International Financial Management

P G Apte

P.G.Apte International Financial Management 1

 CURRENCY MARKETS
•The foreign exchange market is the market in which
currencies are bought and sold against each other.
•The interbank foreign exchange market is an over-
the-counter (OTC) market. Daily turnover about $1.5
trillion. Average transaction is about USD 4 million
•The participants in the wholesale market are
commercial banks, investment institutions,
corporations and central banks. Currency brokers act
as middlemen between dealers
•A small number of currencies account for bulk of
turnover: USD, GBP, EUR, CHF, CAD, JPY, DEM,
AUD
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 CURRENCY MARKETS
•Among the participants, primary price makers or
professional dealers make a two-way market to each other
and to their clients
•Foreign currency brokers act as middlemen between two
market makers. Their main function is to provide
information to market-making banks
•Corporations usually are price takers. However, some non-
bank, non-financial companies do act as market makers.
•Large money centre banks deal in a large number of
currencies. Smaller banks have a restricted range.

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CURRENCY MARKETS
Geographically, the markets span all the time zones from New
Zealand to the West coast of the United States. When it is 3.00
p.m. in Tokyo it is 2.00 p.m. in Hong Kong. When it is 3.00 p.m.
in Hong Kong it is 1.00 p.m. in Singapore. At 3.00 p.m. in
Singapore it is 12.00 noon in Bahrain. When it is 3.00 p.m. in
Bahrain it is noon in Frankfurt and Zurich and 11.00 a.m. in
London. 3.00 p.m. in London is 10.00 a.m. in New York. By the
time New York is starting to wind down at 3.00 p.m., it is noon in
Los Angeles. By the time it is 3.00 p.m. in Los Angeles it is 9.00
a.m. of the next day in Sydney. The gap between New York
closing and Tokyo opening is about 21/2 hours. Thus the market
functions 24 hours. Of all these centres, London, Tokyo and New
York are the big ones accounting for about 50% volume.
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Foreign Exchange Interbank (I/B) Desk of
Bank A
Corporate Desk
of Bank A or
I/B Desk of
Bank B
I/B
Desk
of
Bank A

I/B Desk
of Bank C
P.G.Apte International Financial Management 5
Corporate Foreign Exchange (CorpFx) Desk
of Bank A
Corporate
Client
of Bank A
CorpFx
Desk
of
Bank A

I/B Desk
of Bank A
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Dealings of Corporate Foreign Exchange
(CorpFx) Desk of Bank A

CorpFx Desk of Bank A

Export / Import
Desk of Bank A
Client of Outward / Inward
Bank A Remittance
Desk of Bank A

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 CURRENCY MARKETS
• Spot Markets : Value date 2 business days from
transaction date. If bank holiday in either settlement
centre, push to next business day.
•Outright Forwards : Value date 3 days and beyond.
•Standard forward dates : 1,2,3,6,9,12 months. Spot value
date plus required calendar months.
•Swaps : A spot plus a forward or two forwards. Buy
USD spot vs. EUR, sell USD 3 month forward vs.EUR.
Sell USD 1 month forward, buy USD 3 month forward vs.
GBP.

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 CURRENCY MARKETS
• A spot GBP/USD deal on Friday Dec 8 : Value date
Tuesday Dec 11
•If Dec 11 holiday in NY/London, value date 12 Dec.
•A 2-month forward deal USD/CHF on Monday Dec 11:
Value date Feb 13 2001. If holiday in NY/Zurich, Feb 14.
•A 2-month forward USD/JPY on Dec 26. Value date Feb 28.
If holiday Tokyo/NY, push forward? NO. Pushing forward
must not carry to next calendar month. Push back to Feb 27.
• Spot deals in some currency pairs such as US dollar-
Canadian dollar settled in one business day

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 CURRENCY MARKETS
ACI QUOTATION CONVENTIONS
SPOT RATE QUOTATIONS:
• Base Currency/Quoted Currency Bid Rate/Offer Rate
•USD/CHF : USD base, CHF quoted
•GBP/USD : GBP base, USD quoted
•Most currencies quoted with USD as base. Exceptions are
EUR, GBP, AUD, NZD
•Quotation given as no. of units of quoted currency per unit
of base currency, bid rate/offer rate.
•Bid rate applies to market maker buying base currency.
Offer rate applies to market maker selling base currency.
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 CURRENCY MARKETS
• Currency Codes : All currencies have a 3-letter code used
by SWIFT for all interbank transactions.

DEM : Deutsche Mark CHF : Swiss Franc

NLG : Dutch Guilder BEF : Belgian Franc
FRF : French Franc DKK : Danish Kroner
ESP : Spanish Peseta ITL : Italian Lira
USD : US Dollar AUD : Australian
Dollar
CAD : Canadian Dollar JPY : Japanese Yen
GBP : British Pound IEP : Irish Pound (punt)
INR : Indian Rupee SAR : Saudi Riyal
EUR : Euro

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 CURRENCY MARKETS
SPOT QUOTES : EXAMPLES
USD/CHF SPOT: 1.4575/1.4580

Bid Offer

Bank will buy 1 USD and give CHF 1.4575

Bank will sell 1 USD and want to be paid CHF
1.4580.
Shortened to 1.4575/80 or even 75/80 between
dealers. “1.45” is the “big figure”

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 CURRENCY MARKETS
SPOT QUOTES : EXAMPLES
Interpret these quotes :
GBP/USD : 1.5665/70 USD/DEM : 1.9995/05
GBP/EUR : 1.2545/50 USD/INR : 46.7585/46.7685
USD/JPY : 110.25/35
•Most currencies quoted upto six significant figures. Last
two figures known as “points” or “pips”. GBP/USD the
bid-offer spread is 10 pips. Smaller currencies quoted to 2
decimals.

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 CURRENCY MARKETS
• Quotations in European Terms: Units of a currency per
US dollar. Example : USD/INR : 46.7560/7675
• Quotations in American Terms : US dollars per unit of a
currency. Example : GBP/USD : 1.5060/65
• Direct Quotations: Units of “home” currency per unit of
“foreign” currency. Example : USD/INR above, a direct
quote in India.
• Reciprocal or Indirect Quotations: Units of “foreign”
currency per unit of “home currency”. Example:
USD/GBP : 0.6638/0.6640, an indirect quote in UK.

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 CURRENCY MARKETS
Interbank Arbitrage : Suppose banks A and B are quoting :
A B
GBP/USD : 1.4550/1.4560 1.4538/1.4548

--------- Bank A
bid ask
---------- Bank B
bid ask
Buy GBP from bank B, sell to bank A. Prices will move.
A B
GBP/USD : 1.4550/1.4560 1.4548/1.4558
--------- Bank A
---------- Bank B

No arbitrage. Quotes must “overlap”.

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INVERSE QUOTES AND 2-POINT ARBITRAGE
USD/CHF : 1.4955/1.4962 A bank in Zurich
CHF/USD : 0.6695/0.6699 A bank in NY
Arbitrage Opportunity? Buy Swiss francs 1 million in Zurich
sell in New York.
$(1,000,000/1.4955) i.e. $6,68,700 needed to acquire the Swiss
francs.
$(0.6695 × 1000000) i.e. $6,69,500, obtained on selling, a
riskless profit of $800. Zurich USD/CHF quotes imply certain
CHF/USD quotes:
Implied (CHF/USD)bid = 1/(USD/CHF)ask
Implied (CHF/USD)ask = 1/(USD/CHF)bid
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INVERSE QUOTES AND 2-POINT ARBITRAGE

To prevent arbitrage, the New York bank's (CHF/USD) quotes

must overlap the (CHF/USD) quotes implied by the Swiss bank's
quotes. The latter work out to 0.6684/0.6687. A quote such as
0.6686/0.6689 will not lead to arbitrage though it may lead to a
one-way market for the banks. The rates actually found in the
markets will obey the above relations to a very close
approximation.

GBP/USD: 1.5465/70 USD/GBP ?

USD/INR: 46.7550/46.7650 (100)INR/USD ?
GBP/EUR: 1.3035/45 EUR/GBP?

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Cross-Rates and Three-Point Arbitrage
A New York bank is currently offering these quotes :

USD/JPY : 110.25/111.10
USD/AUD : 1.6520/1.6530

At the same time, a bank in Sydney is quoting :

AUD/JPY : 68.30/69.00

Is there an arbitrage opportunity?

Consider this sequence of transactions: Sell yen against US

dollars and the US dollars against Australian dollars both in
New York and finally sell the AUD for yen in Sydney.
This is known as 3-point arbitrage : Sell A, buy B; Sell B buy C;
Finally sell C buy A.
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Cross-Rates and Three-Point Arbitrage
The calculations are :(N: NY S: Sydney)

1 JPY in NY gets USD [1/(USD/JPY)ask(N) ] = USD (1/111.10)

Sell USD [1/(USD/JPY)ask(N) ] in NY to get AUD {[1/

(USD/JPY)ask(N) ](USD/AUD)bid(N) } = AUD (1/111.10)(1.6520)

Sell AUD {[1/(USD/JPY)ask(N) ](USD/AUD)bid(N) } in Sydney to get

JPY{[1/(USD/JPY)ask(N) ](USD/AUD)bid(N) (AUD/JPY bid(S) }

= JPY (1/111.10)(1.6520)(68.30) = JPY 1.0156

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 EUR Locking Rates
EUR Locking Rates
EUR/ATS= 13.760300
EUR/BEF= 40.339900
EUR/DEM= 1.955830
EUR/ESP= 166.386000
EUR/FIM= 5.945730
EUR/FRF= 6.559570
EUR/IEP= 0.787564
EUR/ITL= 1936.270000
EUR/LUF= 40.339900
EUR/NLG= 2.203710
EUR/PTE= 200.482000

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 INTERBANK SPOT DEALING
•Monday September 21 10.45 am
BANK A: "Bank A calling. DLR-FRF 25 please.
•BANK B: "Forty -Fiftytwo”
(Bank B is specifying a two-way price. Knowing that the
caller is also a forex dealer, the dealer in Bank B quotes
only the last two decimals of the full quotation. For
instance the full quotation might be 4.1540/4.1552.)
•BANK A: “Mine”
(Bank A dealer finds bank B’s price acceptable and wishes to
buy USD 25 million. She conveys this by saying “mine”)

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 SPOT DEALING (Contd.)
•BANK B: OK. I sell you USD 25 million against FRF at
4.1552 value 23 September. BNP Paris for my FRF.
•BANK A: CITIBANK NYK for my dollars. Thanks & Bye.

• Deal is consummated. Back office staff will retrieve details,

exchange confirmatory faxes/telexes and arrange settlement.

•Spot deals account for about 60 % of total turnover.

•Dealers work within limits assigned by management

•Counterparty must be acceptable credit.

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 FORWARD AND SWAP QUOTES
• Forward outrights can be given like spot quotes.
• USD/CHF 3-months 1.5655/65 bid/ask
•More commonly given as a spot quote plus a pair of swap
points
USD/CHF Spot : 1.6525/35
1 month : 15/10 2 months : 25/18 3 months : 35/25
GBP/USD Spot : 1.4925/35
1 month : 12/15 2 months : 20/25 3 months : 28/35

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 FORWARD AND SWAP QUOTES
• To find outrights : Spot quote ± Swap Points
• Each swap point is 0.0001 ( or 0.01)
•When to add, when to subtract?
•Take USD/CHF Spot : 1.6525/35 1 month : 15/10
•If you add : 1 month outright : 1.6540/45
• If you subtract 1 month outrights : 1.6510/1.6525
•Which is correct?
•Two “rules” : 1 Ask > Bid 2 Bid-Ask spread must widen as
you go farther into future

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 FORWARD AND SWAP QUOTES

• Using rule 2, 1.6540/1.6545 is wrong. 1.6510/25 is correct.

• Now take GBP/USD Spot 1.4925/35 2 months : 20/25
• If add, 2 month outrights 1.4945/1.4960, if subtract
1.4905/1.4910. The latter is correct.
•Mechanical rule : If swap points are Big/Small, subtract,
base currency at forward discount, quoted currency at
premium. If swap points Small/Big, add. Quoted currency at
discount, base currency at premium.

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 FORWARD AND SWAP QUOTES
• A quote like : USD/SEK Spot 8.4565/70 3 month : 10/20
•Bank will do either swap:
(1) Buy USD spot, sell USD 3 months forward agnst SEK. The
forward rate would be 20 points above the spot rate.
(2) Sell USD spot, buy 3 months forward, forward rate 10 points
above spot.
In a swap, amount of one currency - usually the base currency-
kept same in the spot and the forward leg. Buy USD 1m spot, sell
USD 1m forward. Amount of SEK will be different.

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INTERBANK FORWARD DEALING
DEC 4 2000
BANK A : "Bank A calling. Three-month yen-dollar
please.”

BANK B : "Thirty two; twenty five."

BANK A : "Fifteen dollars yours at thirty two".

BANK B : "OK. Let's use a spot of 120.50 which is for

value December 6; I buy at 120.18 for value March 6."

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 OPTION FORWARDS
•Delivery date to be chosen by the contract buyer within a
specified interval.
•A 3 month forward with delivery option over 3rd month
•A 6 month forward with delivery option over last three
months.
•Banks extract maximum premium or give least discount
•GBP/USD spot : 1.4565/70 2 Mth. 15/10 3 Mth 22/17
•Customer wants to buy USD, 3 mths forward, option over
3rd month. USD at premium at 2 mths, greater premium
at 3 mths. Bank will charge 3 mths premium.

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 OPTION FORWARDS
•If customer wanted to sell USD, bank would give only 2
months premium.
•USD/CHF Spot 1.6570/75 3 Mths 15/20
(1) Customer wants to buy USD 3 mths forward option
period from spot to 3 months. Rates?
(2) Customer wants to buy CHF. Rates?
•In the Indian market, length of option period cannot
exceed one month.

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 FORWARD QUOTES
INR1F=
Bid Ask
INR= 46.4425 46.4625
INRON= 0.25 0.50
INRTN= 0.75 1.00
INRDECM= 5.00 6.00
INRJANM= 20.75 21.75
INRFEBM= 34.50 35.50
INRMARM= 51.00 52.00
INRAPRM= 67.25 68.25
INRMAYM= 83.50 84.50
INRJUNM= 98.50 99.50
INRJULM= 116.50 117.50
INRAUGM= 133.50 134.50
INRSEPM= 150.50 152.00
INROCTM= 167.50 169.00
INRNOVM= 184.00 185.50
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 BROKEN DATES
• Standard forward are whole months. Banks will do any
number of days forward - 63 days, 135 days etc. These are
“broken date” or “odd date” forwards.
•Interpolate between two whole month dates. OK if the gap
between the two dates is not too long and no special
technical factors are at work.
•USD/INR spot 46.95/96 1 month 10/12 2 mths 20/27
•Customer wants to buy USD 43 days forward.
•15 paise premium from 1 mth to 2 mths. Suppose 30 days in
2nd month. 0.5 paisa per day, 6 paise for 12 days. Rate
would be 46.96+0.12+0.06 = 47.14

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 SHORT DATES
• Delivery same day- cash
•Delivery next day - Tomorrow or “Tom”.
•Markets quote overnight O/N, tomorrow/next T/N and
Spot/Next S/N swaps. These are used to compute rates for
short date transactions.
•Reverse swap points and follow add/subtract rule.
•USD/DEM Spot 1.9545/50 T/N : 5/3 3/5
•Outright for tom : 1.9548/50

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 FOREX AND MONEY MARKETS
• Annualised %Premium/Discount, T-year forward
= [(Forward-Spot)/(Spot)] × (1/T) × 100
•Use mid rates for quick calculations.
•Annualised forward margin = Interest rate differential
True for fully convertible currencies with no capital controls.
• Currency with higher interest rate will be at discount.
•3-month Euro LIBOR : 8% p.a. 3-month USD LIBOR : 6%
•USD will be at a 3-month forward premium of 2% p.a.

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 FOREX AND MONEY MARKETS

This relation between interest rate differential and spot-forward

margin is known as Covered Interest Parity.
It holds for freely convertible currencies with no capital controls.
It is a result of investors arbitraging between money markets in
different currencies in search of highest return.
Holds with Euromarket interest rates.
It is not a causal relation but an equilibrium relationship.
It will be analysed in detail in the next chapter

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 FORWARD-FORWARDS AND
RELATED PRODUCTS
• Buy USD 1 month sell 3 months vs.GBP. A 1-3 swap.
•Related products are FSAs, ERAs and FXAs
•Third currency forwards in the Indian market.
•Forward contracts can be cancelled. Settlement payments
depend upon current forward rates.
•Forward contracts tie up credit limits and attract capital
adequacy norms. FSAs, ERAs and FXAs are innovations to
get around these problems. Analysed in next chapter

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