be forced to close out.
Future Transaction
the practical application
― exchange
future for value-keeping (future
hedge )
(a) short hedge
the investors firstly sell some certain currency
future in the future market, then buy it to cancel
the risks out which arise from the fall of the spot
exchange rate on foreign assets.
(b) Long Hedge
Under long hedge, firstly currency future is
bought, then sell the future to avoid the losses
which may arise from the exchange rate’s
increase.
Case 8
Assumed on March 15th, an American
firm exported goods to Europe,
Germany. After 2 months, it will receive
500,000 EU. To guard against the
depreciation of EU, this firm decided to
do a short hedge on currency future. (It
is known that 1EU future contract is
125,000EU)
spot market
3.15 it will receive
500.00 EU
Rate:1$=1.7985EU
Revenue:500,000/1.79
85=$278,010
5.15
Sell 500,000EU
Rate:1$=1.8400 EU
Revenue:500,000/1.84
00=$271,739
Loss: 278,010271,739=6271
future market
3.15 sell 4 EU future
contracts of June
Rate: 1EU=0.5598EU
Revenue:125,000*4*0.
5598=$279,900
5.15 buy 4 EU future
contracts of June
Rate: 1EU=0.5471EU
Payment:125,000*4*0.
5471=$273,550
Profit: 279,900273,550=6350
Case 9
 At the end of March, IBM’s head office
needs a short-term capital, the branch
of Switzerland will have 250,000 idle Sfr
till 5 months later, so the head office
plans to transfer the capital from
Switzerland to USA. To avoid the losses
arise from the appreciation of Sfr in 3
months later, So the head office
decides to do long hedge.
Spot market
4.1 sell Sfr 250,000
Rate: $1=Sfr1.5404
Revenue:
250,000/1.5404=$162,295.
5
7.1 buy Sfr250,000
Rate: $1=Sfr1.5396
Payment:250,000/1.5396=
$162,379.83
Loss:162,379.83162,295.5=84.33
Future market
4.1 buy 2 Sfr future
contracts of July
Rate:Sfr1=$0.6485
Payment:125,000*2*0.6
485=$162,125
7.1 sell 2 Sfr future
contracts of July
Rate:Sfr1=$0.6494
Payment:125,000*2*0.6
494=$162,350
Profit: 162,350162,125=225
Future Transaction
― exchange
future for speculation
For speculation, the speculators don’t hold
the foreign exchange assets or liabilities.
Only according to the prediction, the
speculators take part in the future market
(a) going long
Believing the exchange rate of certain currency is
going to rise, the speculators firstly buy the future
contract of the currency.
Case 10
On March 1st, the speculator
forecasts that EU/USD will rise a month
later. So he buys 10 3-month future
contracts of EU at the price of 0.5698
USD/EU . ( Each one has the face value
of 125,000EU) and pays the margin of
$15,000, when trading the price of
EU/USD increases as predicted, the
speculator sell the 10 future contract of
EU at the price of 0.5870 USD/EU. What’s
the profit and the real rate of return?
Answer:
On March 1st, the speculator buys 10 3month future contracts of EU
Payment: 125,000*10*0.5698=$712,250
On April 1st, the speculator sells 10 future
contracts of EU
Revenue:125,000*10*0.5870=$733,750
Profit: $733,750- $712,250=21,500
The real rate of return:
21,500/15,000*100%=143%
Exchange future for speculation
(b) Going short
Believing the exchange rate of certain
currency is going to fall, the speculators
firstly sell the future contract of the currency,
then buy the currency’s future contract.
Exercise
Assuming the market prices of CHF in Oct 9th,2007 are
as following:
Spot Rate is that CHF1=USD1.1778/88 ;Dec. Future of
USD/CHF: 0.8510 (each contract denomination for
CHF is CHF125000)
A company will sell CHF2,000,000 in the spot market
two months later in order to clear the payment. For
avoiding the risks, A company decides to hedge it in
the IMM. The prediction of the market prices in two
months are :
Spot Rate 1.1660/70;Dec. Future 0.8560
How does A company do the hedge and how about the
effect?
spot market
future market
10.9 it will buy
CHF2,000,000
Rate:
CHF1=USD1.1778/88
Payment:2,000,000*1.178
8=$2,357,600
12.9 buy CHF2,000,000
Rate:
CHF1=USD1.1660/70
Payment:
2,000,000*1.1670=$2,3
34,000
10.9 buy 16 CHF future
contracts of Dec
Rate: USD1=CHF0.8510
Payment:125,000*16/0.8510
=$2,350,176
Profit: 2,357,6002,334,000=23600
Loss: 2,350,1762,336,449=13727
12.9 sell 16 CHF future
contracts of Dec
Rate: USD1=CHF0.8560
Revenue:125,000*16/0.856
0=$2,336,449
Option Transaction



Whatever advantages the forward or the futures
contract might hold for its purchaser, the two
contracts have a common disadvantage: although
they protect the holder against the risk of adverse
movements in exchange rates, they also eliminate
the possibility of gaining a windfall profit from
favorable movements.
Exchange-traded currency options were first offered
in 1982 by the Philadelphia Stock Exchange (PHLX).
Currency options are one of the faster growing
segments of the global foreign exchange market,
currently accounting for as much as 7% of daily
trading volume.
Option Transaction

Option Transaction :After the buyers of
option contract pay the premium, They get
the rights whether to transact the certain
currency in the appointed period on the
appointed price of the appointed volume or
not.
 In principle, an option is a financial
instrument that gives the holder the right-but
not the obligation-to sell or buy another
financial instrument at a set price at the
expiration date. The seller of the option must
fulfill the contract if the buyer desires it.
Option Transaction
Many exchange provides Option
Transaction: ISE, PHLX andcme,eu
rex
ISE
AUX, ISE Australian Dollar Index (USD/AUD)
BPX, ISE British Pound Index (USD/GBP)
CDD, ISE Canadian Dollar Index (USD/CAD)
EUI, ISE Euro Index (USD/EUR)
SFC, ISE Swiss France Index (USD/CHF)
YUK, ISE Japanese Yen Index (USD/JPY)
PHLX
XDE, PHLX Euro Index (EUR/USD)
XDB, PHLX British Pound Index (GBP/USD)
XDA, PHLX Australian Dollar Index (AUD/USD)
XDN, PHLX Japanese Yen Index (JPY/USD)
XDC, PHLX Canadian Dollar Index (CAD/USD)
XDS, PHLX Swiss France Index (CHF/USD)
the forms
 According to the time of exercising
the option, the option transaction
has two forms:
― European
option
the buyers can exercise the option only on
maturity date.
― American
option
the buyers can exercise the option on any day
before the maturity date.
the forms
 According to the right of buying or
selling.
― call
option
After the buyer of option pays the premium, he
can decide whether to buy certain volume of
foreign currency on the specific price in the
specific term or not.
― put
option
After the buyer of option pays the premium, he
can decide whether to sell certain volume of
foreign currency on the specific price in the
specific term or not.
the forms
 According to the specific contents of
transaction.
― option on spot currency
― option on foreign currency future
― futures-style option
the contents of future transaction are option.
Call Option Transaction
Option
Strike Price
Effect of
Description
Relative to Spot Rate
Immediate Exercise
In-the-money
Strike price < spot rate
Profit
At-the-money
Strike price = spot rate
Indifference
Out-of-the-money Strike price > spot rate
Loss
Exhibit
Profit from buying a call option for
various spot prices at expiration
Contract size: EURO 62,500
Exercise price: $1.14 per euro
Option premium: $0.02 per euro($1250 per contract)
Expiration date: 60 days
2500
1875
Potentially
unlimited
profit
1250
Profit
(loss)
625
Exercise price
0
-625
-1250
$1.10
$1.12
$1.14
$1.16
$1.18
Spot price of euro
at expiration
Limited loss
Break-even price
Call premium
Exhibit
Profit from buying a call option for
various spot prices at expiration
Contract size: EURO 62,500
Exercise price: $1.14 per euro
Option premium: $0.02 per euro($1250 per contract)
Expiration date: 60 days
Out-of-the-money
$1.10
At-the-money
$1.12
$1.14
In-the-money
$1.16
$1.18
Exhibit
Profit from selling/writing a call option
for various spot prices at expiration
Contract size: EURO 62,500
Exercise price: $1.14 per euro
Option premium: $0.02 per euro($1250 per contract)
Expiration date: 60 days
2500
Call premium
1875
1250
Profit
(loss)
625
Spot price of euro
at expiration
Limited profit
0
-625
-1250
$1.10
$1.12
$1.14
$1.16
Exercise price
Break-even price
$1.18
Potentially
unlimited
Loss
Exhibit
Profit from selling a call option for
various spot prices at expiration
Contract size: EURO 62,500
Exercise price: $1.14 per euro
Option premium: $0.02 per euro($1250 per contract)
Expiration date: 60 days
Out-of-the-money
$1.10
At-the-money
$1.12
$1.14
In-the-money
$1.16
$1.18
option transaction
Option fees have three quotations
Example: USD call DEM put,
quantity:USD1,000,000 the spot rate of
USD/DEM is 1.6000
Option fee are typically quoted in terms of
points.0.0220-0.0224. the former is the bid
price and the latter is the offer price. So the
fee of buying the option is
1,000,000*0.0224=USD224,000 and the fee of
selling the option is USD220,000
Forward quotations may also be expressed
as the percent deviation from the spot rate.
Example
 A: OPTION DEAL

HI FRD CAN YOU GIVE ME INDICAION FOR USD
CALL DEM PUT AMOUNT USD 10 MIO STRIKE PRICE
AT 1.60 EUROPEAN SYTLE EXPIRY NOV 18. TOKYO
CUT 03:00 PM
 B: SURE……1.375 1.40 IN USD PCT
 A: OK FIRM PRICE PLS
 B: THE SAME
 A: I BUY
 B: OK DONE TO CFM AT 1.40 WE SOLD YOU OPTION
FOR USD CALL DEM PUT AMOUNT USD 10 MIO
STRIKE AT 1.60 EXPIRY NOV 18. TOKYO CUT 03:00 P,
EUROPEAN STYLE PERMIUM AMOUNT USD 140,000
PLS PAY TO B BANK NEW YORK BRANCH FOR OUR
ACCOUNT THANKS FOR THE DEAL
 B:BI FRD
 A:OK AGREED THANKS BI FRD
Example
A: OPTION EXE PLS
 WE BUY USD 10 MIO AG DEM AT
1.60 VAL NOV 20. USD PAY TO A
BANK NY BRANCH PLS
B: OL AGREED DEM PAY TO B BANK
FRANKFURT BRANCH THANKS
A: THANKS
B: BI FRD
the application
Comparing with forward, future,
option is the financial asset which is
more effective to avoid the exchange
risks. And now option is commonly
used for value-keeping.
 buy the call option
Case 11
On March 1st, a USA firm is going to pay
5,000,000 EU in 3 months later for imported
item. To avoid the losses which may arise
from the appreciation of EU, the firm decides
to buy 40 EU call option with the value date
of June. Assumed that the spot rate of March
1st is 1.8600 EU/$,and exercise price of EU
call option of June is 0.5450 $/EU. the
premium is 0.02 $/EU. The spot rate of 3month later may has two situations:
1$=1.7500EU or 1$=1.9800EU .PLS calculate
the payment in term of USD of the firm
respectively under two situations.
The answers:
1) At the situation of 1$=1.7500EU
the spot rate of 1/1.7500 ,that is , 0.5714 is
Higher than the exercise price of 0.5450 plus 0.02.
so the firm decides to exercise the option.
According to the exchange rate of 0.5450 $/EU ,
the Firms buys 5,000,000EU
The payment: 5,000,000 *0.5450=2,725,000$
The premium: 5,000,000 *0.02=100,000$
The total payment: 2,725,000+ 100,000= 2,825,000$
the application
2) At the situation of 1$=1.9800EU
the spot rate of 1/1.9800 ,that is , 0.5051
plus 0.02 is lower than the exercise price
of 0.5450. so the firm decides to cancel
the option and buy the 5,000,000 EU from
the spot market.
The payment: 5,000,000 *0.5051=2,525,300$
The premium: 5,000,000 *0.02=100,000$
The total payment: 2,525,300+ 100,000=
2,625,300$
the application
 buy the put option
it is to avoid the losses arised from the
Depreciation. Because the buyers of put option
want to sell the foreign currencies at a proper
Price. So if the exercise price is higher than the
Spot price, the options are exercised. If the
Exercise price is lower, the buyers will cancel
The option. But the premium is bound to be paid.
Exercises
Use the following information for problems
Plains States Manufacturing has just signed a
contract to sell agricultural equipment to Boschin, a
German firm, for €1,250,000. The sale was made in
June with payment due six months later in
December. Because this is a sizable contract for the
firm and because the contract is in Euros rather
than dollars, Plains States is considering several
hedging alternatives to reduce the exchange rate
risk arising from the sale. To help the firm make a
hedging decision you have gathered the following
information.
 The spot exchange rate is $.8924/€
 The six month forward rate is $.8750/€
 Plains States’ cost of capital is 11%
 The Euro zone 6-month borrowing rate is 9% (or
4.5% for 6 months)
 The Euro zone 6-month lending rate is 7% (or
3.5% for 6 months)
 The U.S. 6-month borrowing rate is 8% (or 4% for
6 months)
 The U.S. 6-month lending rate is 6% (or 3% for 6
months)
 December put options for €625,000; strike price
$.90, premium price is 1.5%
 Plains States’ forecast for 6-month spot rates is
$.91/€
 The budget rate, or the lowest acceptable sales
price for this project, is $1,075,000 or $.86/€
1. If Plains States chooses to hedge its
transaction exposure in the forward market,
it will __________ €1,250,000 forward at a
rate of ___________.




sell; $.8750/€
sell; $.8924/€
buy; $.8750/€
buy; $.8924/€
2. The cost of a call option to Plains States
would be ____________.
a.$17,653
b.$16,733
c.$18,471
d.There is not enough information to answer
this question.
Exercise
 Suppose that Texas Instruments (TI) must pay
a French supplier €10m in 90 days. Explain
how TI can use currency futures to hedge its
exchange risk. How many futures contracts
will TI nee to fully protect itself?
A . Explain how TI can use currency options to
hedge its exchange risk. How many options
contracts will TI need to fully protect itself?
B. Discuss the advantages and disadvantages of
using currency futures versus currency
options to hedge TI’s exchange risk.
In CME currency Futures
Euro/USD--- €125,000,$ per €
Dec 1.518
currency Futures option
Euro €125,000,cents per €
Price
Feb
12500
1.64
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