CROSS RATE DERIVATION

AND APPLICATIONS
Review:
What is a Foreign Exchange Contract?
A bilateral agreement ¨ Two Parties

to buy or sell ¨ Two Cash Flows

one currency against ¨ Two Currencies

another

at an agreed price ¨ Two-way Quote

at a specific value date ¨ Two Value Dates

Definition of Cross Rates
¨ Exchange rate of one currency against another
derived through a third currency

¨ Example:
¤ Given: USD/JPY
USD/PHP

¤ Derive: JPY/PHP cross or

PHP/JPY cross
How to compute for the cross rate
Majors FX Rate ¨ AUDGBP
AUDUSD 0.7121
¨ EURDKK
GBPUSD 1.3073
USDCAD 1.3345 ¨ AUDJPY
USDDKK 6.5562 ¨ EURCHF
EURUSD 1.1389 AUD 0.7121 AUD 1 USD 0.54471
GBP 1 USD 1.3073 GBP
USDJPY 109.52
NZDUSD 0.6784 EUR
DKK
1.1389 EUR
1 USD
6.5562 USD
1 DKK
7.4669

USDNOK 8.5618 AUD 0.7121 AUD 109.52 USD 77.9892

USDSEK 9.0111 JPY 1 USD 1 JPY

USDCHF 0.9939 EUR

CHF
1.1389 EUR
1 USD
0.9939 USD
1 CHF
1.1320
Cross Rates Exercise (Round Robin)
Majors FX Rate Asian FX Rate
AUDUSD 0.7121 USDCNY 6.7853
GBPUSD 1.3073 USDHKD 7.8458
USDCAD 1.3345 USDINR 71.29
USDDKK 6.5562 USDIDR 14139
USDMYR 4.138
EURUSD 1.1389
USDNZD 0.6784
USDJPY 109.52
USDPHP 52.769
NZDUSD 0.6784 USDSGD 1.3586
USDNOK 8.5618 USDKRW 1127.6
USDSEK 9.0111 USDTWD 30.894
USDCHF 0.9939 USDTHB 31.706
Find the following cross rates

1. GBPMYR 11. CNYHKD

2. JPYPHP 12. INRSGD
3. TWDCHF 13. EURKRW
4. AUDJPY 14. GBPCAD
5. SGDPHP 15. EURNZD
6. SEKMYR 16. SEKNOK
7. CHFNZD 17. PHPCAD
8. EURJPY 18. GBPSGD
9. PHPEUR 19. DKKEUR
10. DKKCAD 20. GBPCNY
Cross Rates with Bid and Offer
¨ The following quotes are available from the interbank market
¤ USDAUD 0.6000 – 0.6015
¤ USDMXN 0.0933 – 0.0935

¨ Compute the implied MXNAUD bid and offer cross rates

!"# ( !"# %.&
¤ Bid à = ×0.6000 = 6.417
$%& ).)+,- %.& $%&
!"# ( !"# %.&
¤ Offer
à = ×0.6015 = 6.447
$%& ).)+,, %.& $%&
¤ MXNAUD 6.417 – 6.447

¨ Be careful! Always refer to the commodity currency. If you need

the bid for MXNUSD, so use the offer (i.e., sell USD buy MXN)
Exercise: Cross Rates with Bid and Offer

Majors Bid Offer Asian Bid Offer

AUDUSD 0.7121 0.7122 USDCNY 6.7853 6.7861
GBPUSD 1.3073 1.3074 USDHKD 7.8458 7.8459
USDCAD 1.3345 1.3345 USDINR 71.29 71.29
USDDKK 6.5562 6.5564 USDIDR 14139 14140
USDMYR 4.138 4.138
EURUSD 1.1389 1.1389
USDPHP 52.769 52.787
USDJPY 109.52 109.53
USDSGD 1.3586 1.3586
NZDUSD 0.6784 0.6786
USDKRW 1127.6 1127.8
USDNOK 8.5618 8.5634 USDTWD 30.894 30.897
USDSEK 9.0111 9.0136 USDTHB 31.706 31.716
USDCHF 0.9939 0.9939
Find the bid and offer for the following cross
rates
1. GBPMYR 11. CNYHKD
2. JPYPHP 12. INRSGD
3. TWDCHF 13. EURKRW
4. AUDJPY 14. GBPCAD
5. SGDPHP 15. EURNZD
6. SEKMYR 16. SEKNOK
7. CHFNZD 17. PHPCAD
8. EURJPY 18. GBPSGD
9. PHPEUR 19. DKKEUR
10. DKKCAD 20. GBPCNY
Financial Intermediation in FX

¨ Example: Corporate client sells USD/CHF to Bank

USD USD

Corporate BANK Market

CHF CHF

¨ Bank’s Transactions:
¤ Buys USD/CHF (Corporate)

¤ Sells USD/CHF (Market)

Financial Intermediation in FX

¨ Example: Corporate client buys USD/CHF to Bank

USD USD
Corporate BANK Market
CHF CHF

¨ Bank’s Transactions:
¤ Sells USD/CHF (Corporate)
¤ Buys USD/CHF (Market)
Example

¨ Example: A Japanese exporter wants to sell

CHF/JPY to Bank A. There is no direct market for a
CHF/JPY cross. What is the bank’s break-even
CHF/JPY buying rate from the exporter if the trader
were to cover at interbank market rates?

¨ The following interbank market rates are given:

USD/JPY 125.50-60
USD/CHF 1.6530-40
Answer
¨ Interbank rates: USD/JPY 125.50-60
USD/CHF 1.6530-40

¨ Step 1: Determine Rates

Exporter Bank A Market
sells CHF/JPY a) buys CHF/JPY
[sell USD/CHF; buy USD/JPY]

Cover:
b) buys USD/CHF 1.6540 offer
c) sells USD/JPY 125.50 bid
Answer
¨ Step 2: Compute the implied CHF/JPY market bid
rates
!"# ( !"# ./0
¤ Bid à $%&
= (.*+,- ./0
×125.50 $%& = 75.88

¨ 75.88 is the market implied bid rate for CHF/JPY

Example

¨ Example: A Japanese exporter wants to buy

CHF/JPY from Bank A. There is no direct market for
a CHF/JPY cross. What is the bank’s break-even
CHF/JPY selling rate from the exporter if the trader
were to cover at interbank market rates?

¨ The following interbank market rates are given:

USD/JPY 125.50-60
USD/CHF 1.6530-40
Answer

¨ Interbank rates: USD/JPY 125.50-60

USD/CHF 1.6530-40

¨ Determine Rates
Exporter Bank Market
buys CHF/JPY a) sells CHF/JPY
[buy USD/CHF; sell USD/JPY]
Cover:
b) sells USD/CHF 1.6530 bid
c) buys USD/JPY 125.60 offer
Answer
¨ Step 2: Compute the implied CHF/JPY market offer
rates
!"# ( !"# ./0
¤ Offer à $%&
= (.*+,- ./0
×125.60 $%& = 75.98

¨ 75.98 is the market implied offer rate for CHF/JPY

Cross Rates with Bid and Offer

Bid Offer
CHF/JPY 75.88 75.98
FX FORWARD EXCHANGE
CONTRACTS
Forward Exchange Rate
¨ The price of an agreed quantity of one currency in
terms of another for delivery on an agreed date or
period in the future

¨ The price of one currency in terms of another with

a maturity beyond spot date
Currency Forwards
¨ Example: An exporter sells USD/PHP 3.0 M value
three months from spot. What is the bank’s
breakeven rate for the 182-day USD/PHP assuming
they cover at the market rates given below?

182 day USD 0.25% / 0.375%

182 day PHP 3.25% / 3.50%
Spot USD/PHP 52.208/ 52.215
Currency Forwards
182 day USD 0.25% / 0.375%
182 day PHP 3.25% / 3.50%
Spot USD/PHP 52.208/ 52.215

¨ Forex Transactions
¤ Forward purchase of USD/PHP
¤ FX Cover: sell spot USD/PHP at 52.208

¨ Money Market Cover

¤ Borrow USD for 182D at 0.375%
¤ Lend PHP for 182D at 3.250%
Arbitrage-Free Price of a Currency Forward

¨ Recover the negative Interest Rate Differential (IRD) through the

Forex Transaction
¤ IRD = 0.375% - 3.250% = - 2.875%

¨ Convert the IRD to exchange points so it will become comparable

with the exchange rate.
¤ Exchange points = Spot x IRD x tenor/360
¤ Exchange points = 52.208 x 2.875% x 182/360 = 0.7588

¨ To recover negative IRD, USD has to be sold higher than the spot
rate (forward premium)
¤ Forward Rate = Spot ± Forward Premium/Forward Discount
¤ USD/PHP Forward = 52.208 + 0.7588 = USD/PHP 52.9668
Formula
¨ Foreign Exchange Rate is equal to:
Forward value of Terms currency
Forward value of commodity currency
¨ Where the forward value = Principal + Interest
¨ 182D USD/PHP forward rate =
*+,
!"."$%×(!"."$%×(."!%× ) !(.$5!%
-./
¨ *+, = 1.$$16
=52.9654
12(1×$.(3!%× )
-./
¨ Swap Points = Forward rate – Spot Rate
¤ Swap points = 52.9654 – 52.208 = 0.7574
Assignment: Currency Forwards
1. Given the following scenario in the interbank market:

EUR/USD spot rate 1.267 – 319

284D EUR 0.125% / 0.225%
284D USD 0.425% / 0.525%.

a. What is the bank’s break even 284D bid and offer

forward rate if it has to cover at market rates?
b. How much should he quote if he wants to make a
3-pip profit both ways?
Assignment: Currency Forwards
2. The following are interbank quotes:

Spot USD/CAD spot 0.9938 - 45.

1-Mo CAD 0.375% / 0.425%
1-Mo USD interest rate 0.1250% / 0.150%.

a. A trader needs to give a quote for 1mo USD/CAD.

What will be his break even bid/offer forward rate
if it needs to cover at market rates?
b. How much should he quote if he wants to make a
5-pip profit both ways?
Interpreting Swap Points
¨ Last digit of the swap points should be aligned to the
last decimal of the spot rate.

¨ If bid rate is larger than offer rate, commodity

currency is at a forward discount.

¨ If bid rate is smaller than offer rate, commodity

currency is at a forward premium.
Interpreting Swap Points
¨ Forward Discount

Example: quoted “60-55”

Spot USD/JPY 126.20-126.30

6-mo. USD/JPY swap 0.60-0.55
6-mo. USD/JPY fwd 125.60-125.75
Interpreting Swap Points
¨ Forward Premium

Example: quoted “25-35”

Spot USD/MYR 2.4957-2.4967

6-mo. USD/MYR swap 0.0025-0.0035
6-mo. USD/MYR fwd 2.4982-2.5002
Concept Check: Swap Points
HKD SGD MYR THB
Spot 7.7433/43 1.4257/67 2.4963/73 25.0900/1110
T/N 0/1 1.6/1.3 2/1.7 40/50
1 week 3/6 9.5/7.5 2/1.5 100/150
1 month 18/23 33/38 4/1 650/725
2 month 40/47 70/65 P/5 1350/1450
3 month 60/70 100/95 4/9 2100/2200
6 month 130/150 195/185 30/35 4500/4650
1 year 330/380 375/335 95/120 9200/9700
Forward Value Dates
¨ Forward date should be an eligible value date.

¨ Value dating rules

¤ Date-to-Date Rule: forward date is the same date in the
forward month, e.g.,
Spot Value Date June 28
Tenor of one month
Forward Value Date July 28
(if a holiday, move over to the next eligible value date)
Forward Value Dates
¨ Value dating rules
¤ Month-end to Month-end: whenever value date begins
with last eligible value date of a month, forward value date
must be last eligible value date of forward month, e.g.,
Spot Value Date June 30
Tenor of six months
Forward Value Date Dec 30

¨ Not allowed to roll-over to next month; should be

last eligible value date of forward month
Typical Maturities

Overnight O/N Deposit today Return tomorrow

Tom/Next T/N Deposit tomorrow Return next day
Spot/Next S/N Deposit spot Return next day
Spot/Week S/W Deposit spot Return week later
1 Month 1M Deposit spot Return 1 mo. Later
2 Months 2M Deposit spot Return 2 mo. Later
3 Months 3M Deposit spot Return 3 mo. Later
6 Months 6M Deposit spot Return 6 mo. Later
12 Months 1Y Deposit spot Return 12 mo. later
Forward Cross Rates with Bid and Offer

¨ Compute for 6-month DKK/CHF bid and offer given

interbank rates below.

Spot USD/DKK 1.4375-85

6-mo. USD/DKK swap 140-135
6-mo. USD/DKK fwd 1.4235-50

Spot USD/CHF 1.2020-30

6-mo. USD/CHF swap 145-138
6-mo. USD/CHF fwd 1.1875-92
Forward Cross Rates with Bid and Offer

¨ Compute the implied DKK/CHF forward bid and

offer cross rates
!"" ' !"" -.!
¤ Bid à = '.)*+, -.! ×1.1875 #$% = 0.8333
#$%
!"" ' !"" -.!
¤ Offer à = ×1.1892 = 0.8354
#$% '.)*4+ -.! #$%

¨ Implied forward bid and offer

¤ DKK/CHF 0.0833-0.8354
Economic Theories for FX
Covered Interest Rate Parity
¨ Holds when any forward premium or discount
exactly offsets differences in interest rates, so that
an investor would earn the same return investing
in either currency.
¨ For example, if CIRP holds and PHP interest rates
are higher than USD interest rates, depreciation of
the PHP relative to the USD will just offset the
higher PHP interest rate
()*+
#$%& ×
,-.
¨ != ()*+ 01
#$%/ ×
,-.
Uncovered Interest Rate Parity
¨ If forward currency contracts are not available, or if
capital flows are restricted so as to prevent
arbitrage
¤ E(%∆") = %& − %(

¨ Typically does not hold in the short run, but

generally holds in the long run. Hence, long-term
expected future sort rates based on Uncovered IRP
are often used as forecasts of future exchange
rates
Fisher Relation
¨ Domestic Fisher Relation
¤ !"#$%"&' = !()&' + +(-./012-3.)

¨ International Fisher Relation

¤ !"#$%"&'5 − !"#$%"&' 7 = + 9./012-3. 5 −
+ 9./012-3. 7
¤ This is based on the idea that with free capital flows,
funds will move to the country with a higher real rat
until real rates are equalized
Purchasing Power Parity
¨ The law of one price (all identical goods should have the same price
in all locations)

¨ Absolute Purchasing Power Parity

¤ Requires that the law of one price be correct on average
¤ S(A/B)=CPI (A)/CPI(B)

¨ Relative Purchasing Power Parity

¤ %∆S(A/B)=CPI (A)/CPI(B)
¤ Ex-ante PPP: use expected inflation

¨ Note: violations of PPP are common in the short-run, but evidence

suggests that relative PPP holds approximately in the long run.
References
¨ O’Brien. Introduction to Foreign Exchange Rates.
Business Expert Press

¨ CFA Level 1 and Level 2 Economics

¨ Bloomberg

¨ Treasury Certification Program (TCP) Foreign Exchange

Module – Ateneo-BAP Institute of Banking