Chapter 5 Outline

ˆ Function and Structure of the FX

Market

ˆ The Spot Market

ˆ The Forward Market

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 Foreign Exchange Market

The Foreign Exchange Market:

ˆ provides the physical and institutional structure through
which the money of one country is exchanged for that of
another country;
ˆ provides the determination rate of exchange between
currencies, and
ˆ is where foreign exchange transactions are physically
completed.

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ˆ Foreign exchange means the money of a foreign country;
that is, foreign currency bank balances, banknotes, checks
and drafts.
ˆ 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.
ˆ The foreign exchange market spans the globe, with prices
moving and currencies trading somewhere every hour of
every business day.

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Circadian Rhythms of the FX Market

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The foreign exchange Market is the mechanism by which
participants:
ˆ transfer purchasing power between countries;
ˆ obtain or provide credit for international trade
transactions, and
ˆ minimize exposure to the risks of exchange rate changes.

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 FX Market Participants

The FX market is a two-tiered market:

ˆ Interbank Market (Wholesale)
ˆ About 700 banks worldwide stand ready to make a
market in foreign exchange.
ˆ Nonbank dealers account for about 20% of the
market.
ˆ There are FX brokers who match buy and sell orders
but do not carry inventory and FX specialists.
ˆ Client Market (Retail)

Market participants include international banks, their

customers, nonbank dealers, FX brokers, and central banks

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The Structure of the Foreign Exchange Market

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Foreign Exchange Trading Activity Around the
World

Foreign exchange market is the largest market in the world,

measured by dollar volume of trade.

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Top 20 Dealers in the Foreign Exchange Market

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 Spot Exchange Rates

ˆ General notation
ˆ S (j/k) = x : 1 unit of currency k equals x units of
currency j
ˆ unit price of currency k in terms of currency j
ˆ S (j/k) = 1/S (k/j)

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 Spot Exchange Rates

Professional dealers and brokers may state foreign exchange

R
quotations in one of two ways

Direct quotation
ˆ the U.S. dollar equivalent

L ˆ e.g. “a Japanese Yen is worth about a penny”

Indirect Quotation
ˆ the price of a U.S. dollar in the foreign currency
ˆ e.g. “ you get 100 yen to the dollar”

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 Direct and Indirect, European
and American Quotes
In the U.S. In Britain
$/£
$/£
£/$
£/$
In Thailand In the European Union
Thai Baht/e

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ˆ Most interbank quotations around the world are stated in
European terms.
ˆ The two most important exceptions are quotes for the
euro and U.K. pound sterling which are both normally
quoted in American terms.
ˆ Besides, Australian Dollar and New Zealand Dollar are
quoted in American terms.
ˆ American terms are also utilized in quoting rates for most
foreign currency options and futures, as well as in retail
markets that deal with tourists.

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 Exchange Rates

USD equiv USD equiv Currency per USD Currency per USD
Country Friday Thursday Friday Thursday
(today) (yesterday) (today) (yesterday)

Argentina (Peso) 0.3309 0.3292 3.0221 3.0377

Australia (Dollar) 0.7830 0.7836 1.2771 1.2762
Brazil (Real) 0.3735 0.3791 2.6774 2.6378
Britain (Pound) 1.9077 1.9135 0.5242 0.5226
1 Month Forward 1.9044 1.9101 0.5251 0.5235
3 Months Forward 1.8983 1.9038 0.5268 0.5253
6 Months Forward 1.8904 1.8959 0.5290 0.5275
Canada (Dollar) 0.8037 0.8068 1.2442 1.2395
1 Month Forward 0.8037 0.8069 1.2442 1.2393
3 Months Forward 0.8043 0.8074 1.2433 1.2385
6 Months Forward 0.8057 0.8088 1.2412 1.2364
Euro 1.3112 1.3136 0.7627 0.7613

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ˆ What is the direct quote for British pound?

ˆ What is the indirect quote for British pound?

ˆ Given one of them, do we know the other?

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 Rates of Appreciation and Depreciation

ˆ The description of appreciation and depreciation refers to

the currency that is in the denominator of the exchange
rate. For $-£ exchange rates, the percentage change in
the exchange rate describes in terms of the £
ˆ Percentage appreciation and depreciation of the pound
= new $/£−old
old $/£
$/£

ˆ For example, if exchange rate changes from $2.00/£ to

$2.50/£, the pound is said to have appreciated relative to
the dollar by 25%:
25% = 100% × $2.50/£−$2.00/£
$2.00/£
ˆ Now let’s examine the rate of depreciation of the dollar
relative to the pound.
100% × £0.40/$−£0.50/$
£0.50/$
= −20%

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 The Bid-Ask Spread
ˆ The bid price is the price a dealer is willing to pay you for
something.
ˆ The ask price is the amount the dealer wants you to pay
for the thing.
ˆ The bid-ask spread is the difference between the bid and
ask prices.
ˆ A dealer could offer
ˆ bid price of $1.25 per e
ˆ ask price of $1.26 per e
ˆ The bid-ask spread represents the dealer’s expected profit.
For major currencies in large transaction sizes, bid-ask
spreads are within 5 “pips”. Pip is a trader jargon for the
fourth decimal point in a currency quote (Percentage In
Point).
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 big small figure
figure
Bid Ask
S($/£) 1.9072 1.9077
S(£/$) .5242 .5243

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

ˆ It is presumed that anyone trading $10m already knows
the “big figure”.
ˆ The percentage bid-ask is computed as:
Percentage spread = 100% ×(ask - bid)/ask
ˆ what is the percentage bid-ask spread here?

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 Cross Rates

ˆ Many currency pairs are only inactively traded, so their

exchange rate is determined through their relationship to
a widely traded third currency (cross rate).
ˆ A vehicle currency is a currency actively used in many
international financial transactions around the world.
ˆ Cross rates can be used to check on opportunities for
intermarket arbitrage.

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ˆ Suppose that S($/e) = 1.50
ˆ i.e. $1.50 = e1.00
ˆ and that S(¥/e) = 50
ˆ i.e. e1.00 = ¥50
ˆ What must be the $/¥ cross rate?

$1.50 = e1.00 = ¥50

$1.00 = ¥33.33
$0.0300 = ¥1

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 Formula

S ($/k) S (j/$)
S (j/k) = =
S ($/j) S (k/$)
S ($/j) S (k/$)
S (k/j) = =
S ($/k) S (j/$)

Back to the Exchange Rates table,

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1 What is the cross-exchange rate between Euro and British
pound S (e/£) from American term quotations?

2 What is the cross-exchange rate between Euro and British

pound S (e/£) from European term quotations?

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 Triangular Arbitrage

ˆ Arbitrage is the act of simultaneously buying and selling

the same or equivalent assets or commodities for the
purpose of making certain, guaranteed profits.

ˆ Suppose we observe these banks posting these exchange

rates.

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 $
Barclays
Credit Lyonnais
S(¥/$)=120
S(£/$)=1.50

¥ Credit Agricole
£
S(¥/£)=85

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First calculate any implied cross rate to see if any arbitrage
exists.
What is the implied S(¥/£) cross rate?

£1.50 = $1.00 ⇔ $1.00 = ¥120

£1.00 = ¥80 ⇔ S(¥/£) = ¥80

Credit Agricole has posted a quote of S(¥/£)=85 so there is

an arbitrage opportunity.
So how can we make money?
✎ Buy the £ @ ¥80; sell @ ¥85.
Then trade yen for your preferred currency.

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 $
Barclays
Credit Lyonnais
S(¥/$)=120
3 1 S(£/$)=1.50
2
¥ Credit Agricole
£
S(¥/£)=85

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As easy as 1-2-3:
1 Sell our $ for £;
2 Sell our £ for ¥;
3 Sell those ¥ for $.
Sell $100,000 for £ at S(£/$)=1.50
receive £150,000
Sell £150,000 for ¥ at S(¥/£)=85
receive ¥12,750,000
Sell ¥12,750,000 for $ at S(¥/$)=120
receive $ 106,250

Profit per round trip = $106, 250 − $100, 000 = $6, 250

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 $
Barclays
Credit Lyonnais
S(¥/$)=120
2 3 S(£/$)=1.50
1
¥ Credit Agricole
£
S(¥/£)=85

➢ Here we have to go clockwise to make money

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➢ If we went counter clockwise we would be the source of
arbitrage profits not the recipient!

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➢ Do we still do clockwise if S(¥/£)=75 instead of
S(¥/£)=85 in order to make money?

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➢ How about counter clockwise?

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 Forward Rate Quotations

ˆ The forward market for FX involves agreements to buy

and sell foreign currencies in the future at prices agreed
upon today.
ˆ Notation: FN (j/k)
ˆ Bank quotes for 1, 3, 6, 9, and 12 month maturities are
readily available for forward contracts.
ˆ Consider the example from above:
ˆ for British pounds, the spot rate is
$1.9077 = £1.00
ˆ While the 180-day forward rate is
$1.8904 = £1.00
ˆ What’s up with that?

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 USD equiv USD equiv Currency per USD Currency per USD
Country Friday Thursday Friday Thursday

Argentina (Peso) 0.3309 0.3292 3.0221 3.0377

Australia (Dollar) 0.7830 0.7836 1.2771 1.2762
Brazil (Real) 0.3735 0.3791 2.6774 2.6378
Britain (Pound) 1.9077 1.9135 0.5242 0.5226
1 Month Forward 1.9044 1.9101 0.5251 0.5235
3 Months Forward 1.8983 1.9038 0.5268 0.5253
6 Months Forward 1.8904 1.8959 0.5290 0.5275
Canada (Dollar) 0.8037 0.8068 1.2442 1.2395
1 Month Forward 0.8037 0.8069 1.2442 1.2393
3 Months Forward 0.8043 0.8074 1.2433 1.2385
6 Months Forward 0.8057 0.8088 1.2412 1.2364
Euro 1.3112 1.3136 0.7627 0.7613

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Clearly the market participants expect that the pound will be
worth less in dollars in six months.
Forward premium and forward discount refer to the currency
that is in the denominator of the exchange rate.
ˆ Forward premium occurs when the price of the currency
contract is higher then the spot rate
ˆ Forward discount occurs when the price of the currency
contract is lower then the spot rate
ˆ The interest rate differential implied by forward premium
or discount
% per annum (p.a.) forward premium or discount of an N day
forward rate
   
forward - spot 360
= × × 100%
spot N days
where N is the number of days in the forward contract.
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➢ For example, suppose the e has S($/e) = 1.25 and
F180 ($/e) = 1.30

➢ The annual forward premium is given by:

F180 ($/e) − S ($/e) 360 1.30 − 1.25
f180,$/e = × = ×2 = 8%
S ($/e) 180 1.25

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 Point quotations

Recall the $/£ spot bid-ask rates,

Spot 1.9072-1.9077
One-Month 32-30
Three-Month 57-54
Six-Month 145-138

✌ Rules:
ˆ add to the spot bid-ask rates if the former point is less
than the latter
ˆ subtract from the spot bid-ask rates if the former point is
greater than the latter

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Restate the following one-, three-, and six-month forward
point bid-ask quotes in outright forward terms.

Spot 1.9072-1.9077
Forward Point Outright Forward bid-ask
Quotations Quotations spreads
1-Month 32-30
3-Month 57-54
6-Month 145-138

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 Forward Cross Exchange Rates
ˆ It’s just an “delayed” example of the spot cross rate
discussed above.
ˆ In generic terms

FN ($/k) FN (j/$)
FN (j/k) = =
FN ($/j) FN (k/$)
and
FN ($/j) FN (k/$)
FN (k/j) = =
FN ($/k) FN (j/$)
ˆ The forward pound-Canadian dollar cross rate

GBP1.00 = USD1.8904

USD1.00 = CAD1.2412
GBP1.00 = CAD2.3464
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 Currency Symbols

In addition to the familiar currency symbols (e.g. £, ¥, e, $)

there are three-letter codes for all currencies.
It is a long list, but selected codes include:
ˆ CHF Swiss francs
ˆ GBP British pound
ˆ ZAR South African rand
ˆ CAD Canadian dollar
ˆ JPY Japanese yen
ˆ AUD Australian Dollar
ˆ NZD New Zealand Dollar

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 Long and Short Positions

ˆ If you have agreed to sell anything (spot or forward), you

are “short”.
ˆ If you have agreed to buy anything (forward or spot), you
are “long”.
ˆ If you have agreed to sell FX forward, you are short.
ˆ If you have agreed to buy FX forward, you are long.
ˆ If you agree to sell anything in the future at a set price
and the spot price later falls then you gain.
ˆ If you agree to sell anything in the future at a set price
and the spot price later rises then you lose.

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Payoff Profiles

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ˆ A forward contract in 180 days
ˆ You can use the direct or indirect quote: F180 (¥/$) =
105 or F180 ($/¥) = .009524
ˆ When the short entered into this forward contract, he
agreed to sell ¥ in 180 days at F180 (¥/$) = 105
ˆ If, in 180 days, S180 (¥/$) = 120, the short will make a
profit by buying ¥ at S180 (¥/$) = 120 and delivering ¥
at F180 (¥/$) = 105.

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ˆ Since this is a zero-sum game, the long position payoff is
the opposite of the short.
ˆ The long in this forward contract agreed to BUY ¥ in 180
days at F180 (¥/$) = 105
ˆ If, in 180 days, S180 (¥/$)=120, the long will lose by
having to buy ¥ at F180 (¥/$) = 105 and delivering ¥ at
S180 (¥/$) = 120

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 Practice Problem
The current spot exchange rate is $1.55/£ and the
three-month forward rate is $1.50/£. Based on your analysis
of the exchange rate, you are confident that the spot exchange
rate will be $1.52/£ in three months. Assume that you would
like to buy or sell £1,000,000.

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❶. What actions do you need to take to speculate in the
forward market? What is the expected dollar profit from
speculation?

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❷. What would be your speculative profit in dollar terms if
the spot exchange rate actually turns out to be $1.46/£?

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