(2013-S1) - FINS3616 - Tutorial Slides - Week 02 - Exchange Rate Basics

INTERNATIONALBUSINESSFINANCEFINS3616

TutorialWeek 2Chapter 2

Your Tutor & Tutor‐in‐Charge:Peter [email protected]

Be sure to check your student email account lots throughout the semester, as I’ll be sending you my slides and lots of other materials.

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CONTACTDETAILS

FINS3616 — Peter Kjeld Andersen (2013‐S1)

ASSESSMENT DATE HOW MUCH

Tutorial Attendance Every week 5%

MidsemesterExamination Week 7 30%

Group Project Weeks 11 + 12 25%

Final Exam Exam Period 40%

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ASSESSMENTS


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COMPONENT HOW TO GET IT HOWMUCH

Attendance

Showing up ON TIME every week.

“ON TIME” is until 15 minutes past the start of the hour.

However, this will become stricter for students who keep arriving after class starts.

Attending less than 9 of the 12 tutorials will result in a mark of 0% out of the 5%.

5%

CLASSPARICIPATION


Q. What is a spot exchange rate contract? When does delivery occur on a spot contract?

A. When currencies in the interbank spot market are traded, certain business conventions are followed.

For example, when the trade involves the U.S. dollar, business convention dictates that spot contracts are settled in 2 business days—that is, the payment of one currency and receipt of the other currency occurs in 2 business days.

One business day is necessary because of the back‐office paperwork involved in any financial transaction.

The second day is needed because of the time zone differences around the world.

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CHAPTER2— QUESTION3


Q. CONTINUED….

A. Several exceptions to the 2‐business‐day rule are noteworthy:

1. For exchanges between the U.S. dollar and the Canadian dollar or the Mexican peso, the rule is 1 business day.

2. If the transaction involves the dollar and the first of the 2 days is a holiday in the United States but not in the other settlement center, the first day is counted as a business day for settlement purposes.

3. Fridays are not part of the business week in most Middle Eastern countries, although Saturdays and Sundays are. Hence, non–Middle Eastern currencies settle on Fridays, and Middle Eastern currencies settle on Saturdays.

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Q. What is a depreciation of the Thai baht relative to the Malaysian ringgit? What happens to the baht price of the ringgit in this situation?

A. A depreciation of the Thai baht relative to the Malaysian ringgit means that it will take more baht to buy one ringgit.

Thus, the baht price of the ringgit is now higher after the depreciation of the baht.

• Let’s say that was the original rate.• The question states that the THB has depreciated relative to the MYR.• This means that, conversely, the MYR has appreciated relative to the THB.

– i.e. each Malaysian ringgit is now able to buy more Thai baht than before.

• So the new appreciated price of the ringgit may be

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Q. Mississippi Mud Pies, Inc. needs to buy 1,000,000 Swiss francs (CHF) to pay its Swiss chocolate supplier. Its banker quotes bid–ask rates of CHF1.3990/USD –CHF1.4000/USD. What will be the dollar cost of the CHF1,000,000?

A. How to break this down:• The company wants to buy CHF, which means they’re selling USD.• If they’re selling USD, they’ll have to do that at the lower CHF/USD price,

which is the bank’s bid of CHF1.3990/$.– Remember… the bank must make a profit on each USD from their

bid/ask• If the company is purchasing CHF 1,000,000 at a price of CHF1.3990/USD,

how many USD do they pay?

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CHAPTER2— PROBLEM1

Cost in USD CHF 1,000,000

CHF1.3990/USD

1,000,000USD1.3990

USD 714,796


Q. If the Japanese yen–U.S. dollar exchange rate is ¥104.30/$, and it takes 25.15 Thai bahts to purchase 1 dollar, what is the yen price of the baht?

A. To prevent triangular arbitrage, the direct quote of the yen price of the baht (¥/THB) must equal the yen price of the dollar times the dollar price of the baht (which is the reciprocal of the baht price of the dollar):

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SDTHB25.15/U

USDYEN104.30/ THBYEN4.1471/


How to tell if there is a triangular arbitrage profit and how to make it:• When you arrange the quotes as follows, the cross multiplication should

equal one

• CASE 1: If it is less than 1, sell the currencies in the numerator to buy the currencies in the denominator of each quote.

– Sell CAD 1.60 to buy USD 1.00.– Sell USD 1.00 and buy EUR 0.80.– Sell EUR 0.80 and buy CAD 2.00.– You now have CAD 0.4 more than when you started.

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CAD1.60 USD1.25 EUR0.5. . 1USD EUR CAD

i e

CAD1.60 USD1.25 EUR0.4. . USD EUR CAD

e g 0.8 i.e. 1

ASIDE:TRIANGULARARBITRAGE

Because our arbitrage test < 1, our % profits here could be

calculated quickly by taking the reciprocal as follows:

(1 / 0.80) – 1 = 0.25 = 25%


How to tell if there is a triangular arbitrage profit and how to make it:• When you arrange the quotes as follows, the cross multiplication should

equal one

• CASE 2: If it is greater than 1, sell the currencies in the denominator to buy the currencies in the numerator.

– Sell USD 1.00 and buy CAD 1.60.– Sell CAD 1.60 and buy EUR 0.96.– Sell EUR 0.96 and buy USD 1.20.– You now have USD 0.2 more than when you started.

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CAD1.60 USD1.25 EUR0.5. . 1USD EUR CAD

i e

ASIDE:TRIANGULARARBITRAGE

CAD1.60 USD1.25 EUR0.6. . USD EUR CAD

e g 1.2 i.e. 1

Because our arbitrage test > 1, our % profits here could be calculated

quickly by subtracting 1.

1.2 – 1 = 0.2 = 20%


Q. As a foreign exchange trader, you see the following quotes for Canadian dollars (CAD), U.S. dollars (USD), and Mexican pesos (MXN):

USD0.7047/CAD MXN6.4390/CAD MXN8.7535/USDIs there an arbitrage opportunity, and if so, how would you exploit it??

A. Flip the MXN/CAD quote and then arrange them to follow the rules…

As it is less than 1, sell the currencies in the numerator to buy the currencies in the denominator.I. Sell USD 1.00 and buy CAD 1.4190.II. Sell CAD 1.419 and buy MXN 9.1372.III. Sell MEX 9.1369 and buy USD 1.0438.IV. You now have USD 0.0438 more than when you started.

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USD0.7047 CAD0.15530 MXN8.7535CAD MXN USD

0.9580 i.e. < 1

Because our arbitrage test < 1, our % profits here could be

calculated quickly by taking the reciprocal as follows:

(1 / 0.9580) – 1 = 0.0438


Q. The exchange rate at the start of the year was . However, the value of the USD has since then appreciated by 25% against the value of the AUD. What is the current USD price of one AUD?

A. It is tempting to say that if the USD has appreciated by 25% against the AUD, then the AUD has depreciated by 25% against the USD.So that you could just work out the new price of an AUD by multiplying by 0.75 again, in which case you would get THIS IS WRONG!!! (it doesn’t work mathematically).Let’s take a look at why:• First, can be inverted to • If the USD appreciates 25% against the AUD, how many AUD can one USD

purchase?x (1 + 0.25) =

• So what is the value if we convert back to the USD price of an AUD?…..which is the same as 1.00 DIVIDED by (1 + 0.25)

– rather than multiplied by (1 ‐ 0.25), which is incorrect

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ASIDE:APPRECIATION/DEPRECIATION


Q. The Mexican peso has weakened considerably relative to the dollar, and you are trying to decide whether this is a good time to invest in Mexico. Suppose the current exchange rate of the Mexican peso relative to the U.S. dollar is MXN 9.5/USD. Your investment advisor at Goldman Sachs argues that the peso will lose 15% of its value relative to the dollar over the next year. What is Goldman Sachs’s forecast of the exchange rate in 1 year?

A. Although the Mexican peso is currently quoted as MXN 9.5/USD, this is the equivalent of USD 0.10526/MXN when we take the reciprocal.

If the value of the MXN falls by 15%, it will be worth:

USD 0.10526/MXN x (1 – 0.15) = USD 0.08947/MXN

This can be re‐expressed as MXN 11.1765/USD when we take the reciprocal.

This is the same as MXN 9.5/USD divided by (1 – 15%).

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USD 1.3007 YEN104.40EUR USD

Q. Deutsche Bank quotes bid–ask rates of $1.3005/€–$1.3007/€ and ¥104.30‐104.40/$. What would be Deutsche Bank’s direct asking price of yen per euro (¥/€)?

A. The direct asking price of yen per euro (¥/€) is the price at which you the customer will buy euros from (and sell yen to) the bank.

So first, identify the rates at which you can buy euros and sell yen against the dollar.– These are $1.3007/€ and ¥104.40/$ respectively

note that selling Yen is the same as buying $, hence the higher ask price per $

Then, create the cross rate:

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1.3007 YEN104.40EUR

YEN135.79 YEN135.79 / EUREUR


Q. Alumina Limited of Australia has called Mitsubishi UFJ Financial Group to get its opinion about the Japanese yen–Australian dollar exchange rate.

The current rate is ¥67.72/A$, and Mitsubishi thinks the Australian dollar will weaken by 5% over the next year. What is Mitsubishi UFJ’s forecast of the future exchange rate?

A. If the Australian dollar weakens by 5% over the next year, it will take 5% fewer Japanese yen to purchase the Australian dollar. Thus, the forecast is

¥67.72/A$ x (1 – 0.05) = ¥64.334/A$

Ask yourself… if the value of the YEN appreciates by 25% against the AUD, by what % would the AUD depreciate against the YEN? What about 100%? What about 100,000,000,000%

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AUD%

1%11

YEN

125.01

1%2020.0

100.11

1%5050.0

1000,000,000,11

1%999999.9999999999.0

There is an asymptote at –100%, because an exchange rate can never become negative.


Q. Illustrate the difference between direct and indirect quotes of an exchange rate.

A. A direct quote for a GIVEN currency gives the price of one unit of the OTHER currency in terms of the given currency. That is, in the form

• GIVEN CURRENCY X.XXXX / OTHER CURRENCY.• e.g. AUD 1.3781/EUR is a direct quote for the AUD

An indirect quote for a GIVEN currency gives the price of one unit of the given currency in terms of the other currency. That is, in the form

• OTHER CURRENCY X.XXXX / GIVEN CURRENCY.• e.g. EUR 0.7256/AUD is an indirect quote for the AUD

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ADDITIONALTUTORIALQUESTION1


Given that EUR/AUD = 0.8316 – 0.7661 (i.e. 1 AUD = units of EUR).

Q. Is this a direct or indirect quote (and from whose viewpoint)?• This is an indirect quote from the Australian perspective, as the Bid > Ask.• Despite how this looks, remember that the quoting bank must still make a

profit from the bid/ask spread.Q. Convert the above rate to both direct and indirect quotation from the other

country’s perspective.• Alternatively, a direct quote from the Australian perspective would be:

– AUD/EUR = 1.2025 – 1.3053• Changing it to a direct quote from the Eurozone perspective, we get:

– EUR/AUD = 0.7661 – 0.8316• And so thus an indirect quote from the Eurozone perspective would give

– AUD/EUR = 1.3053 – 1.2025

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AUSTRALIAN perspective EUROZONE perspective

DIRECT AUD 1.2025/EUR – AUD 1.3053/EUR EUR 0.7661/AUD – EUR 0.8316/AUD

INDIRECT EUR 0.8316/AUD – EUR 0.7661/AUD AUD 1.3053/EUR – AUD 1.2025/EUR

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XXX Currency perspective YYY Currency perspective

DIRECT XXX/YYY: LHS < RHS YYY/XXX: LHS < RHS

INDIRECT YYY/XXX: LHS > RHS XXX/YYY: LHS > RHS

SUMMARYOFDIRECTvs.INDIRECT

Always remember to FIRST look at whether the Bid is less than the Ask:• If Bid < Ask, it’s a Direct quote so the perspective currency is in the numerator.• If Bid > Ask, it’s an Indirect quote so the perspective currency is in the denominator.


Q. Given that HKD/AUD = 5.1235 – 5.0338 and YEN/AUD = 86.24 – 84.71Calculate the equilibrium cross rate between the HKD and the Yen.

A. To answer this question, we need to find two cross rates:1. The HKD/YEN rate at which we could sell HKD to the bank to buy YEN.2. The HKD/YEN rate at which we could sell YEN to the bank to buy HKD.

As the AUD is in the denominator, it’s easier to think of what you (a customer) is doing with the AUD.i.e. we buy AUD from the bank at the high price, and sell AUD to them at the low price.

To find the sell HKD / buy YEN rate, use the rates for doing those things against the AUD:– If I’m selling HKD, I’m simultaneously buying AUD.– And when I buy AUD from the bank, I pay the higher price: HKD 5.1235/AUD– If I’m buying YEN, I’m simultaneously selling AUD.– When I sell AUD to the bank, I receive the lower price: YEN 84.71/AUD

So the sell HKD / buy YEN rate is HKD 5.1235 / YEN 84.71 = HKD 0.0604/YEN

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Q. Given that HKD/AUD = 5.1235 – 5.0338 and YEN/AUD = 86.24 – 84.71Calculate the equilibrium cross rate between the HKD and the Yen.

A. To answer this question, we need to find two cross rates:1. The HKD/YEN rate at which we could sell HKD to the bank to buy YEN.2. The HKD/YEN rate at which we could sell YEN to the bank to buy HKD.

As the AUD is in the denominator, it’s easier to think of what you (a customer) is doing with the AUD.i.e. we buy AUD from the bank at the high price, and sell AUD to them at the low price.

To find the buy HKD / sell YEN rate, use the rates for doing those things against the AUD:– If I’m buying HKD, I’m simultaneously selling AUD.– And when I sell AUD to the bank, I receive the lower price: HKD 5.0338/AUD– If I’m selling YEN, I’m simultaneously buying AUD.– When I buy AUD from the bank, I pay the higher price: YEN 86.24/AUD

So the buy HKD / sell YEN rate is HKD 5.0338 / YEN 86.24 = HKD 0.0584/YEN

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Q. If the market rate between Yen and HKD in Hong Kong is HKD/Yen = 0.0582 ‐ 0.061, is there an arbitrage opportunity for an Australian arbitrageur who has AUD 1m under his/her disposal?

A. No, there is no arbitrage opportunity available.

If you were to purchase one YEN at the quoted market cross rate (and pay HKD 0.061) and sell it through the calculated cross rates from the previous question (and receive HKD 0.0584), you would clearly make a loss for each YEN.

Similarly, if you were to purchase one YEN at the calculated cross rates (and pay HKD 0.0604) and sell it through the quoted market rate (and receive HKD 0.0582), you would likewise make a loss on each YEN.

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BID ASKCalculated Cross Rates

HKD/YEN 0.0584 HKD/YEN 0.0604

ASKQuoted Market Rates


BID

The two buying (i.e. ask) prices for the YEN are both higher than the prices at which you could sell the YEN (i.e. bids).

Therefore, no arbitrage is possible.


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ADDITIONALTUTORIALQUESTION3Q. Repeat part B. for HKD/Yen = 0.062 ‐ 0.065.

Yes, there is an arbitrage opportunity available, if the appropriate transactions are executed.

BID ASKCalculated Cross

Rates


ASKQuoted Market Rates


BID

Purchase YEN with HKD via the AUD using the calculated cross rate of HKD 0.0604/YEN.Then sell YEN for HKD using the quoted cross rate of HKD 0.0620/YEN.

The three steps from a base of AUD 1m would be as follows:I. Sell your AUD 1m at YEN 84.71/AUD = Receive YEN 84.71mII. Sell YEN 84.71m at HKD 0.0620/YEN = Receive HKD 5.25202mIII. Sell HKD 5.25202m at HKD 5.1235/AUD = Receive AUD 1,025,084.41

Your profit is AUD 25,084.41.

We multiplied

We multiplied

We divided


The following data was available on 10 Feb. 2000: • Spot rate (Retail): USD/AUD = 0.6359 ‐ 0.6303 • 3‐month forward margin = 6 ‐ 7 • 3‐month interest rates: 5.78% in Australia, 5.92% in the U.S.

Q. Is the AUD in discount or Premium? Why?A. As the Australian interest rates are lower than those in the United States, the

AUD is traded at a forward premium relative to the USD.

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(2013-S1) - FINS3616 - Tutorial Slides - Week 02 - Exchange Rate Basics

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