CHAPTER 5 THE MARKET FOR FOREIGN EXCHANGE ANSWERS & SOLUTIONS TO END-OF-CHAPTER QUESTIONS AND PROBLEMS QUESTIONS 1. Give a full definition of the market for foreign exchange. Answer: Broadly defined, the foreign exchange (FX) market encompasses the conversion of purchasing power from one currency into another, bank deposits of foreign currency, the extension of credit denominated in a foreign currency, foreign trade financing, and trading in foreign currency options and futures contracts. 2. What is the difference between the retail or client market and the wholesale or interbank market for foreign exchange? Answer: The market for foreign exchange can be viewed as a two-tier market. One tier is the wholesale or interbank market and the other tier is the retail or client market. International banks provide the core of the FX market. They stand willing to buy or sell foreign currency for their own account. These international banks serve their retail clients, corporations or individuals, in conducting foreign commerce or making international investment in financial assets that requires foreign exchange. Retail transactions account for only about 14 percent of FX trades. The other 86 percent is interbank trades between international banks, or non-bank dealers large enough to transact in the interbank market. 3. Who are the market participants in the foreign exchange market? Answer: The market participants that comprise the FX market can be categorized into five groups: international banks, bank customers, non-bank dealers, FX brokers, and central banks. International banks provide the core of the FX market. Approximately 100 to 200 banks worldwide make a market in foreign exchange, i.e., they stand willing to buy or sell foreign currency for their own account. These international banks serve their retail clients, the bank customers, in conducting foreign commerce or making international investment in financial assets that requires foreign exchange. Non-bank dealers are large non-bank financial institutions, such as investment banks, mutual funds, pension funds, and hedge funds, whose size and frequency of trades make it cost- effective to establish their own dealing rooms to trade directly in the interbank market for their foreign exchange needs. Most interbank trades are speculative or arbitrage transactions where market participants attempt to correctly judge the future direction of price movements in one currency versus another or attempt to profit from temporary price discrepancies in currencies between competing dealers. FX brokers match dealer orders to buy and sell currencies for a fee, but do not take a position themselves. Interbank traders use a broker primarily to disseminate as quickly as possible a currency quote to many other dealers. Central banks sometimes intervene in the foreign exchange market in an attempt to influence the price of its currency against that of a major trading partner, or a country that it “fixes” or “pegs” its currency against. Intervention is the process of using foreign currency reserves to buy one’s own currency in order to decrease its supply and thus increase its value in the foreign exchange market, or alternatively, selling one’s own currency for foreign currency in order to increase its supply and lower its price. 4. How are foreign exchange transactions between international banks settled? Answer: The interbank market is a network of correspondent banking relationships, with large commercial banks maintaining demand deposit accounts with one another, called correspondent bank accounts. The correspondent bank account network allows for the efficient functioning of the foreign exchange market. As an example of how the network of correspondent bank accounts facilities international foreign exchange transactions, consider a U.S. importer desiring to purchase merchandise invoiced in guilders from a Dutch exporter. The U.S. importer will contact his bank and inquire about the exchange rate. If the U.S. importer accepts the offered exchange rate, the bank will debit the U.S. importer’s account for the purchase of the Dutch guilders. The bank will instruct its correspondent bank in the Netherlands to debit its correspondent bank account the appropriate amount of guilders and to credit the Dutch exporter’s bank account. The importer’s bank will then debit its books to offset the debit of U.S. importer’s account, reflecting the decrease in its correspondent bank account balance. 5. What is meant by a currency trading at a discount or at a premium in the forward market? Answer: The forward market involves contracting today for the future purchase or sale of foreign exchange. The forward price may be the same as the spot price, but usually it is higher (at a premium) or lower (at a discount) than the spot price. 6. Why does most interbank currency trading worldwide involve the U.S. dollar? Answer: Trading in currencies worldwide is against a common currency that has international appeal. That currency has been the U.S. dollar since the end of World War II. However, the euro and Japanese yen have started to be used much more as international currencies in recent years. More importantly, trading would be exceedingly cumbersome and difficult to manage if each trader made a market against all other currencies. 7. Banks find it necessary to accommodate their clients’ needs to buy or sell FX forward, in many instances for hedging purposes. How can the bank eliminate the currency exposure it has created for itself by accommodating a client’s forward transaction? Answer: Swap transactions provide a means for the bank to mitigate the currency exposure in a forward trade. A swap transaction is the simultaneous sale (or purchase) of spot foreign exchange against a forward purchase (or sale) of an approximately equal amount of the foreign currency. To illustrate, suppose a bank customer wants to buy dollars three months forward against British pound sterling. The bank can handle this trade for its customer and simultaneously neutralize the exchange rate risk in the trade by selling (borrowed) British pound sterling spot against dollars. The bank will lend the dollars for three months until they are needed to deliver against the dollars it has sold forward. The British pounds received will be used to liquidate the sterling loan. 8. A CAD/$ bank trader is currently quoting a small figure bid-ask of 35-40, when the rest of the market is trading at CAD1.3436-CAD1.3441. What is implied about the trader’s beliefs by his prices? Answer: The trader must think the Canadian dollar is going to appreciate against the U.S. dollar and therefore he is trying to increase his inventory of Canadian dollars by discouraging purchases of U.S. dollars by standing willing to buy $ at only CAD1.3435/$1.00 and offering to sell from inventory at the slightly lower than market price of CAD1.3440/$1.00. 9. What is triangular arbitrage? What is a condition that will give rise to a triangular arbitrage opportunity? Answer: Triangular arbitrage is the process of trading out of the U.S. dollar into a second currency, then trading it for a third currency, which is in turn traded for U.S. dollars. The purpose is to earn an arbitrage profit via trading from the second to the third currency when the direct exchange between the two is not in alignment with the cross exchange rate. Most, but not all, currency transactions go through the dollar. Certain banks specialize in making a direct market between non-dollar currencies, pricing at a narrower bid-ask spread than the cross-rate spread. Nevertheless, the implied cross-rate bid-ask quotations impose a discipline on the non-dollar market makers. If their direct quotes are not consistent with the cross exchange rates, a triangular arbitrage profit is possible. 10. Over the past five years, the exchange rate between British pound and U.S. dollar, $/£, has changed from about 1.90 to about 1.45. Would you agree that over this five-year period that British goods have become cheaper for buyers in the United States? CFA Guideline Answer: The value of the British pound in U.S. dollars has gone up from about 1.90 to about 1.45. Therefore, the dollar has appreciated relative to the British pound, and the dollars needed by Americans to purchase British goods have decreased. Thus, the statement is correct. PROBLEMS 1. Using the American term quotes from Exhibit 5.4, calculate a cross-rate matrix for the euro, Swiss franc, Japanese yen, and the British pound so that the resulting triangular matrix is similar to the portion above the diagonal in Exhibit 5.6. Solution: The cross-rate formula we want to use is: S(j/k) = S($/k)/S($/j). The triangular matrix will contain 4 x (4 + 1)/2 = 10 elements. ¥ SF £ $ Euro 129.70 1.2335 .8499 1.3092 Japan (100) .9510 .6552 1.0094 Switzerland .6890 1.0614 U.K 1.5405 2. Using the American term quotes from Exhibit 5.4, calculate the one-, three-, and six-month forward cross-exchange rates between the Australian dollar and the Swiss franc. State the forward cross-rates in “Australian” terms. Solution: The formulas we want to use are: FN(AD/SF) = FN($/SF)/FN($/AD) or FN(AD/SF) = FN(AD/$)/FN(SF/$). We will use the top formula that uses American term forward exchange rates. F1(AD/SF) = 1.0617/.9521 = 1.1151 F3(AD/SF) = 1.0624/.9482 = 1.1204 F6(AD/SF) = 1.0636/.9425 = 1.1285 3. A foreign exchange trader with a U.S. bank took a short position of £5,000,000 when the $/£ exchange rate was 1.55. Subsequently, the exchange rate has changed to 1.61. Is this movement in the exchange rate good from the point of view of the position taken by the trader? By how much has the bank’s liability changed because of the change in the exchange rate? CFA Guideline Answer: The increase in the $/£ exchange rate implies that the pound has appreciated with respect to the dollar. This is unfavorable to the trader since the trader has a short position in pounds. Bank’s liability in dollars initially was 5,000,000 x 1.55 = $7,750,000 Bank’s liability in dollars now is 5,000,000 x 1.61 = $8,050,000 4. Restate the following one-, three-, and six-month outright forward European term bid-ask quotes in forward points. Spot 1.3431-1.3436 One-Month 1.3432-1.3442 Three-Month 1.3448-1.3463 Six-Month Solution: 1.3488-1.3508 One-Month 01-06 Three-Month 17-27 Six-Month 57-72 5. Using the spot and outright forward quotes in problem 4, determine the corresponding bid-ask spreads in points. Solution: Spot 5 One-Month 10 Three-Month 15 Six-Month 20 6. Using Exhibit 5.4, calculate the one-, three-, and six-month forward premium or discount for the Japanese yen versus the U.S. dollar using American term quotations. For simplicity, assume each month has 30 days. What is the interpretation of your results? Solution: The formula we want to use is: fN,CD = [(FN($/¥) - S($/¥/$)/S($/¥)] x 360/N f1,CD = [(.010095 - .010094)/.010094] x 360/30 = .0012 f3,CD = [(.010099 - .010094)/.010094] x 360/90 = .0020 f6,CD = [(.010106 - .010094)/.010094] x 360/180 = .0024 The pattern of forward premiums indicates that the Japanese yen is trading at a premium versus the U.S. dollar. That is, it becomes more expensive to buy a Japanese yen forward for U.S. dollars (in absolute and percentage terms) the further into the future one contracts. 7. Using Exhibit 5.4, calculate the one-, three-, and six-month forward premium or discount for the U.S. dollar versus the British pound using European term quotations. For simplicity, assume each month has 30 days. What is the interpretation of your results? Solution: The formula we want to use is: fN,$ = [(FN (£/$) - S(£/$))/S(£/$)] x 360/N f1,$ = [(.6493 - .6491)/.6491] x 360/30 = .0037 f3,$ = [(.6494 - .6491)/.6491] x 360/90 = .0018 f6,$ = [(.6498 - .6491)/.6491] x 360/180 = .0022 The pattern of forward premiums indicates that the dollar is trading at a premium versus the British pound. The one-month premium is larger than the either the three-month or six-month premium in percentage but not absolute terms. 8. A bank is quoting the following exchange rates against the dollar for the Swiss franc and the Australian dollar: SFr/$ = 1.5960--70 A$/$ = 1.7225--35 An Australian firm asks the bank for an A$/SFr quote. What cross-rate would the bank quote? CFA Guideline Answer: The SFr/A$ quotation is obtained as follows. In obtaining this quotation, we keep in mind that SFr/A$ = SFr/$/A$/$, and that the price (bid or ask) for each transaction is the one that is more advantageous to the bank. The SFr/A$ bid price is the number of SFr the bank is willing to pay to buy one A$. This transaction (buy A$—sell SFr) is equivalent to selling SFr to buy dollars (at the bid rate of 1.5960 and the selling those dollars to buy A$ (at an ask rate of 1.7235). Mathematically, the transaction is as follows: bid SFr/A$ = (bid SFr/$)/(ask A$/$) = 1.5960/1.7235 = 0.9260 The SFr/A$ ask price is the number of SFr the bank is asking for one A$. This transaction (sell A$—buy SFr) is equivalent to buying SFr with dollars (at the ask rate of 1.5970 and then simultaneously purchasing these dollars against A$ (at a bid rate of 1.7225). This may be expressed as follows: ask SFr/A$ = (ask SFr/$)/(bid A$/$) = 1.5970/1.7225 = 0.9271 The resulting quotation by the bank is SFr/A$ = 0.9260—0.9271 9. Given the following information, what are the NZD/SGD currency against currency bid-ask quotations? American Terms European Terms Bank Quotations Bid Ask Bid Ask New Zealand dollar .7265 .7272 1.3751 1.3765 Singapore dollar .6135 .6140 1.6287 1.6300 Solution: Equation 5.12 from the text implies Sb(NZD/SGD) = Sb($/SGD) x Sb(NZD/$) = .6135 x 1.3751 = .8436. The reciprocal, 1/Sb(NZD/SGD) = Sa(SGD/NZD) = 1.1854. Analogously, it is implied that Sa(NZD/SGD) = Sa($/SGD) x Sa(NZD/$) = .6140 x 1.3765 = .8452. The reciprocal, 1/Sa(NZD/SGD) = Sb(SGD/NZD) = 1.1832. Thus, the NZD/SGD bid-ask spread is NZD0.8436NZD0.8452 and the SGD/NZD spread is SGD1.1832-SGD1.1854. 10. Doug Bernard specializes in cross-rate arbitrage. He notices the following quotes: Swiss franc/dollar = SFr1.5971?$ Australian dollar/U.S. dollar = A$1.8215/$ Australian dollar/Swiss franc = A$1.1440/SFr Ignoring transaction costs, does Doug Bernard have an arbitrage opportunity based on these quotes? If there is an arbitrage opportunity, what steps would he take to make an arbitrage profit, and how would he profit if he has $1,000,000 available for this purpose. CFA Guideline Answer: A. The implicit cross-rate between Australian dollars and Swiss franc is A$/SFr = A$/$ x $/SFr = (A$/$)/(SFr/$) = 1.8215/1.5971 = 1.1405. However, the quoted cross-rate is higher at A$1.1.1440/SFr. So, triangular arbitrage is possible. B. In the quoted cross-rate of A$1.1440/SFr, one Swiss franc is worth A$1.1440, whereas the cross-rate based on the direct rates implies that one Swiss franc is worth A$1.1405. Thus, the Swiss franc is overvalued relative to the A$ in the quoted cross-rate, and Doug Bernard’s strategy for triangular arbitrage should be based on selling Swiss francs to buy A$ as per the quoted cross-rate. Accordingly, the steps Doug Bernard would take for an arbitrage profit is as follows: i. Sell dollars to get Swiss francs: Sell $1,000,000 to get $1,000,000 x SFr1.5971/$ = SFr1,597,100. ii. Sell Swiss francs to buy Australian dollars: Sell SFr1,597,100 to buy SFr1,597,100 x A$1.1440/SFr = A$1,827,082.40. iii. Sell Australian dollars for dollars: Sell A$1,827,082.40 for A$1,827,082.40/A$1.8215/$ = $1,003,064.73. Thus, your arbitrage profit is $1,003,064.73 - $1,000,000 = $3,064.73. 11. Assume you are a trader with Deutsche Bank. From the quote screen on your computer terminal, you notice that Dresdner Bank is quoting €0.7627/$1.00 and Credit Suisse is offering SF1.1806/$1.00. You learn that UBS is making a direct market between the Swiss franc and the euro, with a current €/SF quote of .6395. Show how you can make a triangular arbitrage profit by trading at these prices. (Ignore bid-ask spreads for this problem.) Assume you have $5,000,000 with which to conduct the arbitrage. What happens if you initially sell dollars for Swiss francs? What €/SF price will eliminate triangular arbitrage? Solution: To make a triangular arbitrage profit the Deutsche Bank trader would sell $5,000,000 to Dresdner Bank at €0.7627/$1.00. This trade would yield €3,813,500= $5,000,000 x .7627. The Deutsche Bank trader would then sell the euros for Swiss francs to Union Bank of Switzerland at a price of €0.6395/SF1.00, yielding SF5,963,253 = €3,813,500/.6395. The Deutsche Bank trader will resell the Swiss francs to Credit Suisse for $5,051,036 = SF5,963,253/1.1806, yielding a triangular arbitrage profit of $51,036. If the Deutsche Bank trader initially sold $5,000,000 for Swiss francs, instead of euros, the trade would yield SF5,903,000 = $5,000,000 x 1.1806. The Swiss francs would in turn be traded for euros to UBS for €3,774,969= SF5,903,000 x .6395. The euros would be resold to Dresdner Bank for $4,949,481 = €3,774,969/.7627, or a loss of $50,519. Thus, it is necessary to conduct the triangular arbitrage in the correct order. The S(€/SF) cross exchange rate should be .7627/1.1806 = .6460. This is an equilibrium rate at which a triangular arbitrage profit will not exist. (The student can determine this for himself.) A profit results from the triangular arbitrage when dollars are first sold for euros because Swiss francs are purchased for euros at too low a rate in comparison to the equilibrium cross-rate, i.e., Swiss francs are purchased for only €0.6395/SF1.00 instead of the no-arbitrage rate of €0.6460/SF1.00. Similarly, when dollars are first sold for Swiss francs, an arbitrage loss results because Swiss francs are sold for euros at too low a rate, resulting in too few euros. That is, each Swiss franc is sold for €0.6395/SF1.00 instead of the higher no-arbitrage rate of €0.6460/SF1.00. 12. The current spot exchange rate is $1.95/£ and the three-month forward rate is $1.90/£. Based on your analysis of the exchange rate, you are pretty confident that the spot exchange rate will be $1.92/£ in three months. Assume that you would like to buy or sell £1,000,000. a. What actions do you need to take to speculate in the forward market? What is the expected dollar profit from speculation? b. What would be your speculative profit in dollar terms if the spot exchange rate actually turns out to be $1.86/£. Solution: a. If you believe the spot exchange rate will be $1.92/£ in three months, you should buy £1,000,000 forward for $1.90/£. Your expected profit will be: $20,000 = £1,000,000 x ($1.92 -$1.90). b. If the spot exchange rate actually turns out to be $1.86/£ in three months, your loss from the long position will be: -$40,000 = £1,000,000 x ($1.86 -$1.90). 13. Omni Advisors, an international pension fund manager, plans to sell equities denominated in Swiss Francs (CHF) and purchase an equivalent amount of equities denominated in South African rands (ZAR). Omni will realize net proceeds of 3 million CHF at the end of 30 days and wants to eliminate the risk that the ZAR will appreciate relative to the CHF during this 30-day period. The following exhibit shows current exchange rates between the ZAR, CHF, and the U.S. dollar (USD). Currency Exchange Rates ZAR/US D ZAR/US D CHF/US D CHF/US D Maturit y Bid Ask Bid Ask Spot 6.2681 6.2789 1.5282 1.5343 30-day 6.2538 6.2641 1.5226 1.5285 90-day 6.2104 6.2200 1.5058 1.5115 a. Describe the currency transaction that Omni should undertake to eliminate currency risk over the 30-day period. b. Calculate the following: • The CHF/ZAR cross-currency rate Omni would use in valuing the Swiss equity portfolio. • The current value of Omni’s Swiss equity portfolio in ZAR. • The annualized forward premium or discount at which the ZAR is trading versus the CHF. CFA Guideline Answer: a. To eliminate the currency risk arising from the possibility that ZAR will appreciate against the CHF over the next 30-day period, Omni should sell 30-day forward CHF against 30-day forward ZAR delivery (sell 30-day forward CHF against USD and buy 30-day forward ZAR against USD). b. The calculations are as follows: • Using the currency cross rates of two forward foreign currencies and three currencies (CHF, ZAR, USD), the exchange would be as follows: --30 day forward CHF are sold for USD. Dollars are bought at the forward selling price of CHF1.5285 = $1 (done at ask side because going from currency into dollars) --30 day forward ZAR are purchased for USD. Dollars are simultaneously sold to purchase ZAR at the rate of 6.2538 = $1 (done at the bid side because going from dollars into currency) --For every 1.5285 CHF held, 6.2538 ZAR are received; thus the cross currency rate is 1.5285 CHF/6.2538 ZAR = 0.244411398. • At the time of execution of the forward contracts, the value of the 3 million CHF equity portfolio would be 3,000,000 CHF/0.244411398 = 12,274,386.65 ZAR. • To calculate the annualized premium or discount of the ZAR against the CHF requires comparison of the spot selling exchange rate to the forward selling price of CHF for ZAR. Spot rate = 1.5343 CHF/6.2681 ZAR = 0.244779120 30 day forward ask rate 1.5285 CHF/6.2538 ZAR = 0.244411398 The premium/discount formula is: [(forward rate – spot rate) / spot rate] x (360 / # day contract) = [(0.244411398 – 0.24477912) / 0.24477912] x (360 / 30) = -1.8027126 % = -1.80% discount ZAR to CHF MINI CASE: SHREWSBURY HERBAL PRODUCTS, LTD. Shrewsbury Herbal Products, located in central England close to the Welsh border, is an old-line producer of herbal teas, seasonings, and medicines. Its products are marketed all over the United Kingdom and in many parts of continental Europe as well. Shrewsbury Herbal generally invoices in British pound sterling when it sells to foreign customers in order to guard against adverse exchange rate changes. Nevertheless, it has just received an order from a large wholesaler in central France for £320,000 of its products, conditional upon delivery being made in three months’ time and the order invoiced in euros. Shrewsbury’s controller, Elton Peters, is concerned with whether the pound will appreciate versus the euro over the next three months, thus eliminating all or most of the profit when the euro receivable is paid. He thinks this is an unlikely possibility, but he decides to contact the firm’s banker for suggestions about hedging the exchange rate exposure. Mr. Peters learns from the banker that the current spot exchange rate is €/£ is €1.4537, thus the invoice amount should be €465,184. Mr. Peters also learns that the three-month forward rates for the pound and the euro versus the U.S. dollar are $1.8990/£1.00 and $1.3154/€1.00, respectively. The banker offers to set up a forward hedge for selling the euro receivable for pound sterling based on the €/£ forward cross-exchange rate implicit in the forward rates against the dollar. What would you do if you were Mr. Peters? Suggested Solution to Shrewsbury Herbal Products, Ltd. (Note to Instructor: This elementary case provides an intuitive look at hedging exchange rate exposure. Students should not have difficulty with it even though hedging will not be formally discussed until Chapter 8. The case is consistent with the discussion that accompanies Exhibit 5.9 of the text. Professor of Finance, Banikanta Mishra, of Xavier Institute of Management – Bhubaneswar, India contributed to this solution.) Suppose Shrewsbury sells at a twenty percent markup. Thus the cost to the firm of the £320,000 order is £256,000. Thus, the pound could appreciate to €465,184/£256,000 = €1.8171/1.00 before all profit was eliminated. This seems rather unlikely. Nevertheless, a ten percent appreciation of the pound (€1.4537 x 1.10) to €1.5991/£1.00 would only yield a profit of £34,904 (= €465,184/1.5991 - £256,000). Shrewsbury can hedge the exposure by selling the euros forward for British pounds at F3(€/£) = F3($/£) ÷ F3($/€) = 1.8990 ÷ 1.3154 = 1.4437. At this forward exchange rate, Shrewsbury can “lock-in” a price of £322,217 (= €465,184/1.4437) for the sale. The forward exchange rate indicates that the euro is trading at a premium to the British pound in the forward market. Thus, the forward hedge allows Shrewsbury to lock-in a greater amount (£2,217) than if the euro receivable was converted into pounds at the current spot If the euro was trading at a forward discount, Shrewsbury would end up locking-in an amount less than £320,000. Whether that would lead to a loss for the company would depend upon the extent of the discount and the amount of profit built into the price of £320,000. Only if the forward exchange rate is even with the spot rate will Shrewsbury receive exactly £320,000. Obviously, Shrewsbury could ensure that it receives exactly £320,000 at the end of threemonth accounts receivable period if it could invoice in £. That, however, is not acceptable to the French wholesaler. When invoicing in euros, Shrewsbury could establish the euro invoice amount by use of the forward exchange rate instead of the current spot rate. The invoice amount in that case would be €461,984 = £320,000 x 1.4437. Shrewsbury can now lock-in a receipt of £320,000 if it simultaneously hedges its euro exposure by selling €461,984 at the forward rate of 1.4437. That is, £320,000 = €461,984/1.4437. The Market for Foreign Exchange Chapter Five Chapter Outline • Function and Structure of the FX Market – FX Market Participants – Correspondent Banking Relationships • The Spot Market – Spot Rate Quotations – The Bid-Ask Spread – Spot FX Trading – Cross Exchange Rate Quotations – Triangular Arbitrage – Spot Foreign Exchange Market Microstructure Chapter Outline Continued • The Forward Market – Forward Rate Quotations – Long and Short Forward Positions – Non-Deliverable Forward Contracts – Forward Cross-Exchange Rates – Swap Transactions – Forward Premium • Exchange-Traded Currency Funds FX Market Participants • The FX market is a two-tiered market: – Interbank market (wholesale) • About 100-200 banks worldwide stand ready to make a market in foreign exchange. • Nonbank dealers account for about 40% 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. Circadian Rhythms of the FX Market Source: Sam Y. Cross, All About the Foreign Exchange Market in the United States, Federal Reserve Bank of New York, www.newyorkfed.org. 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 Bank B NYC Correspondent Banking Relationships Bank A buys £100m from Bank B for $200m Bank A London Bank B NYC Assets Liabilities Assets Liabilities £ deposit at B £300m B’s Deposit$1,000m $ deposit at A$1000m A’s Deposit £300m £400m $1,200m $1200m £400m $ deposit at B $800m B’s Deposit £200m £ deposit at A £200m A’s Deposit $800m $600m £100m £100m $600m Other Assets £600m Other L&E £600m Other Assets $800m Other L&E $800m Total Assets £1,300m Total L&E £1,300m Total Assets $2,200m Total L&E$2,200m You can check your work: make sure that £1,300m = $1,200x(£1/$2) +£100 + £600 Practice Problem • Bank X is in Milan. Bank Y is in London. • The current exchange rate is €1.10 = £1.00. • Show the correct balances in each account if a currency trader employed at Bank X buys £100,000,000 from a currency trader at Bank Y for €110,000,000. – (The balance sheets are shown on the next slide.) Bank X Practice Problem buys Bank X Milano Bank Y London £100m €110m€1.10 = from Y for £100m£1.00 €110m Bank X Assets Liabilities £ deposit at Y £300m Y’s deposit €1,210m £400m €1,320m € deposit at Y €880m Y’s deposit £200m €770m £100m Other Assets £600m Other L&E £400m Total Assets £1,700m Total L&E Bank Y Assets Liabilities € deposit at X€1,210m X’s deposit £300m €1,320m £400m £ deposit at X £200m X’s deposit €880m £100m €770m Other Assets €590m Other L&E €810m Total Assets €2,020m Total L&E€2,020m Check: £1,700m = €1,320mCheck: €2,020m = £400m x + € 770 + €810x +£100 + £400€ 1.10£ 0 €£1.001 Correspondent Banking Relationships • International commercial banks communicate with one another using: – SWIFT: The Society for Worldwide Interbank Financial Telecommunications. – CHIPS: Clearing House Interbank Payments System. – ECHO: Exchange Clearing House Limited, the first global clearinghouse for settling interbank FX transactions. Spot Rate Quotations • A direct quotation is: – The U.S. dollar equivalent. – E.g., “a Japanese Yen is worth about a penny.” • An indirect quotation is: – The price of a U.S. dollar in the foreign currency. – E.g., “you get 100 yen to the dollar.” • See Exhibit 5.4 in the textbook. Spot Rate Quotations CurrenciesCurrencies .6491 = 1. U.S.U.S.-dollar foreign-dollar foreign-exchange rates in late New York trading.-exchange rates in late New York trading. ------Wednesday------ The direct quote for the Country/currency in US$ per US$ Canadianpound is: dollar £1 = $1.5405.9984 1.0016 1-mos forwardThe indirect quote for the .9986 1.0014 3-most forwardpound is: £.6491 = $1.9988 1.0012 6-mos forward .9979 1.0021 Japanese Note that the direct quote is yen .010094 99.07 1-mos forwardthe reciprocal of the indirect .010095 99.06 Country/currencyCountry/currency Euro area Euro area euroeuro 11-mos forward-mos forward 33-most forward-most forward 66-mos forward-mos forward British British poundpound 11-mos forward-mos forward 3-most forwardquote: 1.9717 =.0100991 99.02 33-most forward-most forward 6-mos forward .010106.5072 98.95 66-mos forward-mos forward ---------- --WednesdayFriday---------- in US$ in US$ 1.30921.3098 1.30931.3093 1.30981.3098 1.31071.3107 per US$per US$ .7638.6783 .7638.7638 .7635.7635 .7630.7630 1.54051.5405 .6491.6491 1.54021.5402 .6493.6493 1.53961.5396 1.53891.5389 .6495.6495 .6498.6498 The Bid-Ask Spread • The bid price is the price a dealer is willing to pay you for something. • The ask price is the amount a dealer wants you to pay for something. • It doesn’t matter if we’re talking used cars or used currencies: the bid-ask spread is the difference between the bid and ask prices. The Bid-Ask Spread • A dealer could offer: – A bid price of $1.3090 per €. – An ask price of $1.3092per €. • While there are a variety of ways to quote the above, the bid-ask spread represents the dealer’s expected profit. Ask Price – Bid Price Percent Spread = × 100 Ask Price $1.3092– $1.3090 0.0153% = x 100 $1.3092 The Bid-Ask Spread A dealer pricing pounds in terms of dollars would likely quote these prices as 00–05. Anyone trading $10m knows the “big figure.” USD Bank American Terms European Terms Quotations Bid Ask Bid Ask Pounds 1.5400 1.5405 .6491 .6494 The Bid-Ask Spread Dealer Customer Buy USD from dealer at indirect ask Currency Conversion with Bid-Ask Spreads • A speculator in New York wants to take a $10,000 position in the pound. • After his trade, what will be his position? Bid Ask S($/£) 1.5400 – 05 S(£/$) .6491– 94 £0.6491 $10,000 × = £6,491 $1.00 Dealer will pay $1.5400 for 1 GBP; he is asking $1.5405. He will pay £.6491 for $1 and will charge £.6494 for $1 £1 $10,000 × = £6,494 $1.5400 Sample Problem • A businessman has just completed transactions in Italy and England. He is now holding €250,000 and £500,000 and wants to convert to U.S. dollars. • His currency dealer provides this quotation: GBP/USD 0.6488 – 93 USD/EUR 1.4739 – 44 • What are his proceeds from conversion? He sells €250,000 at the dealer’s bid price: €250,000 x $1.4739 =$368,475 He sells £500,000 at the dealer’s ask price: £500,000 x=$770,060.06 $1,138,535.06 Another Sample Problem • An Italian has just completed transactions in America and England. – He is now holding $100,000 and £500,000, and wants to convert both amounts to the euro. • His currency dealer provides this quotation: GBP/USD 0.6488 – 93 USD/EUR 1.3095 – 98 • What are his proceeds from conversion? $770,060.06 = £500,000 x $1.00 £.6493 ($770,060.06 + $100,000) x = €664,269.40 Spot FX Trading • In the interbank market, the standard size trade is about U.S. $10 million. • A bank trading room is a noisy, active place. • The stakes are high. • The “long term” is about 10 minutes. Cross Rates • Suppose that S($/€) = 1.50 (i.e., $1.50 = €1.00) and that S($/£) = 2.00 (i.e., £1.00 = $2.00). • What must the €/£ cross rate be? × = €1.00 = £0.75 Pay attention to your “currency algebra”! £10,000 sell £ at bid $15,400 buy € at ask €11,763 Cross Rates with Bid-Ask Spreads USD Bank American Terms European Terms Quotations Bid Ask Bid Ask Pounds 1.5400 1.5405 .6491 .5073 Euros 1.3087 1.3092 .7638 .7641 €/£ €1.1763 £0.8501 To find the €/£ cross bid rate, consider a retail customer who: Starts with £10,000, sells £ for $, and buys €: £10,000 × × = €11,763 He has effectively sold £ at a €/£ bid price of €1.1763/£. €10,000 sell € at bid $13,087 buy £ at ask £8,495 Cross Rates with Bid-Ask Spreads USD Bank Quotations American Terms Bid Ask European Terms Bid Ask Pounds 1.5400 1.5405 .6491 .5073 Euros 1.3087 1.3092 .7638 .7641 €/£ €1.1763 €1.1771 £0.8495 £0.8501 To find the €/£ cross ask rate, consider a retail customer who starts with €10,000, sells € for $, and buys £: €10,000 × = £8,495 1 = €1.1771/£ €1/£0.8495 He has effectively bought £ at a €/£ ask price of €1.1771/£. Cross Rates with Bid-Ask Spreads direct indirect Bank American Terms European Terms Quotations Bid Ask Bid Ask £:$ $1.5400 $1.5405 £.6491 £.6494 €:$ $1.3087 $1.3092 €.7638 €.7641 €/£ €1.1763 €1.1771 £0.8495 £0.8501 Recall that the reciprocal of €1.1763 €1.00 the S(£/€) bid is the S(€/£) ask. £1.00 = £0.8501 He has bought £ at a €/£ ask price of €1.1771/£ Bid-ask quote would be €/£: 1.1763-71 Triangular Arbitrage Bank Quotations Bid Ask Deutsche Bank $:£ $1.5400 $1.5405 Credit Lyonnais $:€ $1.3087 $1.3092 Credit Agricole €/£ €1.1764 €1.1770 “No Arbitrage” €/£ €1.1763 €1.1771 Suppose we observe these banks posting these exchange rates. As we have calculated the “no arbitrage” €/£ cross bid and ask rates, we can see that there is an arbitrage opportunity: Credit Agricole’s bid is too high and their ask is too low. £1 × × = €1.1763 Triangular Arbitrage Bank Quotations Bid Ask Deutsche Bank $:£ $1.5400 $1.5405 Credit Lyonnais $:€ $1.3087 $1.3092 Credit Agricole €/£ €1.1758 €1.1760 “No Arbitrage” €/£ €1.1763 €1.1771 By going through Deutsche Bank and Credit Lyonnais, we can sell pounds for €1.1763. £1 × × = €1.1763 The arbitrage is to buy the pounds from Credit Agricole for €1.1760. Triangular Arbitrage Bank Quotations Bid Ask Deutsche Bank £:$ $1.5400 $1.5405 Credit Lyonnais €:$ $1.3087 $1.3092 Credit Agricole £:€ €1.1758 €1.1760 Start with £1m. Sell £ to Deutsche Bank for $1,540,000: £1,000,000 × = $1,540,000. Buy € from Credit Lyonnais, receive €1,337,132: $1,540,000 × = €1,176,291. Buy £ from Credit Agricole, receive £1,000,247. Spot Foreign Exchange Microstructure • Market microstructure refers to the mechanics of how a marketplace operates. • The bid-ask spreads in the spot FX market: – Increase with FX exchange rate volatility. – Decrease with dealer competition. • Private information is an important determinant of spot exchange rates. The Forward Market • Forward Rate Quotations • Long and Short Forward Positions • Non-Deliverable Forward Contracts • Forward Cross Exchange Rates • Forward Premium • Swap Transactions Forward Rate Quotations • The forward market for FX involves agreements to buy and sell foreign currencies in the future at prices agreed upon today. • Bank quotes for 1, 3, 6, 9, and 12 month maturities are readily available for forward contracts. • Longer-term swaps are available. Forward Rate Quotations Consider the exchange rates shown to the right. For British pounds, the spot exchange rate is $1.5405 = £1.00 while the 180-day forward rate is $1.5389 = £1.00 •What’s up with that? Country/currency in US$ per US$ 1.5405 UK pound.6491 1-mos forward 1.5402 .6493 3-most forward 1.5396 .6495 1.5389 6-mos forward.6498 Clearly market participants expect that the pound will be worth less in dollars in six months. Forward Rate Quotations • Consider the (dollar) holding period return of a dollar-based investor who buys £1 million at the spot exchange rate and sells them forward: gain $1,538,900 – $1,540,000 –$1,100 $HPR = pain = $1,540,000 = $1,540,000 $HPR = –0.0007 Annualized dollar HPR = –0.14% = –0.07% × 2 Forward Premium • The interest rate differential implied by forward premium or discount. • For example, suppose the € is appreciating from S($/€) = 1.55 to F180($/€) = 1.60. • The 180-day forward premium is given by: f180,€v$ =F180($/€) S($/€– S)($/€) × 180360 = 1.601.55 – 1.55 × 2 = 0.0645, or 6.45% Long and Short Forward Positions • If you have agreed to sell anything (spot or forward), you are “short.” • If you have agreed to buy anything (forward or spot), you are “long.” • So, if you have agreed to sell an FX forward, you are short, and if you have agreed to buy an FX forward, you are long. Payoff Profiles US$ .6491 .6493 .6495 Non-Deliverable Forward Contracts • Due to government-initiated capital controls, the currencies of some emerging market countries not freely traded. • For many of these currencies, trading in non-deliverable forward contracts exists. • A non-deliverable forward contract is settled in cash, usually U.S. dollars. – Settlement is calculated by the difference between the forward price agreed to in the contract and the spot price at maturity of the contract multiplied by the contract size. Forward Cross Rates Currencies U.S.-dollar foreign-exchange rates in late New York trading. --------Friday------- Euro area euro 1.3092 .7638 1-mos forward 3-mos forward 1.3093 .7638 1.3098 .7635 6-mos forward 1.3107 .7630 UK pound 1.5405 .6491 1-mos forward 3-mos forward 1.5402 .6493 1.5396 .6495 6-mos forward 1.5389 .6498 The 3-month forward €/£ Country/currency in US$ per US$ cross rate is: £0.8507 × = €1.00 Currency Symbols • In addition to the familiar currency symbols (£, ¥, €, $) there are three-letter codes for all currencies. It is a long list, but selected codes include: CHF Swiss francs GBP British pound ZAR South African rand CAD Canadian dollar JPY Japanese yen Swaps • A swap is an agreement to provide a counterparty with something he or she wants in exchange for something that you want. – Often on a recurring basis, e.g., every six months for five years. • Swap transactions account for approximately 56 percent of interbank FX trading, whereas outright trades are 11 percent. • Swaps are covered fully in Chapter 14. Exchange-Traded Currency Funds • Individual shares are denominated in the U.S. dollar and trade on the New York Stock Exchange. – Consider an ETF where each share represents 100 euros. The price of one share at any point in time will reflect the spot dollar value of 100 euros plus accumulated interest minus expenses. • Six additional currency trusts exist on the Australian dollar, British pound sterling, Canadian dollar, Mexican peso, Swedish krona, and the Swiss franc. • Currency is now recognized as a distinct asset class, like stocks and bonds. Currency ETFs facilitate investing in these currencies. Summary • Spot rate quotations – Direct and indirect quotes – Bid and ask prices • Cross Rates – Triangular arbitrage • Forward Rate Quotations – Forward premium (discount) – Forward points Solution Manual for International Financial Management Cheol S. Eun, Bruce G. Resnick 9780077861605
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