www.themegallery.com chapter 2 the foreign exchange market

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Chapter 2

The Foreign Exchange Market

Learning ObjectivesSummarize 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.


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 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 marketInclude 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 ParticipantsThe 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 2001 2004 2007 2010

Foreign exchange instruments 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

Currency swaps 10 7 21 31 43

Options and other products³ 87 60 119 212 207Memo:

Turnover at April 2010 exchange rates 4 1,705 1,505 2,040 3,370 3,981

Exchange-traded derivatives 5 11 12 26 80 166

Currency distribution of global foreign exchange market turnover

Percentage shares of average daily turnover in April 2010

Currency 1998 2001 2004 2007 2010

US dollar 86.8 89.9 88.0 85.6 84.9

Euro ... 37.9 37.4 37.0 39.1

Deutsche mark 30.5 ... ... ... ...

French franc 5.0 ... ... ... ...

ECU and other EMS currencies 16.8 ... ... ... ...

Slovak koruna2 ... 0.0 0.0 0.1 ...

Japanese yen 21.7 23.5 20.8 17.2 19.0

Pound sterling 11.0 13.0 16.5 14.9 12.9

Australian dollar 3.0 4.3 6.0 6.6 7.6

Swiss franc 7.1 6.0 6.0 6.8 6.4

Canadian dollar 3.5 4.5 4.2 4.3 5.3

Global foreign exchange market turnover by currency pair Daily averages in April, in billions of US dollars and percentages

Amount % Amount % Amount % Amount % Amount %

USD/EUR . . 372 30 541 28 892 27 1,101 28

USD/DEM 309 20 . . . . . . . .

USD/FRF 60 4 . . . . . . . .

USD/XEU 17 1 . . . . . . . .

USD/OthEMS 178 12 . . . . . . . .

USD/JPY 292 19 250 20 328 17 438 13 568 14

USD/Oth 140 9 152 12 251 13 498 15 445 11

USD/GBP 122 8 129 10 259 13 384 12 360 9

USD/AUD 44 3 51 4 107 6 185 6 249 6

USD/CAD 52 3 54 4 77 4 126 4 182 5

USD/CHF 82 5 59 5 83 4 151 5 168 4

EUR/JPY . . 36 3 61 3 86 3 111 3

EUR/GBP . . 27 2 47 2 69 2 109 3

EUR/Oth . . 17 1 35 2 83 2 102 3

20102004 2007

Currency pair

1998 2001

Correspondent Banking Relationships

Large commercial banks maintain demand deposit accounts with one another which facilitates the efficient functioning of the FX market.


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

Bank B

NYC

$200m

£100m


Assets Liabilities

£ deposit at B £300m

Other Assets £600m

B’s Deposit$1,000m

Other L&E £600m

Total Assets £1,300m Total L&E £1,300m

Assets Liabilities

$ deposit at A$1000m

Other Assets $800m

A’s Deposit £300m

Other L&E $800m

Total Assets $2,200m Total L&E$2,200m

£400m $1,200m $1200m £400m

$600mB’s Deposit £200m

$600m

£ deposit at A £200m

£100m

A’s Deposit $800m

Bank A

London

Bank B

NYC

$200m

£100m

$ deposit at B $800m

£100m

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

D€

Euros (€)

$/€ S€

Qeq

eeq

Initially, Qeq euros are traded, and the equilibrium price is eeq.


D€

Euros (€)

$/€ S€

Qeq

eeq

An increase in U.S. demand for euros causes an appreciation of the euro.

D'€

e'eq

Q'eq


D€

Euros (€)

$/€ S€

Qeq

eeq

An increase in the supply of euros causes a depreciation of the euro.

S'€

e'eq

Q'eq

Foreign exchange is demanded by those

wishing to profit from exchange rate changes (speculation).

wishing to buy goods and services from or send gifts or payments to another country.

wishing to minimize risk from exchange rate changes (hedging).

wishing to purchase financial assets in another country.

The Market for Foreign Exchange: Demand

Foreign exchange is supplied by

thosewishing to profit from exchange rate changes (speculation).

selling goods and services to or receiving gifts or payments from another country.

wishing to minimize risk from exchange rate changes (hedging).

in other countries who wish to purchase financial assets in the home country.

The Market for Foreign Exchange: Supply

The Market for Foreign Exchange: Supply

The other is related to financial flows, including speculation and hedging.

One is related to current account transaction.

The total supply and demand for foreign exchange includes two

components.


DG&S

Euros (€)

$/€SG&S

The total equilibrium exchange rate will only be the same as the one for G&S if the current account is exactly in balance.

DTotal

eeq

Qeq

STotal

Transactions in the foreign exchange 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 Market

The Spot TransactionsA 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 transactionProcedure 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 QuotationsLike 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

( ) ( )xySyxS1

=

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 ConversionTo 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:

To express as a percentage, we then multiply by 100

11

1

10

1

-

-

yxSxyS

yxSyxS

yxS

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

( ) ( )( ) 0140.01

57.3

52.31

GBP/AUDS

GBP/AUDSGBPAUDS

0

1 --- ===

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

0140.01

2801.0

2840.01

/S

/SAUDGBPS

0

1 --AUDGBP

AUDGBP

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

A dealer would likely quote these prices as 72-77.

It is presumed that anyone trading $10m already knows the “big figure”.

Bid Ask

1.9072

.5242

S(£/$)

S($/£)

1.9077

.5243

big figure

small figure

Points and PipsExchange rate quotations are measured in

points and pipsA 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 pointsThe 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 0.6451EURO 0.5179 0.4987Yen 65.71 63.10


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.


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.


The confusion would certainly disappear if the exchange rates were expressed as S(X/AUD), which gives the following:


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


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.


Cross Exchange RatesA cross exchange rate is the exchange

rate between two currencies derived from their exchange rates against another currency.

In practice, z is normally the US dollar, and x, and y involve currencies that are not heavily traded.

)/()/(

=)/(zySzxS

yxS

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 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=131.071-month forward rate of EUR/ USDis

the bid=1.8252-0.0030=1.8222

the ask=1.8262-0.0020=1.8240


Conclusion :―If 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.

Exercise

PLS calculate the forward cross rate of GBP/AUD

spot rate:GBP/USD=1.5630/40 6-month points:318/315spot rate:AUD/USD=0.6870/80 6-month points:157/154

Forward transaction example

A: GBP 0.5 Mio

B: GBP 1.8920/25

A: MINE, Pls adjust to 1 Month

B: 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 1An 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 transactionExporter can receive:1,000,000*(1.6750-0.0030)=$1,672,000If he sell the spot GBP on value date,

the exporter can receive:1,000,000*1.6250=$1,625,000So the spread=1,672,000-

1,625,000=$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 2On 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=130,200,000JPYThe 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, 3-month forward rate of £/$ is 1.6729/42. PLS analyze the situation of forward-forward 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

FormsDirect 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.

75

Exhibit 4.9A Triangular Arbitrage

Citibank

Dresdner Bank Barclays Bank

Receive €1,121,651

Receive $1,014,533

End with $1,014,533 Start with $1,000,000

Sell $1,000,000 to Barclays Bank at $1.4443/£

Receive £692,377

Sell £692,377 to Dresnder Bankat €1.6200/£

Sell €1,121,651 toCitibank at $0.9045/€

(1)

(2)

(3)(4)

(5)

(6)

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.

Exercises1 、 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 ArbitrageThe 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 3-month is GBP1=USD0.0100.

%10012

ratespot

remium)discount(p rate remiumdiscount/p the

month

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, 9-month, 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 Transactionthe 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 future market

3.15 it will receive 500.00 EU

Rate:1$=1.7985EU

Revenue:500,000/1.7985=$278,010

3.15 sell 4 EU future contracts of June

Rate: 1EU=0.5598EU

Revenue:125,000*4*0.5598=$279,900

5.15

Sell 500,000EU

Rate:1$=1.8400 EU

Revenue:500,000/1.8400=$271,739

5.15 buy 4 EU future contracts of June

Rate: 1EU=0.5471EU

Payment:125,000*4*0.5471=$273,550

Loss: 278,010- 271,739=6271

Profit: 279,900- 273,550=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 Future market

4.1 sell Sfr 250,000

Rate: $1=Sfr1.5404

Revenue: 250,000/1.5404=$162,295.5

4.1 buy 2 Sfr future contracts of July

Rate:Sfr1=$0.6485

Payment:125,000*2*0.6485=$162,125

7.1 buy Sfr250,000

Rate: $1=Sfr1.5396

Payment:250,000/1.5396=$162,379.83

7.1 sell 2 Sfr future contracts of July

Rate:Sfr1=$0.6494

Payment:125,000*2*0.6494=$162,350

Loss:162,379.83-162,295.5=84.33

Profit: 162,350- 162,125=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 3-

month 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.

ExerciseAssuming 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 0.8560How 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*1.1788=$2,357,600

10.9 buy 16 CHF future contracts of Dec

Rate: USD1=CHF0.8510Payment:125,000*16/0.8510

=$2,350,176

12.9 buy CHF2,000,000

Rate: CHF1=USD1.1660/70

Payment: 2,000,000*1.1670=$2,334,000

12.9 sell 16 CHF future contracts of Dec

Rate: USD1=CHF0.8560Revenue:125,000*16/0.8560

=$2,336,449

Profit: 2,357,600- 2,334,000=23600

Loss: 2,350,176- 2,336,449=13727

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 TransactionMany exchange provides Option

Transaction: ISE, PHLX andｃｍｅ , ｅｕｒｅｘ

ISEAUX, 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

Profit(loss)

Call premium

$1.12 $1.16$1.10 $1.14 $1.18

Break-even price

Potentially unlimited profit

Spot price of euro at expiration

Contract size: EURO 62,500Exercise price: $1.14 per euroOption premium: $0.02 per euro($1250 per contract)Expiration date: 60 days

Limited loss-1250

-625

0

625 Exercise price1250

1875

2500

Exhibit Profit from buying a call option for various spot prices at expiration

In-the-money

$1.12 $1.16$1.10 $1.14 $1.18


Out-of-the-money At-the-money

Exhibit Profit from selling/writing a call option for various spot prices at expiration

Profit(loss)

Call premium

$1.12 $1.16$1.10 $1.14 $1.18

Break-even price

Potentially unlimited Loss

Spot price of euro at expiration


Limited profit

-1250

-625

0

625

Exercise price

1250

1875

2500

Exhibit Profit from selling a call option for various spot prices at expiration

In-the-money

$1.12 $1.16$1.10 $1.14 $1.18


Out-of-the-money At-the-money

option transactionOption 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

ExampleA: 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: THANKSB: 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 $/EU. The spot rate of 3-month later may has two situations: 1$=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 problemsPlains 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.$17,653b.$16,733c.$18,471d.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 FuturesEuro/USD--- €125,000,$ per €Dec 1.518

currency Futures option Euro €125,000,cents per €Price Feb12500 1.64

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Documents

foreign exchange market

fx market participants

fx market transfer

fx market conventions

tiered market

market functionality

perfect market

fx market central banks