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Mahmood-ur-Rahman Lecturer, BIBM

Foreign Exchange Market
Foreign Exchange Market is the

organizational framework where the various national currencies are bought and sold. Practically it is a worldwide market, which is made up of individuals, commercial banks and other authorized agents.
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Arbitrage Arbitrage: Locking in a risk less profit from price disequilibria or distortions in different markets. 3 .

Arbitrage Currency Arbitrage:It refers to the purchasing of foreign currency where its price is low and selling it where the price is high. 4 .

5 .Arbitrage Arbitrage may be due to interest rate differences in two financial centers. which is known as interest arbitrage.

This usually involves an agreement today to buy or sell a certain amount of foreign currency at some future date at a rate agreed upon today.Hedging Hedging: Foreign exchange risks can be avoided or covered by Hedging. 6 .

Speculation Speculation: It is opposite of hedging. 7 . While a hedger seeks to avoid or cover a foreign exchange risk for fear of loss. • Speculation usually occurs in the forward exchange market. the speculator accepts or even seeks a foreign exchange risk in the hope of making a profit.

8 .Covered Interest Arbitrage Covered Interest Arbitrage: It refers to the transfer of liquid funds from one monetary center and currency to another to take advantage of higher rates of return (or interest) and at the same time the resulting foreign exchange risk is covered or hedged by a forward sale of the foreign currency to coincide with the maturity of the foreign investment.

The interest rate is certain: only the future ER at which we will exchange pounds back to USD is uncertain. On day 1. 9 . The strategy is as follows: 1.Covered Interest Arbitrage: Example If we desire to capitalize on relatively high rates of interest in the UK have funds available for 90 days. convert USD into pounds and set up a 90-day deposit in British bank.

engage in forward contract to sell pounds 90-day forward 3.Covered Interest Arbitrage: Example 2. On day 1. 10 . In 90 days when the deposit matures. convert the pounds to USD at the rate that was agreed upon in the forward contract.

60 The 90-day interest rate in USA is 2% The 90-day interest rate in UK is 4% 11 .00.60 The 90-day forward rate of pound is $1.000 to invest The current spot rate of pound is $1.Covered Interest Arbitrage: Example Assume the following information: We have USD 8.

000 to 5. convert $8.00.000 pounds and deposit in British bank 12 .Covered Interest Arbitrage: Example Based on the information we should proceed as follows: On day 1.00.

fulfill the forward contract obligation by converting 5. sell 5.000 pound 90day forward.20.20. By the time the deposit matures and we will have 5. In 90 days when deposit matures.000 pounds.000 pounds into $8.000 13 .Covered Interest Arbitrage: Example On day 1.20.32.

Investing funds from US to UK Impact Upward pressure on the spot rate of pound Downward pressure on the forward rate of the pound Possible upward pressure on US IR and downward pressure on UK IR.6200 $1. Original value Spot rate: $1.Engaging in forward contract to sell pounds 3.60 Forward rate: $1.5888 14 .60 Value after being affected by CIA $1. Using USD to purchase pounds in the spot market 2.Impact of CIA Activity 1.

580 pounds 15 .93.000 to 4.827 X 1.04} = 5. market forces resulting from CIA will cause a market realignment: Convert $8.00.Realignment due to Covered Interest Arbitrage As with other forms of arbitrage.93.000/1.827 pounds ($8.13.00.62) Calculate accumulated pounds over 90 days at 4% { 4.

000] = .580 X 1.02 =2% 16 .00.13.Realignment due to Covered Interest Arbitrage Reconvert pound to dollar at forward rate 0f $ 1.5888 [ 5.976 Determine the yield earned fro CIA: [(8.000)/8.5888] = $8.15.15.976-8.00.

To illustrate how a bank may attempt to capitalize on the expected change in a currency’s value. assume the following: 17 .SPECULATING ON EXCHANGE RATE MOVEMENTS Many commercial banks and other types of firms attempt to capitalize on their speculation of exchange rate movements.

Chicago Bank is able to borrow $20 million on a short-term basis from other banks.52 in 30 days.50 to $0.SPECULATING ON EXCHANGE RATE MOVEMENTS Chicago Bank expects the exchange rate of the German mark (DM) to appreciate from its present level of $0. 18 .

96% marks (DM) Because brokers sometimes serve as intermediaries between banks.2% German 6.SPECULATING ON EXCHANGE RATE MOVEMENTS Present short-term interest rates (annualized) in the interbank market are as follows: Currency Lending Rate Borrowing Rate Dollars 6.48% 6. the lending rate differs from the borrowing rate.72% 7. 19 .

SPECULATING ON EXCHANGE RATE MOVEMENTS  Given the information.54 percent return over the 30-day period [computed as 6.000/$.48% X (30/360)].48 percent annualized.  Lend the marks at 6.000.  Convert the $20 million to DM40 million (computed as $20. which represents a .50). Chicago Bank could:  Borrow $20 million. 20 .

the bank would receive SPECULATING ON EXCHANGE RATE MOVEMENTS DM40. The annual interest on the dollars borrowed is 7.  Use the proceeds of the mark loan repayment (on Day 30) to repay the dollars borrowed.216.006)].0054)].120.000 [computed as DM40. 21 .000 X (1 + . The total dollars necessary to repay the loan is therefore $20.000.000(1 + .6 percent over 30-day period [computed as 7.2 percent.000 [computed as $20.2% X (30/60)].000. or . After 30 days.

it would earn a speculative profit of DM1.  Given that the bank accumulated DM40.000/$.216.52 per mark as anticipated.692.692.52 per mark on Day 30). which is the equivalent of $792. the number of marks necessary to repay the dollar loan is DM38.52 per mark).523.120. 22 .308 (computed as $20.000 from its mark loan.320 (given a spot rate of $.SPECULATING ON EXCHANGE RATE MOVEMENTS  Assuming that the exchange rate on Day 30 is $.

23 . since the funds were borrowed through the interbank market.SPECULATING ON EXCHANGE RATE MOVEMENTS  This speculative profit was earned by the bank without using any funds from deposit accounts.

 To illustrate. it could attempt to make a speculative profit by taking positions opposite to those described in the previous example.SPECULATING ON EXCHANGE RATE MOVEMENTS  If Chicago Bank expected that the mark would depreciate. assume that the bank expects an exchange rate of $.48 for the mark on Day 30. 24 .

the following steps could be taken: 25 . and assuming the bank can borrow DM40 million.  On Day 30. It could borrow marks. and lend the dollars out.  It could borrow marks. convert them SPECULATING ON EXCHANGE RATE MOVEMENTS to dollars.  Using the rates quoted in the previous example. convert them to dollars. and lend the dollars out. it could close out these positions.

 Lend the dollars at 6.  Convert the DM40 million to $20 million (computed as DM40.SPECULATING ON EXCHANGE RATE MOVEMENTS  Borrow DM40 million.0056)].000 X (1 + .000. which represents a .112. the bank would receive $20.000 X $. 26 .000 [computed as $20.000. After 30 days.72 percent.56 percent return over the 30-day period.50).

000 [computed as DM40.232. or . The total marks necessary to repay the loan is therefore DM40.58% over the 30-day period [computed as 6.000 X (1 + . The annual interest on the marks borrowed is 6.0056)].SPECULATING ON EXCHANGE RATE MOVEMENTS  Use the proceeds of the dollar loan repayment (on Day 30) to repay the marks borrowed.96 X (30/360)].96 percent. 27 .000.

48 per mark).SPECULATING ON EXCHANGE RATE MOVEMENTS  Assuming that the exchange rate on Day 30 is $.311.232.48 per mark as anticipated. the number of dollars necessary to repay the mark loan is $19. 28 .000 X $.360 (computed as DM40.

112.SPECULATING ON EXCHANGE RATE MOVEMENTS  Given that the bank accumulated $20.360).311. 29 .000 from its dollar loan. it would earn a speculative profit of $800.112.0000 $19.640 (computed as $20.