chap15 foreign exchange markets

8/8/2019 chap15 Foreign Exchange Markets

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CHAPTER 15

Foreign Exchange Markets


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Foreign Exchange Market

What is the foreign exchange market?

Who are the major participants?


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Foreign Exchange Market

What is the exchange rate?

An exchange rate is the price of a unit of one

currency in terms of another.

How are exchange rates determined?

By supply and demand for the most part

(governments also play a role)


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Foreign Exchange Market An exchange rate is either a spot rate or a

forward rate

Spot rate (S):

Forward rate (F):


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Foreign Exchange Market How are exchange rates quoted? There

are two types of quotations:

Direct:

Indirect:


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International Arbitrage

We will look at three types of

international arbitrage:

Locational arbitrage

Triangular arbitrage

Covered interest arbitrage


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Locational Arbitrage

What is locational arbitrage?

When is locational arbitrage possible?

Bid price:

Ask price:

Locational arbitrage is possible when:


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Locational Arbitrage

Example:

British poundquote:

Bank A BankB

Bid price $1.61 per pound $1.63 per pound

Ask price $1.62 per pound $1.64 per pound

Profit on $1,000:

(1000/1.62)*1.63 = $1006.17

So profit from locational arbitrage is $6.17


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TriangularArbitrage What is triangular arbitrage?

When is it possible?

What is a cross exchange rate:


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TriangularArbitrage How is the theoretical cross exchange

rate calculated?

Value ofCurrency X in terms of US dollar

Value ofCurrency Y in terms of US dollar


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TriangularArbitrage Example:

1 British pound = $1.60

1 Brazilian real= $0.20

1 pound = 8.10 reals

Theoretical cross rate:

1.6/.20 = 8.00 reals per pound

Thus, triangular arbitrage is possible since

the quoted rate (8.10) differs from the

theoretical (8.00)


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TriangularArbitrage To capitalize on the price discrepancy

(assuming you have $1,000):

1. Buyovervalued

Overvalued currency: pound

1,000/1.60 = $625 pounds

2. Converttoundervalued

Undervalued currency: real

625*8.10 = 5062.50 real


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TriangularArbitrage 3. Reconvert to home currency (dollar)

5062.50*.20 = $1012.50

Arbitrage profit = $12.50


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CoveredInterestArbitrage

(CIA) What is CIA?

To understand CIA we must understand:

Interest rate differentials:

Forward differentials: (F-S/S) * 360/n

where n is the number of days

When is CIA possible?


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Example:

US investor with $1,000,000

US interest rate = 6%

Mexican interest rate = 8%

Spot rate: 1 peso = $0.50

1 year forward rate: 1 peso =$0.55

Is CIA possible? Lets see.


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Convert dollars to pesos:

$1,000,000/0.50 = 2,000,000 pesos

Invest at 8 percent for 1 year

2,000,000* 1.08 = 2,160,000 pesos

Reconvert to dollars:

2,160,000*0.55 = $1,188,000

So, was CIA worthwhile?


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GovernmentInterventioninForeign

Exchange Markets

Why do governments intervene?

To smooth exchange rates

To execute objectives of the central banks

To establish implicit boundaries


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Exchange Markets

How do governments intervene:

Direct Intervention

Sterilized

Unsterilized


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Exchange Markets

Indirect Intervention


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Summary

Basics of Foreign Exchange Market

Characteristics of the market

Major participants

Spot versus forward rates

Types of quotations

International Arbitrage

Government Intervention

chap15 foreign exchange markets

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