Review of Week 1

2
Week Two

1. The Theory of Comparative Advantage

→ Liberalization of international trade will enhance
the overall social welfare.
• Trade liberalization (economic integration)

2-1
 The Market for Week 2
Foreign Exchange

Objective:
Today’s class serves to introduce the institutional
framework within which exchange rates are
determined.
Today’s class lays the foundation for much of the
discussion throughout the remainder of the
semester, thus it deserves your careful attention.
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 What is Foreign Exchange (FX)?
1. Foreign exchanges are the institution or
system involved with changing one currency
into another.

2. Foreign exchange is used to refer to foreign

currency that is obtained through the foreign
exchange system.

source: Collins Cobuild Dictionary

2-3
 Topics
•
 Function andStructure
Functionand Structureofof
Structure of the
the FX
FXFX
the Market
Market
• The
  FX
The Market
Spot
Spot Participants
Market
Market
 Correspondent
 Spot Rate Banking Relationships
Quotations
• The Forward Market

 The Forward Market
Market
 The
 Spot
 The Market
Bid-Ask
Forward RateSpread
Quotations
• Exchange-Traded Currency Funds
  Spot

The FX
andTrading
Forward
Long Market
Short Forward Positions
  Cross
 Exchange
Forward Rate Quotations
Cross-Exchange
Exchange-Traded CurrencyRates
Funds

 Triangular Arbitrage
Swap Transactions

 Spot Foreign
Forward Exchange Market Microstructure
Premium

 The Forward Market
Exchange-Traded Currency Funds
2-4
 Topics
 Function and Structure of the FX Market
 FX Market Participants

 The Spot Market

 The Forward Market

2-5
 Topics
 Function and Structure of the FX Market
 The Spot Market
 Spot Rate Quotations

 The Bid-Ask Spread

 Cross Exchange Rate Quotations

 Triangular Arbitrage

 The Forward Market

2-6
 Topics
 Function and Structure of the FX Market
 The Spot Market
 The Forward Market
 Forward Rate Quotations

 Long and Short Forward Positions

 Forward Cross-Exchange Rates

 Forward Premium

2-7
 Function and Structure of the FX
Market
• Over-the-counter (OTC) markets
– No central market place
– via telephones, computer terminals, and
automated dealing systems.

2-8
 Circadian Rhythms of the FX
Market
Electronic Conversations per Hour
45000 average peak
40000
35000
30000
25000
20000
15000
10000
5000
0
1:00 3:00 5:00 07:00 9:00 11:00 13:00 15:00 17:00 19:00 21:00 23:00
10 am in Lunch Europe Asia going Lunch Americas London New 6 pm in
Tokyo hour in coming in out hour in coming in going out Zealand NY
Tokyo London coming in

2-9
 Topics
 Function and Structure of the FX Market
 FX Market Participants

 The Spot Market

 The Forward Market

2-10
 FX Market Participants
• The FX market is a two-tiered market:
– Interbank Market (Wholesale)
– Client Market (Retail)

• Market participants include:

– International banks
– Bank customers
– Nonbank dealers
– FX brokers
– Central banks.

2-11
 FX Market Participants (cont’d)
• International banks
– The core of FX market
– About 100-200 banks worldwide stand ready to
make a market in foreign exchange

• Bank customers
– MNCs, money managers, and private speculators.

2-12
 FX Market Participants (cont’d)
• Nonbank dealers
– Investment banks, mutual funds, pension funds,
and hedge funds, etc.
• FX brokers
– Fulfill the role of financial intermediary.
– Match dealers (buyers and sellers) for a fee, but do
not take a position themselves

2-13
 FX Market Participants (cont’d)
• Central bank
– Intervenes in the foreign exchange market in
an attempt to influence the price of its
currency

2-14
 Topics
 Function and Structure of the FX Market
 The Spot Market
 Spot Rate Quotations

 The Bid-Ask Spread

 Cross Exchange Rate Quotations

 Triangular Arbitrage

 The Forward Market

2-15
 Spot Rate Quotations
(All the following definitions treat the U.S. as the “home
country”.)
• Direct quotation (or American terms)
– the price of one unit of the foreign currency in
U.S. dollars
– e.g. “a Japanese Yen is worth about a penny”
• Indirect Quotation (or European terms)
– the price of a U.S. dollar in the foreign currency
– e.g. “you get 100 yen to the dollar”

2-16
Spot Rate Quotations
USD equiv USD equiv Currency per Currency per
Country Friday Thursday USD Friday USD 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
Spot Rate Quotations
USD equiv USD equiv Currency per Currency per
Country Friday Thursday USD Friday USD Thursday
Argentina (Peso) 0.3309 0.3292 3.0221 3.0377
Australia (Dollar) 0.7830 0.7836 1.2771 1.2762
The direct quote for
Brazil (Real) 0.3735 0.3791 2.6774 2.6378
British pound is:
Britain (Pound) 1.9077 1.9135 0.5242 0.5226
£1 = $1.9077
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
Spot Rate Quotations
USD equiv USD equiv Currency per Currency per The indirect
Country Friday Thursday USD Friday USD Thursday quote for British
Argentina (Peso) 0.3309 0.3292 3.0221 3.0377 pound is:
Australia (Dollar) 0.7830 0.7836 1.2771 1.2762 £.5242 = $1
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
Spot Rate Quotations
USD equiv USD equiv Currency per Currency per
Country Friday Thursday USD Friday USD Thursday
Argentina (Peso) 0.3309 0.3292 3.0221 3.0377
Australia (Dollar) 0.7830 0.7836 1.2771 1.2762 Note that the
Brazil (Real) 0.3735 0.3791 2.6774 2.6378 direct quote is
Britain (Pound) 1.9077 1.9135 0.5242 0.5226 the reciprocal of
the indirect
1 Month Forward 1.9044 1.9101 0.5251 0.5235
quote:
3 Months
Forward 1.8983 1.9038 0.5268 0.5253
1
1.9077=
6 Months
Forward 1.8904 1.8959 0.5290 0.5275
Canada (Dollar) 0.8037 0.8068 1.2442 1.2395
.5242
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
 The Bid-Ask Spread
• The bid price is the price at which a dealer
want to buy a currency.
• The ask price is the price at which a dealer
want to sell a currency.
• It doesn’t matter if we’re talking used cars or
used currencies: the bid-ask spread is simply
the difference between the bid and ask prices.

2-21
 The Bid-Ask Spread
• A dealer could offer
– bid price of $1.4739 per €
– ask price of $1.4744 per €

• While there are a variety of ways to quote that, the

bid-ask spread represents the dealer’s expected profit.

Bid-Ask Spread = Ask Price – Bid Price

0.0005 = $1.4744 – $1.4739
2-22
 The Bid-Ask Spread

big
USDfigure
Bank small figure
American Terms European Terms
Quotations Bid Ask Bid Ask
Pounds 1.9712 1.9717 .5072 .5073

A dealer pricing pounds in terms of dollars would likely quote

these prices as 12–17.

2-23
 The Bid-Ask Spread
USD Bank Direct quotation Indirect quotation
Quotations Bid Ask Bid Ask
Pounds 1.9712 1.9717 .5072 .5073

Notice that the reciprocal

of the S($/£) bid is the
S(£/$) ask.
£.5073 £1.00
=
$1.00 $1.9712
2-24
Questions

?
 Currency Conversion with
Bid-Ask Spreads
• A speculator in New York wants to take a
$10,000 position in the pound.
• After his trade, what will be his position?
Bid Ask Dealer will pay $1.9715 for 1
S($/£) 1.9715 – 20 GBP; he is asking $1.9720.
He will pay £.5071 for $1
S(£/$) .5071 – 72
and will charge £.5072 for
$1 £.5071
$10,000 × = £5,071
$1
2-26
 Sample Problem
• A businessman has just completed transactions
in Italy and England. He is now holding
€250,000 and £500,000 and wants to convert to
U.S. dollars.
• His currency dealer provides this quotation:
GBP/USD 0.5025 – 76
USD/EUR 1.4739 – 44
 Assuming no other fees, what are his proceeds
from conversion?
2-27
 Sample Problem Solution
When he sells €250,000 he will trade with a dealer at the
dealer’s bid price of $1.4739 per €:
USD/EUR 1.4739 – 44
$1.4739
€250,000 x =$368,475
€1.00

When he sells £500,000 he will trade with a dealer at the

dealer’s ask price of £0.5076 per $:

GBP/USD 0.5025 – 76 $1.00

£500,000 x =$985,027.58
£.5076
$1,353,502.58
5-
 Cross Rates
• Suppose that S($/€) = 1.50
– i.e. $1.50 = €1.00
• and that S($/£) = 2.00
– i.e. £1.00 = $2.00
• What must the €/£ cross rate be?
$1.50 £1.00 £0.75
× =
€1.00 $2.00 €1.00
€1.00 = £0.75
Pay attention to your “currency algebra”!
2-29
 Cross Rate Bid-Ask Spread
USD Bank Direct quotation Indirect quotation
Quotations Bid Ask Bid Ask
Pounds 1.9712 1.9717 .5072 .5073
Euros 1.4738 1.4742 .6783 .6785
To find the €/£ cross bid rate, consider a retail customer who:
Starts with £1, sells £ for $, and then buy € using $:
$1.9712 €1
£1 × × = €1.3371
£1.00 $1.4742
He has effectively sold £ at a €/£ bid price of €1.3371/£
2-30
 Cross Rate Bid-Ask Spread
USD Bank Direct quotation Indirect quotation
Quotations Bid Ask Bid Ask
Pounds 1.9712 1.9717 .5072 .5073
Euros 1.4738 1.4742 .6783 .6785
To find the £/€ cross bid rate, consider a retail customer who:
Starts with €1, sells € for $, and then sell $ for £:
$1.4738 £1
€1 × × = £0.7475
€1.00 $1.9717
He has effectively sold € at a £/ € bid price of £0.7475/ €
2-31
 Cross Rate Bid-Ask Spread

Bank S(£/€) S(€/£)

Quotations Bid Ask Bid Ask
£:€ £0.7475 £0.7479 €1.3371 €1.3378

Recall that the reciprocal of €1.00 €1.3378

=
the S(£/€) bid is the S(€/£) £.7475 £1.00
ask.
Recall that the reciprocal of £1.00 £.7479
=
the S(€/£) bid is the S(£/€) €1.3371 € 1.00
2-32
ask.
 Triangular Arbitrage
What Does Triangular Arbitrage Mean?
• The process of converting one currency to another, converting
it again to a third currency and, finally, converting it back to
the original currency within a short time span.
• This opportunity for riskless profit arises when the currency's
exchange rates do not exactly match up. Triangular arbitrage
opportunities do not happen very often and when they do, they
only last for a matter of seconds.
• Traders that take advantage of this type of arbitrage
opportunity usually have advanced computer equipment and/or
programs to automate the process.”
(
source: http://www.investopedia.com/terms/t/triangulararbitrage.asp)
 Triangular Arbitrage
Suppose we observe
these banks posting $
these exchange Barclays
HSBC
rates. S(¥/$)=120 S(£/$)=1.50

First calculate any

¥ Credit Agricole £
implied cross rate to see
if an arbitrage S(¥/£)=85
opportunity exists.
£1.50 $1.00 £1.00
× =
$1.00 ¥120 ¥80
 Triangular Arbitrage
• To evaluate if an arbitrage opportunity exists,
always ask the question:
“Is the cross rate implied by the first two
quotes consistent with the third quote?”
 Triangular Arbitrage
The implied S(¥/£) cross rate is
£1.50 $1.00 £1.00
$
× = Barclays
$1.00 ¥120 ¥80 HSBC
S(¥/$)=120 S(£/$)=1.50
Credit Agricole has posted a
quote of S(¥/£)=85 so there is
an arbitrage opportunity.
¥ Credit Agricole £
S(¥/£)=85
So, how can we make money? BUY LOW SELL HIGH!
The price of £ is higher at Credit Agricole (CA) than the implied price from Barclays
and HSBC => sell £ to CA.
 Triangular Arbitrage

1. Sell our $ to HSBC for £, $$

2. Sell our £ to CA for ¥, Barclays
HSBC
3. Sell those ¥ to B for $. S(¥/$)=120 3 1S(£/$)=1.50

¥ Credit Agricole £
S(¥/£)=85

It doesn’t matter where you start – the key is to go in

the right direction.
 Triangular Arbitrage
•Sell $100,000 for £ at S(£/$) = 1.50 and receive
£150,000

•Sell our £150,000 for ¥ at S(¥/£) = 85 and receive

¥12,750,000

•Sell ¥12,750,000 for $ at S(¥/$) = 120 and receive

$106,250

Finally, profit per round trip = $106,250 – $100,000 = $6,250

 The Forward Market
• Forward Rate Quotations
• Long and Short Forward Positions
• Forward Cross Exchange Rates
• Forward Premium

2-40
 The Forward Market
• A forward contract is an agreement to buy or
sell an asset in the future at prices agreed upon
today.
• The forward market for FX involves
agreements to buy and sell foreign currencies
in the future at prices agreed upon today.

2-41
 Forward Rate Quotations
• The forward market for FX involves
agreements to buy and sell foreign currencies
in the future at prices agreed upon today.
• Bank quotes for 1, 3, 6, 9, and 12 month
maturities are readily available for forward
contracts.

2-42
 Forward Rate Quotations
Consider these Country/currency in US$ per
US$
exchange rates: for
UK pound 1.9717 .5072
British pounds, the spot 1-mos forward 1.9700 .5076
exchange rate is 3-most forward 1.9663 .5086
$1.9717 = £1.00 while 6-mos forward 1.9593 .5104

the 180-day forward Clearly market participants

rate is $1.9593 = £1.00 expect that the pound will be
•What’s up with that? worth less in dollars in six
months.
2-43
 Forward Premium
• Forward premium (or discount) of a forward rate =
Annualized deviation of the forward rate from the spot
rate.
• For example, suppose the € is appreciating from S($/€) =
1.55 to F180($/€) = 1.60

• The 180-day forward premium is given by:

F180($/€) – S($/€) 360 1.60 – 1.55

f180,€v$ = × = ×2
S($/€) 180 1.55
= 0.0645 or 6.45%
 Long and Short Forward Positions
• If you have agreed to sell anything (spot or
forward), you are “short”.
• If you have agreed to buy anything (forward or
spot), you are “long”.
• If you have agreed to sell FX forward, you are
short.
• If you have agreed to buy FX forward, you are
long.

2-45
 Payoff Profiles
Long position
profit If you agree to buy anything in the
future at a set price and the spot
price later rises then you gain.

0 S180($/¥)

F180($/¥) = .009524

If you agree to buy anything in the future at

a set price and the spot price later falls then
loss
2-46
you lose.
 Payoff Profiles
profit
If you agree to sell anything in the
future at a set price and the spot
price later falls then you gain.

0 S180($/¥)

F180($/¥) = .009524

If you agree to sell anything in the

loss future at a set price and the spot Short position
2-47 price later rises then you lose.
 Forward Cross Exchange Rates
• It’s just an “delayed” example of the spot cross
rate discussed before.
• In generic terms
FN ($ / k )
FN ( j / k ) =
FN ($ / j )
Notice that the “$”s cancel.
and
FN ($ / j )
FN (k / j ) =
FN ($ / k )
2-48
 Forward Cross Rates
Currencies January 4, 2008

U.S.-dollar foreign-exchange rates in late New York trading.

--------Friday-------
The 3-month forward £/ €
Country/currency in US$ per US$
cross rate is Euro area euro 1.4744 .6783
$1.4744 £1.00 £0.7498 1-mos forward 1.4747 .6781
× = 3-mos forward 1.4744 .6782
€1.00 $1.9663 €1.00
6-mos forward 1.4726 .6791
UK pound 1.9717 .5072
1-mos forward 1.9700 .5076
3-mos forward 1.9663 .5086
6-mos forward 1.9593 .5104
2-49
 Learning Activities
• Please recall what you learn in the lecture
today by creating a list of terms or ideas
related to it
 Summary
• Spot rate quotations
– Direct and indirect quotes
– Bid and ask prices
• Cross Rates
– Triangular arbitrage
• Forward Rate Quotations
– Forward premium (discount)
– Forward points

2-51
 End of Week 2

1-52