k. the foreign exchange market

7/29/2019 K. the Foreign Exchange Market

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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.


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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.


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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 individualexporters and corporations or at wholesale level in the InterBank market.


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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


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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 .

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 ofanother 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

W H O L E S A L R E T A I L M

F O R E I G N E X C H


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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 of major

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. Theirmain 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.


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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 theircorporate 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 toroute deals between two ADs through brokers .


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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

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

Types of transaction

Cash

T + 0

Tom

T + 1

Spot

T + 2

Forward

T + 3


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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 1st

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


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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 two-

way 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 matchingsellers with buyers. In the interbank market collecting a commission from both.


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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 hisbooks. If he does, he will quote a price based on his information about the current


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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 froma position depends upon the size of the position and the variability of exchange


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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.


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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


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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.


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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 butpayment 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 differencebetween the spot

and the forward rates is known as either the forward discount or the forwardpremium 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.


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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


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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.

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)


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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 59 63

Bank A Bank B

2. The following quotes are obtained from the banks:

Bank A Bank B

FFr/$ spot 4.9570/80 4.9578/90

i. Is there an arbitrage opportunities

Ans. There is no arbitrage opportunity in this case. This can be represented

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.


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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?

Ans. In London: DEM/ GPB spot 3.5250/55

JPY/ GPB spot 180.0080/181.0030

Therefore, JPY/ DEM = B1 A1 [where B1 - 180.0080

A2 B2 A1 181.0030

B2 - 3.5250

A2 3.5255]

= 180.0080 181.0030

3.5255 3.5250

= 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.


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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


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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 59 63Bank A Bank B


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III. The following quotes are obtained from the banks:

Bank A Bank B

FFr/$ spot 4.9570/80 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 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.


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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 A1 [where B1 - 180.80

A2 B2 A1 181.30

B2 - 3.5250

A2 3.5255]

= 180.80 181.30

3.5255 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


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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 +51.2835 JPY

At B + x -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 SFr/$ =1.5530/35

Therefore GPB/$ =0.6542/0.6547

Also in New York:

SFr/GPB =B1 B2

A2 A1

=1.5275 1.5285

0.6547 0.6542

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

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:


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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



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 :0.5875/85

1- month fwd :12/18

2-month fwd :15/25

3- month fwd :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 :0.5875/58

1-month fwd :0.5887/0.5903

2-month fwd :0.5890/0.5910

3-month fwd :0.5895/0.5915

those corresponding to the ask price. Therefore, the forward points will be

subtractedform the spot rate figure. Thus, the outright rates are:


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DEM/$ spot - 1.5880/ 90

1 month forward - 1.5870/ 85



k. the foreign exchange market

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