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brokers, local and multi-national banks, and other participants. The exhibit below shows the volume of trade that takes place each hour. Typical daily market activity is $1.2B. Exhibit 4.1 Foreign Exchange Activity
2 5 ,0 0 0
2 0 ,0 0 0
1 5 ,0 0 0
1 0 ,0 0 0
5 ,00 0
Greenwich Mean Time
1 2 3 4 5 6 7 8 9 1 0 1 1 1 2 1 3 1 4 15 16 1 7 1 8 1 9 2 0 2 1 2 2 2 3 2 4
10 AM Lunch Europe In Tokyo In Tokyo opening
Americas London open closing
Afternoon in America
6 pm In NY
Source: Federal Reserve Bank of New York, “The Foreign Exchange Market in the United States,” 2001, www.ny.frb.org.
Q: According to your book, who are the main participants in the foreign exchange market? A: 1) bank and nonblank foreign exchange dealers 2) individuals and firms 3) speculators and arbitragers 4) central banks and treasuries 5) foreign exchange brokers
Q: What makes central banks and treasuries different from other market participants? A: Their goal is NOT profit; it is to support economic policies or political commitments.
The Foreign Exchange Market
1) the spot currency exchange market and 2) the forward currency exchange market.Two basic markets exist. dollar (as the home currency). The Spot Market Currencies trade for “immediate” delivery in the spot market (but settle 2 days after the trade date).$ equivalent. Q: If the spot rate for Mexican pesos is Ps9.52 / $ The Foreign Exchange Market 2 .504.S.” The Wall Street Journal uses this format for listing quotes under the heading “Currency per U. A contract to deliver U. $0. dollars forward for Haitian gourde.S. 90.” Ps100.” Indirect Quotation – the foreign currency price of a unit of home currency.99Bd$/$ is an indirect quote for the Barbados dollar (as the foreign currency) and the U.50/ Bds$ is a direct quote for the U. dollars for Haitian gourde in 6-months at F180 = Review Direct Quotation – is the home currency price of a unit of foreign currency.” The Wall Street Journal uses this format for listing quotes under the heading “U.S.000 spot from your bank on Monday.20 on Wednesday. Ps9. This is also known as “European terms. Standard forward contracts are for 30. 000 = $10.S.5200/$ and your company buys Ps100.S. how much must your company pay and on what day? A: The company will pay The Forward Market Currencies trade for future delivery. 35G $ represents the six-month forward rate to buy Haitian gourde forward for U. and 180 days after the trade date.$. This is also known as “American terms. 1. dollars or the six month forward rate to sell U. For example. For example. Note “buying forward” and “selling forward” can be used to describe the same transaction.S.S. For example. dollar (as the home currency) and the Barbados dollar (as the foreign currency).
6372/$. (See below) Bid-Ask Quotes The bid is the price a dealer will buy a security. c.6531/$. The Foreign Exchange Market 3 . The exchange rates posted by four U. d.6261 – 80 1. Bid = $22 A dealer’s profit comes from the spread between the bid and the ask. Ask = $22. A dealer makes money on the spread between the bid and the ask.S.000 in Swiss securities. Bank D has the highest bid for dollars at Sfr1.6116 – 33 1. The ask is the price a dealer will sell a security. In this example.5 A dealer’s spread is calculated as follows: ask − bid spread = x 100 ask Q: Assume an investor wants to invest $20. The investor will be selling dollars. banks are as follows: Sfr/$ Sfr/$ Sfr/$ Sfr/$ Bank A Bank B Bank C Bank D 1.6357 Swiss francs but will sell dollars at Sfr1. Exchange rates are generally quoted with the lower price the bank pays (the bid) on the left and the higher price at which they will sell (the ask) on the right. A customer will buy at the ask and sell at the bid.6531 – 49 At which of these banks should the investor make the currency exchange? a.A Broker is an agent that facilitates trading between market participants.6357 – 72 1. A Dealer keeps an inventory of securities and stands willing to buy or sell at a given spread. b. In this example Bank A will buy dollars for 1. Bank A Bank B Bank C Bank D A: Choice “d” is correct. so the bank with the highest bid will be the target. A broker charges a commission.
Exchange rates are generally quoted with the lower price the bank pays (the bid) on the left and the higher price at which they will sell (the ask) on the right. so the bank with the lowest ask will be the target.6357 – 72 1.6133/$. Q: The exchange rates posted by four U. 0. f. d.6116 – 33 1. g.6531 – 49 With which of the four banks should the investor deal? e.6357 – 72 1.15625 Bid 100 1/32 100 4/32 100 2/32 Ask 100 5/32 100 6/32 100 5/32 A: The correct answer is “a.6116 – 33 1.6261 – 80 1. banks are as follows: Sfr/$ Sfr/$ Sfr/$ Sfr/$ Bank A Bank B Bank C Bank D 1. Bank A will buy dollars for 1.6531 – 49 ask − bid x 100 ask Remember the formula for a dealer’s spread is: spread = Q: Compute the bid-asked spread for the following bond. (100 5/32) – (100 4/32) = 1/32 = 0.S. Bank A Bank B Bank C Bank D A: Choice “b” is correct.” Subtract the highest bid that you can sell from the lowest offer where you can buy.03125 0. In this example. c.6261 – 80 1.S. banks are as follows: Sfr/$ Sfr/$ Sfr/$ Sfr/$ Bank A Bank B Bank C Bank D 1.0625 0.03125 The Foreign Exchange Market 4 .6357 Swiss francs but will sell dollars at Sfr1. b. In this example.Q: Assume that an investor has just received Sfr 25.125 0. h. Bank B has the lowest asking price for dollars at Sfr1.6372/$. Dealer I II III a. The exchange rates posted by four U. The investor will be buying dollars.000 and wants to obtain dollars for Francs.
000 Nicaraguan naira at today’s spot rate (~15.4. and price.000.351 dollars Bank A 0 nira . Bank A .189 dollars Bank A has in effect borrowed at the forward percent per year interest rate of 2. To minimize foreign exchange risk Spot against a forward .5nira / $ − 15. one party will “win” on this transaction.597%.10.161 dollars and simultaneously sells 10.161 dollars Bank B .4nira / $ 360 x x 100 = 2.Forward Transactions – A forward transaction requires delivery at a future value date of a specified amount of one currency for a specified amount of another currency. but payment and delivery are not required until maturity. Forward rates are usually quoted for value dates of one.645.4nira / $ 90 Note: the above formula is explained in detail later in these notes. ff = 15.4nira/$).000. To transfer purchasing power 2.649.5nira/$) from Bank B Bank A + 10. Example: Bank A buys 10. Note: Futures are exchange-traded agreements that call for future delivery of a standard amount of a currency (or other security or even commodity) at a fixed time.597% 15. Q: What are the three functions of the foreign exchange market? A: 1.000 nira + 645. place.000 nira + 649. Note: The exchange rate is established at the time of the agreement. Depending on the actual interest rates in 3 months. two.000.000.000 nira . The Foreign Exchange Market 5 .000.351 dollars Bank B + 10.buy currency in the spot market and sell the same amount back to the same bank in the forward market.000 nira . three. and twelve months.000. six. To provide credit 3.000 back to Bank B for dollars for delivery in 3 months (at the 3-month forward rate ~15.189 dollars Bank B 0 nira + 4.10.
T = 2 months T = 3 months Dealer -₤ 20.740.000 and paid back $33.9Col $ 0.000. then you can multiply the two exchange rates to get the third. the difference between the prices should be the interest rate differential.000.S.6870/₤ and simultaneously buys ₤20.5928/$ − £0.000 + ₤20. Example: Given the following quotations: Dominican Republic pesos per U.640.557% £0. $33.296% interest.5 RD$ 2713. RD$ Col $ RD$ ÷ = $ $ Col $ 45.740.557% on an annual basis.S.640.5945/$ 360 x x 100 = −3.000. which is 3.000 forward for delivery in three months at $1.5/$ Colombian pesos per U.646Col $ ÷ = or $ $ Col $ RD$ Note: If the rates are given in different terms (i. dollar: RD$45.557% $33.016766 RD$ 59.Forward-forward swaps – The simultaneous purchase and sale of two forward contracts.740.000 $100.$ 33.000 0 Dealer + $33.000 x 100 = 0.000 .000 To check the parity condition you can use the formula for the forward premium.000 forward for dollars for delivery in 2 months at $1. Because of interest rate parity.5945/$ 30 Essentially the dealer borrowed $33.740.000.6820/₤.000 Cross rates – A “cross rate” is the exchange rate between two currencies implied by their value with respect to a third currency. so for a onemonth loan the dealer paid 0.e.9/$ Find the exchange rate between the Dominican Republic peso and the Colombian peso. Example: A dealer sells ₤20. ff = £0.000. indirect and direct quotes).000 − $33. dollar: Col$2713.296% x 12 = 3.640. RD$ $ RD$ x = $ Col $ Col $ The Foreign Exchange Market 6 .
The cross-exchange rate cancels out the common currency against which they were originally quoted. measured in pesos per guilder? a.2902/G P0.3032/G A: Choice “a” is correct.Q: Assume the following exchange rates for Mexican pesos and Netherlands guilders versus the U.S. P4. which of the following is the cross exchange rate between the pesos and the guilder.7069/G P4. pesos pesos pesos dollar pesos $ = x or = guilders guilder dollar guilder guilder $ The Foreign Exchange Market 7 . b. d.3006 Based on this information.8700 2. c. dollar: Pesos/$ Guilders/$ 9.2331/G P22.
9038euros/$ A: Choice “b” is correct.91 /$ The Foreign Exchange Market 8 .9045 – 49 ¥/$ 100. Note: Since the bid is the lower 0. the implied bid/ask spread is choice “b. d.9036 – 38 €/$ 0.06 /$ Q: Can wants to sell.06€/$ which gives you the bid ¥103.05€/$ which gives you the ask ¥106.7526 – 110. Step 2 Use the highest quote for the yen which is ¥112/$ and multiply that by the highest quote for the dollar which is 1. c.05 /$ € 1. b. use the relatively lowest rate for the currency you want to calculate the bid and the relatively highest exchange rate that you are looking for to calculate the ask.05 – 1.6755 111.3435 – 111.0448 ¥100.9036 /$ €0.6755/euro .6508 110. The Boston dealers are quoting the following exchange rates of euros and yen against U. ¥ 110 /$ ¥112 /$ € 1.Cross Exchange Rates with Bid/Ask dealer spreads When calculating exchange rates with bid/ask spreads. 110.22 – 44 What is the yen/euro cross-rate in the spot market? a. euros for Japanese yen to be delivered in Boston.9036euros/$ exchange rate and the ask is the higher exchange rate.3189/euro and the 0.9957 111. if given the following quotes: ¥/$ 110 – 112 €/$ 1.3189 – 111.7526 – 111. Spot: Forward (60 days) €/$ 0.61/$ = ¥111.91/$ = ¥111.S.61 /$ ¥100.06 If you want the bid/ask for the ¥/€.6667/€.9038 /$ ¥100. The bid calculation is ask calculation is ¥100. For example.” €0. Step 1 Use the lowest quote for the yen which is ¥110/$ and multiply that by the lowest quote for the dollar which is 1. delivery.7736/€.61 – 91 ¥/$ 100. by means of a 60-day forward contract.
465.500 euros The Foreign Exchange Market 9 .377) £0.651 to Bank A at $0.651euros £ Step 3 – Sell €1. 000 x = £692.121.9045/€ (or 1.4443/₤ (Receive ₤692. 014.4443/₤ (or 0. Step 1 – Sell €1.121.500 euros Step 2 – Sell $904.000.000 to Bank B at $1.4443/₤ (Receive ₤626.1056euros 0.290euros x = £904.6200/₤ (or 0. an arbitrage opportunity exists.6200/₤ (Receive €1.1056€/$) Bank B quote: $1.255) £0.000.500 x = £626.6924₤/$) Bank C quote: €1.9045/€ (Receive $1.500) $0.255 $ Step 3 – Sell ₤626.651euros x = $1.6924£ 1.000 to Bank A at $0.121. Step 1 – Sell $1.014.9045/€ (Receive $904.692377 $1.Triangular Arbitrage – Arbitrage among three currencies.000euros x = $904.533) £0.692377 $904.9045 1. the exchange rate for the €/₤ should be: 1. The following three steps illustrate how to profit from this disparity. Example: Bank A quote: $0.000.6200/₤ (Receive €1.121.500 to Bank B at $1.255 to Bank C at €1.377 to Bank C at €1.533 euros Alternatively.620euros £692.6200/₤.377 x = 1.5968euros ÷ = $ $ £ Since Bank C quotes the exchange rate as €1.651) 1.014.6178₤/€) Note: these are “bid” quotes Remember: the “bid” is lower than the “ask” Based on the cross rate relationship. 000.9045 1.377 $ Step 2 – Sell ₤692.533) $0.6178 1.
41% 2.06euro / $ − 1.9 R$ / $ 90 The forward real is selling at a 4.9 R$ / $ 360 x x 100 = 4.Forward percent per year premium/discount formula (Indirect Quotations): Remember: an indirect quote is foreign/domestic.932 R$ / $ − 3R$ / $ x 100 = −2. ff = Spot − Forward 360 x x 100 Forward n Example: Suppose the spot rate for the Brazilian real is 2.41% per year premium to the dollar. What is the percent change in the spot rate for the real? %∆ = 2.04euro / $ 360 x x 100 = 2.932R$/$ and the 3-month forward rate is 2.04euro / $ 270 Spot exchange rate changes formula (Indirect Quotations): %∆ = Beginning rate − Ending rate x 100 Ending rate Example: Suppose the spot rate for the Brazilian real is 2. The spot exchange rate is $0. What is the percent per year premium (or discount) for the real? ff = 2. What is the forward premium on the euro? A: The forward premium for the euro is: ff = 1.9R$/$. The Foreign Exchange Market 10 .267% from Monday to Friday.932R$/$ on Monday and increases to 3R$/$ on Friday.267% 3R $ / $ The Brazilian real depreciated by 2.932 R$ / $ − 2.96/€.94/€.84% 1. dollar and the euro is $0. Q: The nine-month forward exchange rate between the U.S.
worldbank.com Resources for your Career Session 1 LIFA Exam: www.Final Project Session 1 The World Factbook: http://www. b. t and Problems 1-4 Chapter 4 – Problems 2-5 Chapter 5 – Problems 2 & 11 Chapter 6 – Problems 2 & 3 Chapter 7 – Problems 1 – 10 Chapter 14 – Problems 1 & 2 The midterm on September 12th will cover these chapters.investopedia. The Foreign Exchange Market 11 .org/data/countrydata/countrydata. e.gov/cia/publications/factbook/index.org CFA Exam: www.html Potential value drivers (destroyers) Chapter 1 Session 2 The World Bank: http://www.html Resources for Finance Courses Session 1 www.com Practice Homework Problems Chapter 1 – Question 1 & 2 Chapter 2 – Problems 1 & 8 Chapter 3 – Questions 2-5 & 10 a.cfainstitute.the-ira.jobsinthemoney.org Session 2 www.cia. s.
your project proposals should be no more than 1 page. let me know who your designated team leader is. e-mails. Finally. You will be graded on professionalism (no typos). Of course I will happily accept your project proposals early! What it should include: Team members’ names (each team should have 4-5 members). and the two different industries or companies you want to invest in. and phone numbers. You will loose 5 points for turning it in after 4:30pm and 10 points for turning it in after 7pm. and required information).) Your project proposal is worth 10% of your final project grade. your chosen country (or countries). timeliness. and preparation (your reasons for choosing your country and industries/companies).) Also.Project Proposals are due next week! Project Proposals Your project proposals are due by the date noted in the syllabus (before 4:30pm). (This is a good way to make sure each of you can get in contact throughout the semester. and your team will be required to meet with me outside of class. (You will loose 50 points for turning it in after the date noted in the syllabus. signatures. overall appearance. I want my copy to be signed by all team members. and I am already looking forward to your final projects! The Foreign Exchange Market 12 . completeness (all contact info. I have already heard some exciting ideas.
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