AFU 08112/08104

BA, BEF & BFB III 2022/23

TOPIC:
THE FOREIGN EXCHANGE
MARKET
BY:
HARRISON NGOWI (ACPA.)
 TOPIC OVERVIEW
➢Introduction

➢Foreign Exchange Market (FOREX)

➢Foreign Exchange Rates

➢Forward Markets

➢Cross Rates

➢Arbitrage
 INTRODUCTION
⚫ Over the last two decades, the foreign exchange
market(FOREX) has witnessed unprecedented
growth following developments in the world
economy
– Introduction of WTO
– The globalization of trade
– Growth in international investments
– Expansion of international trade
– The General Agreement on Tariffs and Trade
(GATT)
 MONEY AS MEDIUM OF
EXCHANGE
⚫ In the past, the value of a commodity or
service was expressed in terms of some other
commodity or service ( barter system).
⚫ In the monetary world, the value of every
commodity or service is expressed in terms
of money
⚫ The value of money is measured in terms of
its purchasing power of goods and services.
 MONEY AS MEDIUM OF
EXCHANGE
⚫ Different countries have different currencies
as their monetary unit.

⚫ The terms MONEY and CURRENCY have

different connotations in economic terms
but no distinction is observed btn them in
common parlance/jargon
 NEED OF FOREX
⚫ To access goods or services from abroad,
you need currency of that country.
⚫ In such situations, it should be possible to
acquire the required amount of the foreign
currency by exchanging a specific amount
of domestic currency for it
⚫ No need of FOREX if the world was using
single currency.
 NEED OF FOREX
⚫ However, since it is not practical to have a
single currency for all nations, it is
imperative to have a FOREIGN
EXCHANGE MARKET.
⚫ ISO developed a system of 3-letter codes
for all the currencies in the world to
facilitate easy and efficient currency
trading. E.g. TSH/TZS or KES or UGS etc.
CURRENCIES AND CODE
CURRENCY CODE
US DOLLAR USD
EURO EUR
JAPANESE YEN JPY
STERLING POUND GBP
SWISS FRANC CHF
CANADIAN DOLLAR CAD
AUSTRALIAN DOLLAR AUD
SWEDISH KRONOR SEK
DANISH KRONOR DKK
NORWEGIAN KRONOR NOK
GOLD XAU
KENYA SHILLING KES
UGANDA SHILLING UGX
SOUTHAFRICAN RAND ZAR
 CURRENCIES AND CODE
ZAMBIAN KWACHA ZMW
MALAWIAN KWACHA MWK
MOZAMBIQUE MET MZM
BOTSWANA PULA BWP
BURUNDI FRANC BIF
NEWZEALAND DOLLAR NZD
SAUDIARABIAN RILA SAR
HONGKONG DOLLAR HKD
SINGAPORE DOLLAR SGD
INDIAN RUPEE INR
PAKISTAN RUPEE PKR
UAE DIRHAM AED
SDR SDR
CHINESE YUAN CNY
OMANI RIAL OMR
OTHER CURRENCIES
 FOREIGN EXCHANGE
MARKET
⚫ A foreign exchange transaction is a trade of
one currency for another currency in the
FOREIGN EXCHANGE MARKET
(FOREX)
⚫ Forex have NO physical location……
FOREIGN EXCHANGE MARKET

⚫ The Foreign Exchange Market provides:

– The physical and institutional structure
through which the money of one country is
exchanged for that of another country
– The determination rate of exchange between
currencies
– Is where foreign exchange transactions are
physically completed
FOREIGN EXCHANGE MARKET
⚫ Foreign exchange means the money of a
foreign country; that is, foreign currency
bank balances, banknotes, checks and
drafts.
⚫ A foreign exchange transaction is an
agreement between a buyer and a seller that
a fixed amount of one currency will be
delivered for some other currency at a
specified date.
 FOREX Cont….
⚫ The Market:
⚫ the anyplace where money denominated
in one currency is bought and sold with
money denominated in another
currency.
 GEOGRAPHY
⚫ The foreign exchange market spans the
globe, with prices moving and currencies
trading somewhere every hour of every
business day.
⚫ The volume of currency transactions flows
across the globe as the major currency
trading centers open and close throughout
the day.
FOREIGN EXCHANGE MARKET

International Trade and Capital

Transactions:
facilitated with the ability
to transfer purchasing
power between countries
FOREIGN EXCHANGE MARKET

➢ The foreign exchange market

– Is the market where one buys or sells
the currency of country A with
the currency of country B
➢ A currency exchange rate
– Is simply the ratio of
a unit of currency of country A to
a unit of the currency of country B
at the time of the buy or sell transaction
FOREIGN EXCHANGE MARKET

⚫ The foreign exchange market is a market

where foreign currencies are bought and
sold.
⚫ It is an international market where various
currency exchange transactions take place;
this is in the shape of simultaneously buying
one currency and selling another.
 CHARACTERISTICS OF
FOREX
⚫ Twenty-four hours, non-stop trading
⚫ Trading volume – largest mkt
⚫ Extreme liquidity
⚫ Its geographical dispersion
⚫ Long trading hours
⚫ Variety of factors that affect price
⚫ New Technology of trading - electronic
⚫ Major trading centers
 FUNCTIONS
⚫ The main functions of foreign exchange
market are: -
– Transfer of purchasing power
– Provision of credit through financing of
inventory in transit
– Minimization of foreign exchange risk –
hedging facilities.
 ORGANIZATION OF THE
FOREIGN EXCHANGE MARKET
⚫ PARTICIPANTS IN THE FOREIGN
EXCHANGE MARKET
⚫ Participants at 2 Levels (Mkt Segment)
⚫ 1. Wholesale Level (95%)
⚫ - major commercial banks
⚫ 2. Retail Level
⚫ - banks dealing for business
customers.
 ORGANIZATION cont…

⚫ Two Sub markets of Currency Markets

⚫ 1. Spot Market:
⚫ - immediate transaction
⚫ - recorded by 2nd business day
⚫ 2. Forward Market:
⚫ - transactions take place at a
specified future date
PARTICIPANTS BY MARKET
⚫ Spot Market
⚫ a. commercial banks
⚫ b. brokers
⚫ c. customers of commercial
banks
⚫ d. central banks
PARTICIPANTS BY MARKET
⚫ Forward Market
⚫ a. arbitrageurs (hold currency)
⚫ b. speculators
⚫ c. hedgers
 MARKET PARTICIPANTS
⚫ The foreign exchange market consists of two tiers:
⚫ The interbank or wholesale market
⚫ The client or retail market (specific, smaller
amounts)
⚫ Five broad categories of participants operate
within these two tiers; bank and nonbank foreign
exchange dealers, individuals and firms,
speculators and arbitragers, central banks and
treasuries, and foreign exchange brokers.
 BANK AND NONBANK FOREIGN
EXCHANGE DEALERS
⚫ Banks and a few nonbank foreign exchange dealers
operate in both the interbank and client markets.
⚫ The profit from buying foreign exchange at a “bid”
price and reselling it at a slightly higher “offer” or
“ask” price.
⚫ Dealers in the foreign exchange department of large
international banks often function as “market makers.”
⚫ These dealers stand willing at all times to buy and sell
those currencies in which they specialize and thus
maintain an “inventory” position in those currencies.
 INDIVIDUALS AND FIRMS
⚫ Individuals (such as tourists) and firms (such
as importers, exporters and MNEs) conduct
commercial and investment transactions in the
foreign exchange market.
⚫ Their use of the foreign exchange market is
necessary but nevertheless incidental to their
underlying commercial or investment purpose.
⚫ Some of the participants use the market to
“hedge” foreign exchange risk.
 SPECULATORS AND
ARBITRAGERS
⚫ Speculators and arbitragers seek to profit from
trading in the market itself.
⚫ They operate in their own interest, without a need
or obligation to serve clients or ensure a
continuous market.
⚫ While dealers seek the bid/ask spread, speculators
seek all the profit from exchange rate changes and
arbitragers try to profit from simultaneous
exchange rate differences in different markets.
 CENTRAL BANKS AND
TREASURIES
⚫ Central banks and treasuries use the market to
acquire or spend their country’s foreign exchange
reserves as well as to influence the price at which
their own currency is traded.
⚫ They may act to support the value of their own
currency because of policies adopted at the
national level or because of commitments entered
into through membership in joint agreements such
as the European Monetary System.
 CENTRAL BANKS AND
TREASURIES
⚫ The motive is not to earn a profit as such, but
rather to influence the foreign exchange value
of their currency in a manner that will benefit
the interests of their citicizens.
⚫ As willing loss takers, central banks and
treasuries differ in motive from all other
market participants.
 FOREIGN EXCHANGE
BROKERS
⚫ Foreign exchange brokers are agents who facilitate
trading between dealers without themselves
becoming principals in the transaction.
⚫ For this service, they charge a commission.
⚫ It is a brokers business to know at any moment
exactly which dealers want to buy or sell any
currency.
⚫ Dealers use brokers for their speed, and because they
want to remain anonymous since the identity of the
participants may influence short term quotes.
 TRANSACTIONS
IN THE INTERBANK MARKET
⚫ A swap transaction in the interbank market 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.
⚫ Some different types of swaps are:
⚫ Spot against forward
⚫ Forward-Forward
⚫ Nondeliverable Forwards (NDF)
 MARKET MAKERS
⚫ Market makers stand ready to buy and sell
standard amounts of the currencies for
which they are making a market, and seek
to make a profit on the spread between the
two prices
⚫ Contribution of Market Makers;
⚫ Liquidity
⚫ Price discovery, and
⚫ Price stability in the forex
SIZE OF THE CURRENCY MARKET

⚫ In April 2001, a survey conducted by the

Bank for International Settlements (BIS)
estimated the daily global net turnover in
traditional foreign exchange market activity
to be $1,210 billion.
⚫ This was the first decline observed by the
BIS since it began surveying banks on
foreign currency trading in the 1980s.
GLOBAL FOREIGN EXCHANGE
MARKET TURNOVER – DAILY
AVERAGE
800

700 Spot
Forwards
600 Swaps

500

400

300

200

100

0
1989 1992 1995 1998 2001
SIZE OF THE CURRENCY MARKET

⚫ A. Largest in the world

⚫ 2005: $1.9 trillion daily
⚫ B. Market Centers (1998):
⚫ London = $637 billion daily
⚫ New York= $351 billion daily
⚫ Tokyo = $149 billion daily
⚫ C. Benchmark: 1999 USGDP = $9.1trillion
 Geographic Distribution of Foreign
Exchange Market Turnover (daily averages in April,
billions of US dollars)
700 United States
United Kingdom
600
Japan
500 Singapore
Germany
400

300

200

100

0
1989 1992 1995 1998 2001
Source: Bank for International Settlements, “Central Bank Survey of Foreign Exchange and Derivatives
Market Activity in April 2001,” October 2001, www.bis.org. 4-37
SIZE OF THE CURRENCY MARKET

⚫ In April 2007, the average daily foreign

exchange turnover increased to USD 3.2
trillion from USD1.95 trillion in April 2004
(BIS survey report)

⚫ It is evident that there has been an increased

in average daily foreign exchange turnover
over a period of three years.
SIZE OF THE CURRENCY MARKET

⚫ UK accounts for a major share (34.1%) in

the forex turnover, followed by US,
Switzerland, Japan, etc

⚫ Currency pair of USD/EUR account for a

major share of turnover (27%), followed by
USD/JPY, USD/GBP and USD/AUD.
SIZE OF THE CURRENCY MARKET

⚫ Foreign exchange swaps accounted for

55.6% of the forex turnover in April 2007,
followed by spots (32.6%) and outright
forwards (11.7%)
 ASSIGNMENT – GROUP
WORK
⚫HOW IS THE SIZE OF THE
MARKET (FOREX)
CURRENTLY (2022)???
Provide segment wise like
above.
NETWORKS FOR INTERNATIONAL
TRANSACTIONS
⚫ The society for Worldwide Interbank
Financial Telecommunication (SWIFT) and
the Clearing House Interbank Payment
System (CHIPS) are the dominant networks
used for international transactions and
settlements.
 HOMEWORK
⚫ Discuss how SWIFT and CHIPS together
act as a bridge to international transactions.
 THE US DOLLAR AS A
VEHICLE CURRENCY
⚫ A substantial proportion o f exchange
trading takes place through an intermediate
currency known as the vehicle currency.

⚫ Vehicle currency reduce transaction costs,

eliminate the needs to for dealers to keep
larger number of currencies in hand.
VEHICLE CURRENCY CONT…
⚫ It simplify conversion of currencies
⚫ GBP which was once the dominant global
currency has now been replaced by the US
dollar.
⚫ The Euro is now emerging as another dominant
currency.
⚫ In fact, there is a predictions that, over the next
15 years, it may surpass the US dollar as the
leading international currency.
 CLASS WORK – AFU 08112
⚫ The forex has witnessed unprecedented growth following
developments that have taken place in the world economy over
the last two decades.
⚫ According to BIS, the average daily forex turnover increased by
65% from 2004 to 2007 and continued increasing to date.
⚫ It was evidenced that a substantial proportion of forex trading
takes place through an intermediate currency known as the
“vehicle currency”
⚫ Required;
1) Discuss what is the vehicle currencies
2) Point out benefits of vehicle currencies
3) How vehicle currency facilitate an exchange of currencies (give
examples)
4) Point out past, current and future expected vehicle currency.
FOREIGN EXCHANGE RATES

⚫ A foreign exchange rate is the price of one

currency expressed in terms of another
currency.

⚫ A foreign exchange quotation (or quote) is a

statement of willingness to buy or sell at an
announced rate.
 FOREIGN EXCHANGE RATES
An example from Tanzania banks
CURRENCY CODE CASH RATES
BUYING SELLING
US DOLLAR USD 2290.0000 2,320.0000
EURO EUR 2467.0000 2,597.0000
JAPANESE YEN JPY 18.5600 23.5600
STERLING POUND GBP 2947.0000 3,077.0000
SWISS FRANC CHF 2349.3500 2,399.3500
CANADIAN DOLLAR CAD 1724.3200 1,754.3200
AUSTRALIAN DOLLAR AUD 1546.3200 1,576.3200
SWEDISH KRONOR SEK 221.3400 251.3400
DANISH KRONOR DKK 320.5300 350.5300
NORWEGIAN KRONOR NOK 231.6300 261.6300
GOLD XAU 3,584,435.37 3,591,835.3700
KENYA SHILLING KES 21.0200 26.0200
UGANDA SHILLING UGX 0.6050 0.6550
SOUTHAFRICAN RAND ZAR 153.0000 163.0000
ZAMBIAN KWACHA ZMW 149.0000 162.0000
 FOREIGN EXCHANGE RATES
An example from Tanzania banks
CURRENCY CODE CASH RATES
BUYING SELLING
MALAWIAN KWACHA MWK 2.8900 3.3900
MOZAMBIQUE MET MZM 0.0895 0.0905
BOTSWANA PULA BWP 207.4600 217.4600
BURUNDI FRANC BIF 1.2050 1.2550
NEWZEALAND DOLLAR NZD 1492.1600 1,504.1600
SAUDIARABIAN RILA SAR 614.3000 616.8000
HONGKONG DOLLAR HKD 296.2200 298.7200
SINGAPORE DOLLAR SGD 1666.5400 1,679.5400
INDIAN RUPEE INR 29.9300 34.9300
PAKISTAN RUPEE PKR 14.7000 15.2000
UAE DIRHAM AED 623.7000 633.7000
SDR SDR 3163.4000 3,193.4000
CHINESE YUAN CNY 320.9600 340.9600
OMANI RIAL OMR 5868.0200 6,128.0200
FOREIGN EXCHANGE RATES
⚫ Most foreign exchange transactions involve the
US dollar.
FOREIGN EXCHANGE RATES
⚫ Professional dealers and brokers may state foreign
exchange quotations in one of two ways:
– The foreign currency price of one unit of home currency
– The home currency price of a unit of foreign currency
⚫ Most foreign currencies in the world are stated in
terms of the number of units of home currency
needed to buy one unit of foreign currency.

⚫ SEE EXAMPLE IN NEXT SLIDE

 FOREIGN EXCHANGE RATES
An example from Tanzania banks
CURRENCY CODE CASH RATES
BUYING SELLING
MALAWIAN KWACHA MWK 2.8900 3.3900
MOZAMBIQUE MET MZM 0.0895 0.0905
BOTSWANA PULA BWP 207.4600 217.4600
BURUNDI FRANC BIF 1.2050 1.2550
NEWZEALAND DOLLAR NZD 1492.1600 1,504.1600
SAUDIARABIAN RILA SAR 614.3000 616.8000
HONGKONG DOLLAR HKD 296.2200 298.7200
SINGAPORE DOLLAR SGD 1666.5400 1,679.5400
INDIAN RUPEE INR 29.9300 34.9300
PAKISTAN RUPEE PKR 14.7000 15.2000
UAE DIRHAM AED 623.7000 633.7000
SDR SDR 3163.4000 3,193.4000
CHINESE YUAN CNY 320.9600 340.9600
OMANI RIAL OMR 5868.0200 6,128.0200
 EXCHANGE RATE
QUOTATIONS
⚫ BASE CURRENCY V/s QUOTED
CURRENCY

⚫ One unit of Base currency is traded for a

variable amount of the counter/quoted
currency.
 EXCHANGE RATE
QUOTATIONS
⚫ AMERICAN TERMS V/s EUROPEAN
TERMS

⚫ It should be noted that American terms and

European terms are reciprocals.
 EXCHANGE RATE
QUOTATIONS
⚫ DIRECT QUOTES V/s INDIRECT QUOTES
⚫ Foreign exchange quotes are at times described as either direct or
indirect.
⚫ In this pair of definitions, the home or base country of the
currencies being discussed is critical.
⚫ A direct quote is a home currency price of a unit of foreign
currency.
⚫ An indirect quote is a foreign currency price of a unit of home
currency.
⚫ The form of the quote depends on what the speaker regard as
“home.”
 EXCHANGE RATES QUOTATIONS
CURRENCY CODE CASH RATES
BUYING SELLING
US DOLLAR USD 2290.0000 2,320.0000
EURO EUR 2467.0000 2,597.0000
JAPANESE YEN JPY 18.5600 23.5600
STERLING POUND GBP 2947.0000 3,077.0000
SWISS FRANC CHF 2349.3500 2,399.3500
CANADIAN DOLLAR CAD 1724.3200 1,754.3200
AUSTRALIAN DOLLAR AUD 1546.3200 1,576.3200
SWEDISH KRONOR SEK 221.3400 251.3400
DANISH KRONOR DKK 320.5300 350.5300
NORWEGIAN KRONOR NOK 231.6300 261.6300
GOLD XAU 3,584,435.37 3,591,835.3700
KENYA SHILLING KES 21.0200 26.0200
UGANDA SHILLING UGX 0.6050 0.6550
SOUTHAFRICAN RAND ZAR 153.0000 163.0000
ZAMBIAN KWACHA ZMW 149.0000 162.0000
 EXCHANGE RATES QUOTATIONS
CURRENCY CODE CASH RATES
BUYING SELLING
MALAWIAN KWACHA MWK 2.8900 3.3900
MOZAMBIQUE MET MZM 0.0895 0.0905
BOTSWANA PULA BWP 207.4600 217.4600
BURUNDI FRANC BIF 1.2050 1.2550
NEWZEALAND DOLLAR NZD 1492.1600 1,504.1600
SAUDIARABIAN RILA SAR 614.3000 616.8000
HONGKONG DOLLAR HKD 296.2200 298.7200
SINGAPORE DOLLAR SGD 1666.5400 1,679.5400
INDIAN RUPEE INR 29.9300 34.9300
PAKISTAN RUPEE PKR 14.7000 15.2000
UAE DIRHAM AED 623.7000 633.7000
SDR SDR 3163.4000 3,193.4000
CHINESE YUAN CNY 320.9600 340.9600
OMANI RIAL OMR 5868.0200 6,128.0200
 EXCHANGE RATE
QUOTATIONS
⚫ BID V/s ASK RATES
⚫ Interbank quotations are given as a bid and ask (also
referred to as offer).
⚫ A bid is the price (i.e. exchange rate) in one currency at
which a dealer will buy another currency.
⚫ An ask is the price (i.e. exchange rate) at which a dealer
will sell the other currency.
⚫ Dealers bid (buy) at one price and ask (sell) at a slightly
higher price, making their profit from the spread between
the buying and selling prices.
⚫ A bid for one currency is also the offer for the opposite
currency.
 IN FOREX TRADING
⚫ Forex trading is the simultaneous buying of
one currency and selling another.
⚫ Currencies are traded through a broker or
dealer, and are traded in pairs;
– for example the euro and the U.S. dollar
(EUR/USD) or the British pound and the
Japanese yen (GBP/JPY).
⚫ When you trade in the forex market, you
buy or sell in currency pairs.
 Base Currency

⚫ The base currency is the first currency in

any currency pair.
⚫ The currency quote shows how much the
base currency is worth as measured against
the second currency.
⚫ For example, if the USD/CHF rate equals
1.6350, then one USD is worth CHF
1.6350.
 Base Currency

⚫ In the forex market, the U.S. dollar is

normally considered the “base” currency for
quotes, meaning that quotes are expressed
as a unit of 1 USD per the other currency
quoted in the pair.
⚫ The primary exceptions to this rule are the
British pound, the euro, and the Australian
and New Zealand dollar.
 Quote Currency

⚫ The quote currency is the second currency

in any currency pair.
⚫ This is frequently called the pip currency
and any unrealized profit or loss is
expressed in this currency.
 BID V/s ASK RATES
FOR DEALERS & CUSTOMERS
 EXCHANGE RATE
QUOTATIONS
⚫ PIP V/s LOT
⚫ A PIP is the smallest price increment a
currency can make against another currency
in foreign exchange trading.

⚫ A LOT is the standard unit size of a foreign

exchange transaction. E.g. 100,000 units,
10,000 units or 1,000 units of Base currency
 TRANSACTIONS COSTS
⚫ Bid-Ask Spread
⚫ used to calculate the fee charged by the
broker
⚫ Bid = the price at which
the broker is willing to buy
⚫ Ask = the price the broker will sell
the currency
 TRANSACTIONS COSTS

If you are selling If you want to buy

dollars for euros, this dollars wit euros, this
is the rate at which the is the rate at which the
broker will buy them broker will sell them to
from you you
 TRANSACTIONS COSTS
⚫ Percent Spread Formula (PS):
 ILLUSTRATION

⚫Suppose the spot quote

for the Swedish krona
is $.1395-99, what is
the percent spread?
 ILLUSTRATION CONT…
⚫ PS = Ask –Bid x 100
⚫ Ask

⚫ = .1399 - .1395 x 100

⚫ .1399
⚫ = .29% or 29 basis points
 EXAMPLE
⚫ Example;
⚫ Today (27th August, 2019) US Dollar is
quoted at TZS 2,275 to TZS 2,315, in
Tanzania (Quote by NMB Bank).
⚫
⚫ REQUIRED:
⚫ Calculate the percentage bid-ask spread.
FACTORS INFLUENCING EXCHANGE
RATE
⚫ There are many factors that influence the
exchange rates and also demand and supply
for a particular currency;
– Relative rates of Inflation
– Balance of Payment
– Relative Interest rates
– Capital Transactions
– Confidence in a Currency
– Direct intervention by the authorities
– Change in economic policies
– Political developments
– Expectations, Etc…….
 THE FORWARD MARKET
⚫ INTRODUCTION
⚫ Definition of a Forward Contract
⚫ an agreement between a bank and a
customer to buy or sell
⚫ 1. a specified amount of currency
against another currency
⚫ 2. at a specified future date and
⚫ 3. at a fixed exchange rate.
 PURPOSE OF A FORWARD
⚫ Hedging
⚫ the process of reducing or mitigating
exchange rate risk.
HEDGING TOOLS
THE FORWARD MARKET
Forward Contracts Require performance by
both parties
1. Contract Terms may be
a. 30-day
b. 90-day
c. 180-day
d. 360-day
2. Longer-term Contracts possible
FORWARD EXCHANGE RATES
QUOTATION
⚫ Forward rates are typically quoted in terms
of points.
⚫ A forward quotation 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 EXCHANGE RATES
QUOTATION
⚫ Forward quotations may also be expressed
as the percent-per-annum deviation from the
spot rate.
⚫ This method of quotation facilitates
comparing premiums or discounts in the
forward market with interest rate
differentials.
FORWARD EXCHANGE RATES
QUOTATION
⚫ Itcan be quoted either …. Or …..
– Outright quotation or Swap
quotation
– Premium, Discount form or At Par
– Point form or Cent form
 The forward rate premium or
discount
⚫ Direct Quotation and Forward Rates
– In determining the forward rate bank
will ADD “premium” and DEDUCT
“discounts” with the most favourable
margins.
⚫ Indirect Quotation and Forward Rates
– In determining forward rate bank
will DEDUCT “premium and ADD
“discount” with the most favorable
 EXAMPLE
⚫ The US Dollar and the Tanzania shillings
(TZS) are quoted as follows
⚫ Spot 2,270 – 2,315
⚫ 1 month forward 42 – 62 dis
⚫ 3 months forward 78 – 98 dis
⚫ 6 months forward 20 – 15 pm
⚫ Required;
⚫ Determine forward Outright rates.
 EXAMPLE TWO
⚫ On 30th August, a UK bank quotes the
following rates for the US Dollar
⚫ Spot rate 1.9425 – 1.9435
⚫ 1 month 0.53c – 0.43c pm
⚫ 3 months 0.80c – 0.56c pm
⚫ 6 months 0.96c – 0.81c pm
⚫ Required;
⚫ Determine forward Outright rates.
 EXAMPLE THREE
⚫ The following information is given by Mapesatele a
dealer in foreign currencies who operates from the
Tanzanian main business city, Dar es Salaam.
⚫ The spot rate of exchange between Burundi Franc (BIF)
is given at TSHS 1.75/BIF.
⚫ The 90-day forward rate is given at TSHS 1.35/BIF.
⚫
⚫ Required:
⚫ Determine whether the Burundi Franc is trading at
premium or discount and calculate the annualized
premium/discount.
 EXAMPLE FOUR
⚫ Latang’amwaki is a well-known and successful currency speculator
who relies on forecasting exchange rate. The spot exchange rate is
TZS.2,150/$ and the six-month forward rate is TZS.2,100/$.
⚫ Based on his analysis and forecast of the exchange rate, he is pretty
confident that the spot exchange rate will be TZS.2,120/$ in six-
months.
⚫ Assume that he would like to buy or sell $ 10,000,000.
⚫ Required;
⚫ (i) What actions should Latang’amwaki take to speculate in the
forward market?
⚫ (ii) What is the expected TZS profit from speculation if his forecast
turns out to be accurate?
⚫ (iii) What would be his speculative profit in dollar terms if the spot
exchange rate actually turns out to be TZS. 2,160/$?
 FUTURE SPOT RATES
⚫ Theoretically, the forward rate should
exactly reflect the expected future spot rate.

⚫ In reality, the presence of transaction costs

and risk premiums keeps the forward rate
and the expected future spot rate different.
 CROSS RATES
⚫ The complication in the exchange market
arises when both currencies related to the
transactions are not quoted in either to the
transactions.
⚫ To find the exchange rate between the
currencies, we should work out through the
relationship to quoted currencies. The rate
obtained is called Cross Rate.
 CROSS RATES
⚫ Therefore, CROSS RATE is the exchange
rate between two currencies derived from
their exchange rate against another
currency.
⚫ It is the rate of exchange between any two
currencies as determined through medium
of some other currency.
 EXAMPLE

⚫ The USD is quoted at AUD

1.1197/1.2135 and the GBP is
quoted at AUD 2.1920/2.2500.

⚫ What is the direct quote in USA

between the USD and the GBP?
 EXAMPLE TWO
⚫ Given the spot exchange rate between Ugandan
Shillings (UGX) and Tanzanian Shilling
(TSHS) is TSHS 0.585/UGX, and the exchange
rate between Tanzanian Shillings (TSHS) and
Kenyan Shillings (KES) is TSHS 20.76/KES.

⚫ Required:
⚫ Calculate the spot cross rate between Ugandan
Shillings (UGX) and Kenyan Shillings (KES),
UGX/KES.
 EXAMPLE THREE
⚫ Consider the following spot and three -
month forward quotations for a U.S Dollar
($),
Spot 3-month-forward
⚫ € /$ 0.81070 – 0.81103 0.81170 – 0.81243
⚫ ¥ /$ 107.490 – 107.541 107.347 – 107.442
⚫ Required:
⚫ Based on these rates, calculate the 3 month-
forward cross-rate for yen in terms of Euros.
 CROSS RATES
⚫ Usefulness of Cross Rates
1. To determine the exchange rate between
currencies.
2. To check if the opportunity for inter markets
arbitrage exist. (i.e Triangular Arbitrage)
 CROSS RATES
⚫ Many currency pairs are only inactively traded, so
their exchange rate is determined through their
relationship to a widely traded third currency
(cross rate).
⚫ Cross rates can be used to check on opportunities
for intermarket arbitrage.
⚫ This situation arose because one bank’s
(Dresdner) quotation on €/£ is not the same a
calculated cross rate between $/£ (Barclay’s) and
$/€ (Citibank).
4-93
 TRIANGULAR ARBITRAGE

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

(6) Receive $1,014,533 (1) Sell $1,000,000 to

Barclays Bank at $1.4443/£

Dresdner Bank Barclays Bank

(5) Sell €1,121,651 to (2) Receive £692,377
Citibank at $0.9045/€
(4) Receive €1,121,651 (3) Sell £692,377 to Dresnder Bank
at €1.6200/£ 4-94
 ARBITRAGE
⚫ If discrepancies occur within the foreign
exchange market, with quoted prices of
currencies varying from what the market
prices should be, certain market forces will
realign the rates.
⚫ The realignment occurs as a result of
international arbitrage.
 ARBITRAGE
⚫ Arbitrage refers to the selling and buying of
the same currency to profit from exchange
rate discrepancies within a market center or
across market centers.
TYPES OF INTERNATIONAL
ARBITRAGE
⚫ International arbitrage takes three common
forms
1. Locational arbitrage
2. Triangular arbitrage
3. Covered interest arbitrage
TRIANGULAR ARBITRAGE
⚫ If three currencies are involved in an
arbitrage operation, it is called a three-point
arbitrage or a triangular arbitrage.

⚫ Triangular arbitrage opportunity arises

when the currency direct quotes are not in
alignment with the cross exchange rates.
 ARBITRAGE
⚫ The existence of arbitrage opportunity is
evidence that, the exchange rate is not in
equilibrium at that time.
 TO TEST IF ARBITRAGE
OPPORTUNITY EXIST
⚫ Existence of arbitrage opportunity can be
done either by;
– CROSS RATE,
OR
– PRODUCT OF THE EXCHANGE RATES
 PRODUCT OF THE EXCHANGE
RATES
⚫ For arbitrage profit in triangular trading to
be zero, the product of the exchange rates
should be equal to ONE.
⚫ When it is zero, the exchange rates in this
case are in equilibrium
⚫ When the exchange rates of the given are in
equilibrium, the product of their reciprocal
rates must also be equal to ONE
 EXAMPLE
⚫ Consider the following exchange rate
quotation in the market
⚫ INR 39.7925/USD
⚫ USD 2.0592/GBP

⚫ GBP 0.0122/INR

⚫ Is there opportunity for arbitration?

 PRODUCT OF THE
EXCHANGE RATES
⚫ If the product of the rates is not equal to
one, THE OPPORTUNITY EXIST and
this is the same as Cross rate not equal to
similar market quoted rate.
 HOW TO EXPLOIT THE
OPPORTUNITY?
⚫ If product is less than one BUY BASE
CURRENCY in exchange of quoted
currency.

⚫ If the product is greater than one SELL

BASE CURRENCY in exchange of quoted
currency.
 EXAMPLE
⚫ Consider the following exchange rate
quotation in the market. Check if Arbitrage
opportunity exist.
⚫ Market quotations
⚫ USD 2.0592/GBP
⚫ GBP 0.4256/AUD
⚫ AUD 1.1310/USD
RESTORATION OF DISEQUILIBRIUM
⚫ If the product of the cross rates is less than
one, at least one of these rates should rise
and if it is greater than one, at least one of
the rates must fall.
⚫ The arbitrageurs will bring the exchange
rates back into equilibrium through the
buying and selling of currencies
⚫ Arbitrage opportunities now days is very
rare due to highly advanced communication
networks.
 CLASS QUIZ
⚫ CRDB Bank arranged a forward contract with its
exporter customer to buy USD 40,725 at
TZS/USD = 2,345. The receipt of proceeds was
delayed and the exporter asked for an extension of
one month fixed.
⚫ Required;
⚫ Show the transaction on the customer’s bank
account if the rates ruling on the maturity date of
the forward contract were;
⚫ Spot TZS/USD 2,285 – 2,305
⚫ One month forward 2 - 5 pm
 THE END!!!!!!!
⚫THANK YOU FOR
YOUR ATTENTION
⚫ALL THE BESTS
⚫@ H. NGOWI 2022