exchange rate basics

Introduction and Exchange Rate Basics

TEN BASIC QUESTIONS ABOUT

GLOBALIZATION

19-Mar-17ASHOK PATIL

2

What is globalization?

How new is globalization?

What has led to increased globalization?

What are some positive effects of globalization?

When people trade, how do both sides benefit?

What are some negative effects of globalization?

What roles do the International Monetary Fund (IMF), the World Bank and the World Trade Organization (WTO) play in globalization?

What are some effects of multinational businesses?

What are some of the issues involved with outsourcing jobs?

What is the future of globalization?

3

Turnover on the global FX

Trading in foreign exchange markets averaged $5.3 trillion per day

in April 2013. This is up from $4.0 trillion in April 2010 and $3.3

trillion in April 2007. FX swaps were the most actively traded

instruments in April 2013, at $2.2 trillion per day, followed by spot

trading at $2.0 trillion.

The US dollar remained the dominant vehicle currency; it was on

one side of 87% of all trades in April 2013. The euro was the second

most traded currency, but its share fell to 33% in April 2013 from

39% in April 2010. The turnover of the Japanese yen increased

significantly between the 2010 and 2013 surveys. So too did that of

several emerging market currencies, and the Mexican peso and

Chinese renminbi entered the list of the top 10 most traded

currencies.

Source: BIS: Triennial Central Bank Survey of FX and derivatives, 2013

http://www.bis.org/press/p130905.htm

http://www.bis.org/press/p130905.htm

4

The foreign exchange market consists of two tiers:

the interbank or wholesale market (multiples of $1M US or equivalent in transaction size), and

the client or retail market (specific, smaller amounts).

Five broad categories of participants operate within these two tiers: bank and nonbank foreign exchange dealers, individuals and firms, speculators and arbitragers, central banks and treasuries, and foreign exchange brokers.

Market Participants

5

Banks and a few nonbank foreign exchange dealers operate in both the interbank and client markets.

They profit from buying foreign exchange at a “bid” price and reselling it at a slightly higher “offer” or “ask” price.

Dealers in the foreign exchange department of large international banks often function as “market makers.”

These dealers stand willing at all times to buy and sell those currencies in which they specialize and thus maintain an “inventory” position in those currencies.

Market Participants

6

Individuals (such as tourists) and firms (such as

importers, exporters and MNEs) conduct

commercial and investment transactions in the

foreign exchange market.

Their use of the foreign exchange market is

necessary but nevertheless incidental to their

underlying commercial or investment purpose.

Some of the participants use the market to

“hedge” their foreign exchange risk.

Market Participants

7

Speculators and arbitragers seek to profit from trading in the market itself.

They operate in their own interest, without a need or obligation to serve clients or ensure a continuous market.

While dealers seek the bid/ask spread, speculators seek all the profit from exchange rate changes and arbitragers try to profit from simultaneous exchange rate differences in different markets.

Market Participants

8

Central banks and treasuries use the market to acquire or spend their country’s foreign exchange reserves as well as to influence the price at which their own currency is traded.

They may act to support the value of their own currency because of policies adopted at the national level or because of commitments entered into through membership in joint agreements such as the European Monetary System.

The motive is not to earn a profit as such, but rather to influence the foreign exchange value of their currency in a manner that will benefit the interests of their citizens.

As willing loss takers, central banks and treasuries differ in motive from all other market participants.

Market Participants

Types of Activities

9

Speculation

An activity that leaves one open to exchange rate fluctuations where one aims to make a profit.

Hedging

Allows the firm to transfer exchange rate risk inherent in foreign currency transactions or positions.

Arbitrage – take advantage of inconsistent prices to make risk-free profits. These profits are unlikely to last long.

Spatial (or Locational) Arbitrage

Triangular Arbitrage

Covered Interest Arbitrage

10

A Spot transaction in the interbank market is

the purchase of foreign exchange, with

delivery and payment between banks to

take place, normally, on the second

following business day.

The date of settlement is referred to as the

value date.

Types of Transactions

11

An outright forward transaction (usually called just “forward”) requires delivery at a future value date of a specified amount of one currency for a specified amount of another currency.

The exchange rate is established at the time of the agreement, but payment and delivery are not required until maturity.

Forward exchange rates are usually quoted for value dates of one, two, three, six and twelve months.

Buying Forward and Selling Forward describe the same transaction (the only difference is the order in which currencies are referenced.)


12

A swap transaction in the interbank market is the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates.

Both purchase and sale are conducted with the same counterparty.

Some different types of swaps are:

spot against forward,

forward-forward,

nondeliverable forwards (NDF).



13

IN US$ US$ VS. % CHG PER US$

Country/currency Fri Thurs 1-Day YTD Fri Thurs

Americas

Argentina peso 0.2209 0.2212 0.12 5.1 4.5268 4.5212

Brazil real 0.4978 0.4808 -3.40 7.7 2.0090 2.0798

Canada dollar 0.9835 0.9679 -1.58 -0.4 1.0168 1.0332

Chile peso 0.001998 0.001968 -1.52 -3.7 500.50 508.20

Colombia peso 0.0005607 0.0005534 -1.30 -8.1 1783.50 1807.00

Ecuador US dollar 1 1 unch unch 1 1

Mexico peso 0.0748 0.0735 -1.75 -4.1 13.3722 13.6103

Peru new sol 0.3753 0.3752 unch -1.2 2.6645 2.6650

Uruguay peso 0.04608 0.04607 unch 9.5 21.7025 21.7045

Venezuela b. fuerte 0.22988506 0.22988506 unch unch 4.3500 4.3500

Friday, June 29, 2012

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

This is referred to as

European terms

Basics of Exchange Rate

19-Mar-17

14

ASHOK PATIL

Abbreviations of currency

names


15

Contractual parties abbreviate the names of the currencies instead of writing full names.

It is important that all the parties involved use standard abbreviations.

These standards are provided by ISO. In most cases, the abbreviation is two-digit country code plus a letter from the name of the currency. E.g. JPY, USD, INR, GBP, etc.

However, in many places, symbols of the currencies is also used E.g. $ for USD, ₹ for INR, € for EUR, £ for GBP, ¥ for

JPY, etc.

Nominal Exchange Rate Quotes


16

The nominal exchange rate between two countries is the

rate at which one country’s currency can be exchanged

for the other country’s currency.

In other words, it is the price of one currency in terms of

other currency.

Two ways to express rates (quote or reference

currency/base currency)

Home currency units per unit of foreign currency (direct quote) e.g.

₹50/$ (hc/fc) from Indian point of view.

Most often employed in theoretical economic literature

So a rise in this exchange rate (say ₹52/$) means price of fc has increased,

hence a relative cheapening of hc or depreciation of hc.

Foreign currency per unit of home currency (indirect quote) $0.02/₹

Commonly employed in UK


17

I view home currency/foreign currency is the

better way to express exchange rate i.e.

₹50/$.

Consistency is important

Note that reciprocal of direct quote is indirect

quote.

You might also come across exchange rate

quotation in American terms (USD/Foreign

Currency) or European terms (Foreign

currency/USD)

Bilateral vs trade-weighted

exchange rate


18

Note: When the price of a single good or class of goods goes up, while all others stay the same, we say the price of that single good or class of goods has risen. The reason for such rise in one good or class of goods has to be found out in the context of changes in the market for that good or class of goods.

If the prices of one good or class of goods increases along with other goods goes up (inflation), we say value of money has fallen.

Determination of exchange rate (freely-floating regime – no government

intervention)


19

Demand for vs supply of a currency (as

applied in economics.) will determine the

equilibrium exchange rate.


21

Normally, two rates are quoted for exchange

rates: buying rate and selling rate.

Typically banks buy and sell at different rates.

i.e. they buy at lower rate and sell at higher

rate.

The buying rate is called ‘bid’ and selling rate

is called ‘ask’.

The difference between the bid and ask is

called ‘spread’.

Inter-bank Rates in ₹ as on June

28, 2012


22

Currency Buy (bid) Sell (ask/offer)

US Dollar 57.0300 57.0500

Euro 70.7500 71.0000

GB Pounds 88.3000 88.5500

Please note that the it is always ‘buy low and sell high’.

What it means, in case of USD rate, is:

•If you want to buy dollar from bank, you have to pay ₹ 57.0500, whereas

•If you want to sell dollar to bank, you will receive ₹57.0300.

One can calculate the spread of ₹0.02

Bid-ask spread = (Ask – Bid)/Ask

i.e. Bid –ask spread = (57.05 – 57.03)/57.05 = .035%

Less treaded and more volatile currency spread will be high.


23

Bid Ask

$/£ 1.4482 1.4484

Bid: Dealer buys £ for $ at the Bid, Client sells £ for $

(i.e., dealer will buy £1,000,000 for $1,448,200).

Ask: Dealer sells £ for $ at the Ask, Client buys £ with

$ (i.e., dealer will sell £1,000,000 for $1,448,400).


24

Banks act as market makers and realise their

profits from the spread:

Bid-Ask Spread = (Ask-Bid)/Ask

Consider the DIRECT quote of $ 1.4482 –

1.4484/£

%1380.0100

4484.1

4482.14484.1%

spread

Cross Rates

25

Many currency pairs are inactively traded, so their

exchange rate is determined through their relationship

to a widely traded third currency.

For example, an Australian importer needs Danish

currency to pay for purchases in Copenhagen.

The Australian dollar (symbol A$) is not widely quoted

against the Danish kroner (symbol DKr).

However, both currencies are quoted against the U.S.

dollar. Assume the following quotes:

Australian dollar A$1.5431/US$

Danish kroner DKr7.0575/US$

26

The Australian importer can buy one U.S. dollar for

A$1.5431 and with that dollar buy DKr7.0575. The

cross-rate calculation would be:

A$/DKr 0.2186US$DKr7.0575/

S$A$1.5431/U

dollar .kroner/U.SDanish

dollar .dollar/U.S Australian

However, calculating cross-rates is

usually not as easy as this!

Cross rate with bid-ask quotes


27

Let’s define S($/ask₤) as the offer rate/ask rate of the dealer/bank to sell ₤ with $

S($/bid ₤) as the buying/bid rate of the dealer/bank to buy ₤ with $

Since buying of one currency is selling of other currency, we can write S($/ask₤) as S(bid$/ ₤); we can write S($/bid ₤) as S(ask$/ ₤)

We will stick to the former method i.e. S($/ask₤) and S($/bid ₤)

S(ask$/£)S($/bid£)

and

S(bid$/£)S($/ask£)

Bid-ask rate conversion


28

We know that,

S(£/ask$)

1S($/bid£)

S(£/bid$)

1

S(£ask/$)

1S($/ask£)

as modified isequation the

involved are ratesask and bid asbut

S(£/$)

1S($/£)

thatknow We

and

Example with common currency in

numerator


29

Rates on the euro and pound vis-à-vis the US

dollar are quoted as

S($/bid€)=1.3520

S($/ask€)=1.3550

S($/bid₤)=2.0250

S($/ask₤)=2.0285

Then,

It can be written as

$ 1.3520-50/ €


$ 2.0250-85/ ₤

6691.00250.2

3550.1

($/bid£) S

)($/ask S)S(£/ask

6666.00285.2

3520.1

($/ask£) S

)($/bid S

($/£) S

)($/ S) S(£/bid

Example with common currency in

denominator


30

Rates on the euro and pound vis-à-vis the US

dollar are quoted as

S(€/bid$) = 0.7380

S(€/ask$) = 0.7396

S(₤/bid$)=0.4930

S(₤/ask$)=0.4938

Then,


€ 0.7380-96/$


₤ 0.4930-38/$

6691.07380.0

4938.0

$)/( S

)$/(£ S)S(£/ask

6666.07396.0

4930.0

$)/( S

)$/(£ S

$)/( S

)$/(£ S) S(£/bid

bid

ask

ask

bid

31

We have the following rates:

US$1.4419 – 36 / GBP

US$0.6250 – 67 / CHF

Calculate the CHF / GBP rate!

= CHF 2.3008 – 98 / GBP.

Also calculate GBP/CHF rate.

= GBP 0.4329 – 0.4346/CHF


32


US$1.4419 – 36 / GBP

US$0.6250 – 67 / CHF


CHF/GBPb = [USD/GBP]/[USD/CHF] = [USD/GBPb]/[USD/CHFa]

=1.4419/.6267

= 2.3008

CHF/GBPa = [USD/GBPa]/[USD/CHFb] =1.4436/.6250

= 2.3098

Calculate the GBP/CHF rate.

GBP/CHFb = [USD/CHFb]/[USD/GBPa] =0.6250/1.4436

=0.4329

GBP/CHFa = [USD/CHFa]/[USD/GBPb] = 0.6267/1.4419

=0.4346

Example 2


33


GBP 0.6927 – 35/ US$

CHF 1.5957- 1.6000/ US$


= CHF 2.3008 – 98 / GBP.

Also calculate GBP/CHF rate.

= GBP 0.4329 – 0.4346/CHF


34


GBP 0.6927 – 35/ US$

CHF 1.5957- 1.6000/ US$


CHF/GBPb = [CHF/USD]/[GBP/USD] =[CHF/USDb]/[GBP/USDa]

= 1.5957/0.6935

=2.30093

CHF/GBPa = [CHF/USDa]/[GBP/USDb] =1.6000/0.6927

= 2.3098

Calculate the GBP/CHF rate.

GBP/CHFb = [GBP/USDb]/[CHF/USDa] = 0.6927/1.6000

=0.4329

GBP/CHFa = [GBP/USDa]/[CHF/USDb] = 0.6935/1.5957

=0.4346

35

Forward rates can be quoted as either as an outright quote, points or as an annualised % forward premium or discount.

Forward Quotes – Points

36

A forward quotation expressed in points is not a

foreign exchange rate as such. It is the difference

between the forward rate and the spot rate.

When the Bid Points > Ask Points, you subtract

the points from the spot rate to get the outright

forward quote.

If the Bid Points < Ask Points, you add the points

to the spot rate to get the outright forward quote

37

For quotations expressed in hc/fc (Direct quotations) the formula:

f hc/fc = Forward – Spot 360

Use this formula for denominator currency forward premium/discount.

For quotations expressed in fc/hc terms (Indirect quotations) the formula becomes:f fc/hc = Spot – Forward 360

Use this formula for numerator currency forward premium/discount.

100nSpot

xx

100nForward

xx

Forward Quotes – Percentage

Derivation


38

)/(

)/()/(

**)/(/1

)/()/(

)/(/1

*/)/()/(

)/(/1

)/(/1)/(/1

___/_____

)/(

)/()/(

/

/

/

/

/

hcfcForward

hcfcForwardhcfcSpotf

ForwardSpothcfcSpot

hcfcForwardhcfcSpotf

hcfcSpot

ForwardSpothcfcForwardhcfcSpotf

hcfcSpot

hcfcSpothcfcForwardf

belowastermshcfcforconvertedbecanwhich

fchcSpot

fchcSpotfchcForwardf

hcfc

hcfc

hcfc

hcfc

fchc

Example (used excel to

calculate)

Spot: $1.0899/€

Forward: $1.0917/€

Forward premium for €(fc) (use hc/fc – direct formula)

= (1.0917 –1.0899)/1.0899

=0.1652%

Spot: €0.917515/$

Forward: €0.916003/$

Forward discount for $ (fc) (hc/fc – direct formula)

= (0.916003-0.917515)/0.917515

=-0.165%

19-Mar-17

39

ASHOK PATIL

F for $ (hc) (use fc/hc – indirect formula)

= spot – forward/spot

= 1.0899 – 1.0917)/1.0917

=-0.165%

F for € (hc) (use fc/hc – indirect formula)

= spot – forward/spot

= 0.917515 – 0.916003)/0.916003

= 0.1652%

Arbitrage in the foreign exchange

market


40

Arbitrage is the exploitation of price

differentials for riskless guaranteed profits.

For illustration, please assume that the

transaction costs are negligible and that there

is single rate quotation (no bid-offer spread

quotes)

Financial center arbitrage (Locational

arbitrage)

The rates for a currency pair across two financial

centers must be same otherwise arbitrage is

possible

Cross currency arbitrage

Locational Arbitrage:

The prices charged by different banks for foreign exchange cannot vary significantly. Prices are kept more or less in line with one another through a process called “LocationalArbitrage”

If the price of a currency varies from one bank to another, an arbitrager will be able to "buy low" and "sell high.“ Such an activity should lead to an increase in the rate at the low-priced bank and decrease in the rate at the high-priced bank.

Arbitrage activity will continue as long as the difference in prices is large enough to generate a profit.

Example, single exchange rate


42

Suppose the exchange rate is $1.89/£ in NY but only $1.87/£ in London.

Then it would be profitable for banks to buy pounds in London and simultaneously sell them in NY and make 2 cents for every pound bought and sold.

The act of buying pounds in London will appreciate pound in London and selling pounds in NY will depreciate pound in NY.

This will continue until the rates at both centers coincide, say at $1.88/£.

Locational Arbitrage, bid-ask spread exchange rate

Locational arbitrage is possible when a

bank’s buying price (bid price) is higher than

another bank’s selling price (ask price) for

the same currency.

Example

Bank C Bid Ask Bank D Bid Ask

NZ$ $.635 $.640 NZ$ $.645 $.650

Buy NZ$ from Bank C @ $.640, and sell it to

Bank D @ $.645. Profit = $.005/NZ$.

Example


44

Zurich: USD 1.4955-62/CHF

New York: CHF 0.6695-99/USD

Calculate locational arbitrage.

Convert one of them to get the price of the same currency, let’s say CHF.

New York: USD 1.4927 – 36/CHF

We already have Zurich: USD 1.4955 – 62 /CHF

Apply Buy low, sell high

Buy CHF in New York @ $1.4936 and sell in Zurich @ $1.4955; a profit of $.0019 per CHF bought and sold.

OR


45

Zurich: USD 1.4955-62/CHF

New York: CHF 0.6695-99/USD

Calculate locational arbitrage.

Convert one of them to get the price of the same currency, let’s say USD.

Zurich: CHF.6682-87/USD

We already know NY: CHF 0.6695-99/USD

Buy low, sell high

Buy USD in Zurich @ CHF0.6687 and sell in New York @ CHF0.6695; a profit of CHF 0.0008 per $ bought and sold.

Solution in tabular format


46

Zurich New York

Bid Ask Bid Ask

US$ CHF.6682 CHF.6687 CHF.6695 CHF.6699

Buy US$ from Zurich @ CHF.6687, and sell it in New York @ CHF.6695. Profit = CHF.0008/US$.

OR

Zurich Bid Ask New York Bid Ask

CHF $1.4955 $1.4962 CHF$1.4928 $1.4936

Buy CHF from New York @ $1.4936, and sell it in Zurich @ $1.4955; Profit = $0.0019/CHF.

Example: Bank A Bank B

Bid price for SF $ .50 $ .52

Ask price for SF $ .51 $ .53

In this example profitable arbitrage opportunity exists. Given that the arbitrager has $1m.

Buy SF from bank A at .51 and simultaneously sell them to Bank B at .52. so that :

$1,000,000 SF = 1,000,000/.51 = SF 1,960,784.

Sell to Bank B for $1,960,784 * .52 = $1,019,608 for a profit of $19,608.

The high demand for SF in Bank A leads to an increase in price and increased supply of SF in Bank B leads to a decrease in price.

Such a situation usually disappears before most firms even become aware of it.

48 Cross rates can be used to check on opportunities for inter-

market arbitrage. Suppose the following exchange rates

are available:

Bank of America: Dutch guilders (fl) per U.S. $ fl1.9025/U.S.$

Dominion Bank: Canadian dollars per U.S. $ C$1.2646/U.S.$

ABN Amro Bank: Dutch guilders per Canadian $ fl1.5214/C$

The synthetic cross rate between Dutch

guilders and Canadian dollars is:

/C$fl1.5044S$C$1.2646/U

1.9025/US$fl

dollar S.dollars/U.Canadian

dollar .S.guilders/UDutch

You get more

guilders from ABN

Amro

Observation


49

If we look at exchange rates offered by Bank of America for fl/US$ and Dominion Bank for C$, we can calculate the exchange rate between fl and C$ using cross rate calculation:

i.e. if you carry a transaction between BOA and DB, you will get 1.5044 fl per C$. This is less than what ABN is offering. So there is a scope for arbitrage.

1.5044 )$/(

C$1

5044.1

2646.1

1

1

9025.1

C$

$

$$/$

$/

C$

CflS

flfl

C

flfl

How the actual transaction can

happen?


50

Apply ‘buy low, sell high rule’.

So you would like to buy C$ at low rate from transaction between BOA and DB and sell it to ABN.

To do this, you must get C$ from BOA and DB; this means you must start with assumption that you have fl.

So you sell fl to BOA to get US$ and then sell US$ to DB to receive C$. Once you receive C$, sell it to ABN to receive fl.

By doing this you have started with fl and ended with more fl.

Calculation


51

So you sell fl to BOA to receive US$ and then sell US$ to DB to receive C$. Once you receive C$, sell it to ABN to receive fl.

Assume, you have 1 mln fl to begin with.

Sell this fl to BOA to receive US$ How many US$ will you receive with the exchange rate of

fl1.9025/U.S.$?

You will receive 1/1.9025 US$ = 525624 US$

Sell these US$ to DB to receive C$ How many C$ will you receive with the exchange rate of

C$1.2646/U.S.$?

You will receive 1.2646*525624 C$ = 664704 C$

Sell these C$ to ABN to receive fl How many fl will you receive with the exchange rate of

fl1.5214/C$?

You will receive 664704*1.5214 = 1011281 fl

So a gain of 1011281-1000000 = 11281 fl

52

Divided by

1.9025 fl/US$

US$525,624

United StatesMultiplied by

1.2646 C$/US$

C$664,704

Canada

Multiplied by

1.5214 fl/C$

(Start)(End)

Netherlandsfl1,000,000fl1,011,281

Profit = fl 11,281



are available:





guilders and US dollars is (ABN & DB):

/$9240.11/1.2646

1.5214

[1/C$/US$]

/C$

dollar dollars/C. US

dollar guilders/CDutch fl

fl

Calculation


54

Assume, you have 1 mln $ to begin with.

Sell this $ to DB to receive C$ 1.2646*1 mln =

C$ 1.2646 mln

Sell these C$ to ABN to receive fl 1.2646*1.5214

= fl1.9240 mln

Sell these fl to BOA to get $ 1.9240/1.9025 =

$1.011281 mln

So a gain of 1011281-1000000 = $11281



are available:




The synthetic cross rate between C$ and US $ is

(ABN & BOA):

/$2505.1$1.5214

1.9025

fl/C$

$fl/ C


56

You may start with 1 C$; sell it to ABN to get

fl1.5214. Sell these fl1.5214 to BOA to get

$1.5214/1.9025 = $ 0.7997.

Sell these $0.7997 to DB to get C$

0.7997*1.2646 = C$ 1.011281

Triangular Arbitrage:

Example 1:

Consider the following quotes in New York,

Frankfurt, and London. (Assume no transaction

costs)

Frankfurt ($/€ = 1.2471)

London (€/£ = 1.4544)

New York ($/£ = 1.8590)

Is Triangular Arbitrage feasible? Show Why/Why

not?

Describe a strategy to profit from triangular

arbitrage.

What percentage profit is possible?

19-Mar-17ASHOK PATIL58

On the Bases of New York and Frankfurt

quotes:

1.4544 ≠ 1.4907, triangular arbitrage exists.

The € is worth more in London (fewer € required to buy £ in London

compared to cross rate). Hence acquire € elsewhere and sell it in London.

E.g. sell 1 L in NY and get 1.8590 $, sell these $ in frankfurt to get

1.8590/1.2471 euro, sell these euro in London to get 1.8590/1.2471/1/4544

= 1.02493 L.

OR

Start with 1 euro and buy 1/1.4544 L in London then sell these L in NY to get

1/1.4544*1.8590 $, sell these $ in frankfurt to get 1/1.4544*1.8590/1.2471

euro = 1.02493 euro.

4907.12471.1

8590.1

)(/$

)($

)(

frankfurt

NYLLondon

L

59

Measuring a change in the foreign currencyfor quotations expressed in home currency terms (direct):

%∆ = Ending rate – Beginning Rate

Quotations expressed in foreign currency terms (indirect):

%∆ = Beginning Rate – Ending Rate

Beginning Ratex 100

Ending Ratex 100

Measuring a Change in the Spot Rate

Example

60

The Australian dollar was quoted at A$1.8445/US$

on Aug 19, 2002, while on March 2, 2004 it was

quoted at A$1.335/US$.

What is the appreciation/depreciation of the US$?

61

Thus, the appreciation/depreciation of the US$,

relative to the A$ from t-1 to t is:1

1,

1

A$1.335/$ $1.844527.6%

$1.8445

t tt t

t

S S A /$R

S A /$

Thus, the U.S.$ has depreciated relative

to the A$ by 27.6%

62

To calculate the appreciation/depreciation of the

Australian dollar, relative to the US dollar,

Use the other formula % change = (beginning rate –

ending rate)/ ending rate = (1.8445 – 1.335)/1.335

= 38.2%

Or we can have the denominator currency to be the A$

by At t-1: A$1.8445/US$ = US$0.5422/A$

At t: A$1.335/US$ = US$0.7491/A$

Then use % change = (ER- BR)/BR formula

11,

1

$0.7491 $0.5422 / $38.2%

$0.5422 / $

t tt t

t

S S AR

S A

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In general, the percentage appreciation in one

currency is not equal to the percentage

depreciation in the other currency. Instead…

)1(

11

$

$

US

AR

R

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Cross rates can be used to check on opportunities for inter-market arbitrage. Suppose the following exchange rates are available:

Bank of America: Dutch guilders (fl) per U.S. $ fl1.9025-28/U.S.$

Dominion Bank: Canadian dollars per U.S. $ C$1.2646-51/U.S.$

ABN Amro Bank: Dutch guilders per Canadian $ fl1.5214-22/C$


guilders and Canadian dollars is:fl/bidC$ = [fl/$b]/[C$/$a]

= [1.9025/1.2651]

=1.5038

fl/askC$=1.5046

fl1.5038-46/C$

ABN Amro’s bid rate

is higher than

BOA/DB’s ask rate


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ABN Amro: fl1.5214-22/C$

BOA/DB rate:fl1.5038-46/C$

First find out whether one bank’s bid price is higher than the ask rate of the other bank for the same currency.

Then solve as usual: buy low, sell high.

Here, ABN Amro’s bid rate of fl1.5214/C$ is higher than BOA/DB’s ask rate of fl1.5046. Therefore arbitrage is possible.

Buy C$ from BOA/DB and sell it to ABN Amro.

To buy C$, first sell your fl into $, then sell these $ to receive C$. Now sell these C$ to ABN Amro.

Bank of America: Dutch guilders (fl) per U.S. $ fl1.9025-28/U.S.$

Dominion Bank: Canadian dollars per U.S. $ C$1.2646-51/U.S.$



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Assume, you have 1 mln fl to begin with.

Sell this fl to BOA to receive US$ How many US$ will you receive with the exchange rate of fl1.9025-

28/U.S.$?

You will receive 1/1.9028 US$ = 525541 US$

Sell these US$ to DB to receive C$ How many C$ will you receive with the exchange rate of C$1.2646-

51/U.S.$?

You will receive 1.2646*525541 C$ = 664599 C$

Sell these C$ to ABN to receive fl How many fl will you receive with the exchange rate of fl1.5214-

22/C$?

You will receive 664599*1.5214 = 1011122 fl

So a gain of 1011122-1000000 = 11122 fl

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Divided by

1.9028 fl/US$

US$525,541

United StatesMultiplied by

1.2646 C$/US$

C$664,599

Canada

Multiplied by

1.5214 fl/C$

(Start)(End)

Netherlandsfl1,000,000fl1,011,122

Profit = fl 11,122

68

Cross rates can be used to check on opportunities for inter-

market arbitrage. Suppose the following exchange rates are

available:

Bank of America: Dutch guilders (fl) per U.S. $ fl1.9025-

28/U.S.$

Dominion Bank: Canadian dollars per U.S. $ C$1.2646-

51/U.S.$


The synthetic cross rate between (BOA/ABN)

USD and Canadian dollars is:

C$ 1.2498-1.2507/$

Therefore, you should buy $ from BOA/ABN and sell

DB’s bid rate is

higher than

BOA/ABN’s ask rate


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So if you start with selling 1C$ to ABN to get

fl1.5214, which then can be sold to BOA to get

US$0.7996 (= 1.5214/1.9028= $0.7996)

These $ can now sold to DB to get C$1.01112

(=0.7996*1.2646= 1.01112)

So a profit of C$0.01112 for every C$ you

have.

Quotation Convention


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The inter-bank market uses quotation conventions adopted by ACI (Association Cambiste Internationale).

A currency pair is denoted by a 3-letter SWIFT codes for the two currencies separated by an oblique or a hyphen USD/CHF: US dollar-Swiss franc: dollar-swissy

GBP/JPY: Great Britain Pound-Japanese Yen

USD/INR: US dollar-Indian Rupee

GBP/USD: Great Britain Pound-US dollar: cable

The first currency in the pair is the base currency and the second is the quoted currency. Thus in USD/INR, USD is the base currency and INR is the quoted currency.

The exchange rate quotation is given as the number of units of the quoted currency per unit of the base currency. Thus USD/INR quotation will be given as number of rupees per dollar.

exchange rate basics

Economy & Finance

Transcript of exchange rate basics