chap15 Foreign Exchange Markets
-
Upload
lan-nguyen -
Category
Documents
-
view
227 -
download
0
Transcript of chap15 Foreign Exchange Markets
-
8/8/2019 chap15 Foreign Exchange Markets
1/22
CHAPTER 15
Foreign Exchange Markets
-
8/8/2019 chap15 Foreign Exchange Markets
2/22
Foreign Exchange Market
What is the foreign exchange market?
Who are the major participants?
-
8/8/2019 chap15 Foreign Exchange Markets
3/22
-
8/8/2019 chap15 Foreign Exchange Markets
4/22
Foreign Exchange Market
What is the exchange rate?
An exchange rate is the price of a unit of one
currency in terms of another.
How are exchange rates determined?
By supply and demand for the most part
(governments also play a role)
-
8/8/2019 chap15 Foreign Exchange Markets
5/22
-
8/8/2019 chap15 Foreign Exchange Markets
6/22
Foreign Exchange Market An exchange rate is either a spot rate or a
forward rate
Spot rate (S):
Forward rate (F):
-
8/8/2019 chap15 Foreign Exchange Markets
7/22
Foreign Exchange Market How are exchange rates quoted? There
are two types of quotations:
Direct:
Indirect:
-
8/8/2019 chap15 Foreign Exchange Markets
8/22
International Arbitrage
We will look at three types of
international arbitrage:
Locational arbitrage
Triangular arbitrage
Covered interest arbitrage
-
8/8/2019 chap15 Foreign Exchange Markets
9/22
Locational Arbitrage
What is locational arbitrage?
When is locational arbitrage possible?
Bid price:
Ask price:
Locational arbitrage is possible when:
-
8/8/2019 chap15 Foreign Exchange Markets
10/22
Locational Arbitrage
Example:
British poundquote:
Bank A BankB
Bid price $1.61 per pound $1.63 per pound
Ask price $1.62 per pound $1.64 per pound
Profit on $1,000:
(1000/1.62)*1.63 = $1006.17
So profit from locational arbitrage is $6.17
-
8/8/2019 chap15 Foreign Exchange Markets
11/22
TriangularArbitrage What is triangular arbitrage?
When is it possible?
What is a cross exchange rate:
-
8/8/2019 chap15 Foreign Exchange Markets
12/22
TriangularArbitrage How is the theoretical cross exchange
rate calculated?
Value ofCurrency X in terms of US dollar
Value ofCurrency Y in terms of US dollar
-
8/8/2019 chap15 Foreign Exchange Markets
13/22
TriangularArbitrage Example:
1 British pound = $1.60
1 Brazilian real= $0.20
1 pound = 8.10 reals
Theoretical cross rate:
1.6/.20 = 8.00 reals per pound
Thus, triangular arbitrage is possible since
the quoted rate (8.10) differs from the
theoretical (8.00)
-
8/8/2019 chap15 Foreign Exchange Markets
14/22
TriangularArbitrage To capitalize on the price discrepancy
(assuming you have $1,000):
1. Buyovervalued
Overvalued currency: pound
1,000/1.60 = $625 pounds
2. Converttoundervalued
Undervalued currency: real
625*8.10 = 5062.50 real
-
8/8/2019 chap15 Foreign Exchange Markets
15/22
TriangularArbitrage 3. Reconvert to home currency (dollar)
5062.50*.20 = $1012.50
Arbitrage profit = $12.50
-
8/8/2019 chap15 Foreign Exchange Markets
16/22
CoveredInterestArbitrage
(CIA) What is CIA?
To understand CIA we must understand:
Interest rate differentials:
Forward differentials: (F-S/S) * 360/n
where n is the number of days
When is CIA possible?
-
8/8/2019 chap15 Foreign Exchange Markets
17/22
CoveredInterestArbitrage
Example:
US investor with $1,000,000
US interest rate = 6%
Mexican interest rate = 8%
Spot rate: 1 peso = $0.50
1 year forward rate: 1 peso =$0.55
Is CIA possible? Lets see.
-
8/8/2019 chap15 Foreign Exchange Markets
18/22
CoveredInterestArbitrage
Convert dollars to pesos:
$1,000,000/0.50 = 2,000,000 pesos
Invest at 8 percent for 1 year
2,000,000* 1.08 = 2,160,000 pesos
Reconvert to dollars:
2,160,000*0.55 = $1,188,000
So, was CIA worthwhile?
-
8/8/2019 chap15 Foreign Exchange Markets
19/22
GovernmentInterventioninForeign
Exchange Markets
Why do governments intervene?
To smooth exchange rates
To execute objectives of the central banks
To establish implicit boundaries
-
8/8/2019 chap15 Foreign Exchange Markets
20/22
GovernmentInterventioninForeign
Exchange Markets
How do governments intervene:
Direct Intervention
Sterilized
Unsterilized
-
8/8/2019 chap15 Foreign Exchange Markets
21/22
GovernmentInterventioninForeign
Exchange Markets
Indirect Intervention
-
8/8/2019 chap15 Foreign Exchange Markets
22/22
Summary
Basics of Foreign Exchange Market
Characteristics of the market
Major participants
Spot versus forward rates
Types of quotations
International Arbitrage
Government Intervention