TOPIC 5

FOREIGN EXCHANGE
MARKET

OUTLINE

• Spot market for Foreign Exchange

– Market characteristics
– Arbitrage

• Forward market for Foreign Exchange

– Why is it used
– Market characteristics
– Arbitrage

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 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

Copyright © 2014 by the McGraw-Hill

Companies, Inc. All rights reserved.

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 https://www.wsj.com/market-data/currencies

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 CROSS RATES
• Suppose that S = 1.20$/€ and S = 1.50$/£
• What must the £/€ cross rate be?

CROSS RATES

𝐺𝐵𝑃
=?
𝐸𝑈𝑅

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 LOCATIONAL ARBITRAGE
• Buy low in one location & sell high in another location
In the FX market
– The buying price (ask price) in one bank is lower than the selling
price (bid price) of another bank
• Market adjustments which will eliminate locational
arbitrage
In the FX market:
– The ask price will rise and bid price will fall
– Till ask price (of one bank) is greater than or equal to bid price (of
another bank) 9

LOCATIONAL ARBITRAGE PROFIT

CASE 1: ARBITRAGE POSSIBLE CASE 2: NO ARBITRAGE POSSIBLE

• New York Bank quotes: • Chicago Bank quotes:

– Ask $1.24/1€ – Ask $.62/1SF

– Bid $1.21/1€ – Bid $.60/1SF

• Credit Lyonnais (LCL) Bank • Berlin Bank quotes:

quotes: – Ask $.64/1SF

– Ask $1.30/1€ – Bid $.62/1SF

– Bid $1.26/1€

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 IMPLIED CROSS RATE

£1 = $1.50
Implied cross rate: £/SF?
SF1 = $0.50

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TRIANGULAR ARBITRAGE: WHEN IMPLIED & ACTUAL CROSS

RATES ARE DIFFERENT

£1 = $1.50
Implied cross rate: £1 = $1.50/0.5 = SF3.0
SF1 = $0.50
If actual cross rate: £1 = SF3.50 If actual cross rate: £1 = SF2.50

$ $

£ SF £ SF12
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 TRIANGULAR CURRENCY ARBITRAGE

– Example, suppose the exchange rate for the British pound

and Swiss Franc:
– Pound per $1 in New York = .6 → 1$ = .6£
– SF per $1 in Frankfurt = 2.00 → 1$ = 2SF
– SF per pound in London = 3.00 → 1£ = 3SF
– Is there an arbitrage opportunity, assume you have $100?

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TRIANGULAR ARBITRAGE: CFA PROBLEM #10, P.141

$1 = SFr1.5971
Implied cross rate: SFr1= A$?
$1 = A$1.8215

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 TRIANGULAR ARBITRAGE: CFA PROBLEM #11
Dresdner Bank: $1 = €0.7627
Actual rate UBS: SFr1 = €0.6395
Credit Suisse: $1 = SFr1.1806

$1 = €0.7627
Implied cross rate: SFr1= €?
$1 = SFr1.1806
Have arbitrage opportunity?

SFr €
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THE FORWARD MARKET

Forward rates can be expressed in two ways. Commercial customers are usually
quoted the actual price. In the interbank market dealers quote the forward rate as the
swap rate
Swap rate
Spot 30-day 90-day 180-day
£: $1.4040-80 19-17 26-22 42-35
SFr:$0.6963-68 4-6 9-14 25-38
Outright rate £ SFr
Duration Bid Ask Spread Bid Ask Spread
Spot $1.4040 $1.4080 .285 $.6963 $.6968 .086
Forward 30-days $1.4021 $1.4053 .228 $.6967 $.6974 .100
Forward 90-days $1.4014 $1.4058 .313 $.6972 $.6982 .143
Forward 180-days $1.3998 $1.4045 .335 $.6988 $.7006 .257

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 INTEREST RATE PARITY THEORY
• Spot and forward rate are closely linked to each other and to interest in
different currencies through the medium of arbitrage.
• The movement funds between two currencies to take advantage of interest
rate differential is a major determinant of the spread between forward rate
and spot rates.
• According to interest parity theory, the currency of the country with a
lower interest rate should be at a forward premium in terms of the
country with higher rate
• In the efficient market with no transaction cost, the interest differential
should be equal to forward differential

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INTEREST RATE PARITY - IRP

Defined:
– S: Spot rate
– F: Forward rate
– rh: Interest rate in home currency
– rf: Interest rate in foreign currency
There are two cases:
– borrow in home currency (US$)
– Borrow in foreign currency (£)

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 INTEREST RATE PARITY - IRP
CASE 1a: Borrow in home currency (US$)
t0 t1 year
Borrowing $1 Paying

Receiving

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INTEREST RATE PARITY - IRP

𝐹
𝑆
(1 + 𝑟𝑓 ) > (1 + 𝑟ℎ )

1+𝑟
𝐹 > 𝑆 1+𝑟ℎ = f
𝑓

Have arbitrage opportunity as borrowing in home currency (US$)

and sell foreign currency at F

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 INTEREST RATE PARITY - IRP

1 + rh F 1 + rh
= F =S
1 + rf S 1 + rf

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INTEREST RATE PARITY - IRP

CASE 1b: Borrow in foreign currency (£)
t0 t1 year
Borrowing £1 Paying

Receiving

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 INTEREST RATE PARITY - IRP

𝑆
(1 + 𝑟ℎ ) > (1 + 𝑟𝑓 )
𝐹

1 + 𝑟ℎ
𝐹<𝑆 =𝑓
1 + 𝑟𝑓

Have arbitrage opportunity as borrowing in foreign currency (£)

and buy foreign currency at F

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ARBITRAGE OPPORTUNITY
▪ Indicate: f: forward rate compute from interest rate parity equation,
F: forward rate in the market

(1 + rh )
f =s
(1 + rf )

▪ If F > f : borrow in home currency & Sell foreign currency in forward rate
▪ If F < f : borrow in foreign currency & Buy foreign currency in forward rate

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 ARBITRAGE OPPORTUNITY
Problem #11, Page 173

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INTEREST RATE PARITY - IRP

When transaction cost exist, how can define arbitrage
opportunity.
Defined:
– Sb & Sa : Bid price and ask price (spot rate)
– Fb & Fa : Bid price and ask price (Forward rate)
– rha & rhb : borrow rate (ask rate) and lend rate (bid rate) in home
currency
– rfa & rfb : borrow rate and lend rate (foreign currency)
There are two cases:
– borrow in home currency
– Borrow in foreign currency
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 INTEREST RATE PARITY - IRP
CASE 2a: Borrow in home currency (US$)
t0 t1 year
Borrowing $1 Paying

Receiving

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INTEREST RATE PARITY - IRP

CASE 2b: Borrow in foreign currency (£)
t0 t1 year
Borrowing £1 Paying

Receiving

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 INTEREST RATE PARITY - IRP
• Borrow in home currency

1 + 𝑟ℎ𝑎
𝐹𝑏 > 𝑆𝑎 = 𝑓𝑎
1 + 𝑟𝑓𝑏

• Fb> fa: company can gain in the foreign exchange, by selling foreign
currency at forward rate
• Borrow in foreign currency
1 + 𝑟ℎ𝑏
𝐹𝑎 < 𝑆𝑏 = 𝑓𝑏
1 + 𝑟𝑓𝑎

• Fa < fb: company can gain in the foreign exchange, by buying foreign
currency at forward rate
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INTEREST RATE PARITY - IRP

Suppose the annualized interest rate on 180-day GBP deposits
is 67/16-5/16%, meaning that GBP can borrowed at 67/16% (ask
rate) and lent at 65/16% (bid rate). At the same time, the
annualized interest rate on 180-day AUD deposits is 9 3/8-1/8%,
spot rate and 180 days forward quotes on AUD are £0.4706-
80/AU$ and £0.4811-75/AU$ respectively. Is there an
arbitrage opportunity? Compute the profit.

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 EXAMPLE - IRP
Suppose the annualized interest rate on EUR deposits is 7-
7.5%, meaning that EUR can borrowed at 7.5% (ask rate) and
lent at 7% (bid rate). At the same time, the annualized interest
rate on USD deposits is 91/4-3/4%, spot rate and one year
forward rate quotes on EUR are 1.2320-60$/€ and 1.2430-
80$/€ respectively. Is there an arbitrage opportunity? Compute
the profit.

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COVERED COST AND ARBITRAGE OPPORTUNITY

Problem: American company have to pay £100.000 to British

company due in 180 days. Company want to expose this
payment. Suppose, Spot rate: $1.73/£, and 180 day-Forward
rate: $1.74/£. Interest in European money market: 5%/year
for $ and 6%/year for £.

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 COVERED COST AND ARBITRAGE OPPORTUNITY

Problem 1 - P.171

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