Foreign Exchage

The Foreign Exchange

Market

Concepts

1. Value Date:

The settlement of a transaction takes place by transfers of deposits between

two parties. The day on which these transfers are effected is called the

Settlement Date or the Value Date.

2. Spot Rate:

When the exchange of currencies takes place on the second working day

after the date of the deal, it is called spot rate.

3. Forward Transactions :

If the exchange of currencies takes place after a certain period from the date

of the deal (more than 2 working days), it is called a forward rate. A trader

may quote a forward transaction for any future date. It is a binding contract

between a customer and dealer for the purchase or sale of a specific quantity

of a stated foreign currency at the rate of exchange fixed at the time of

making the contract.

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4. Swap Transaction:

A swap transaction in the foreign exchange market is combination of a spot

and a forward in the opposite direction. Thus a bank will buy DEM spot

against USD and simultaneously enter into a forward transaction with the

same counter party to sell DEM against USD against the mark coupled with

a 60- day forward sale of USD against the mark. As the term ‘swap’ implies,

it is a temporary exchange of one currency for another with an obligation to

reverse it at a specific future date.

5. Bid Rate:

The bid rate denotes the number of units of a currency a bank is willing to

pay when it buys another currency.

6. Offer Rate :

The offer rate denotes the number of units of a currency a bank will want to

be paid when it sells a currency.

7. Bid - Offer Rate:

The bid offer Rate is the rate which states both, the price which is the bank is

willing to pay to buy other currencies and the price the bank expects when it

sells the same currency. Bid and Ask will always be from a bank’s point of

view. Thus (A/B)bid will denote the number of units of A the bank will pay

when it buys one unit of B and (A/B)ask will mean the number of units of A

the bank will want to be paid in order to sell one unit of B.

8. European Quote:

The quotes are given as number of units of a currency per USD. Thus

DEM1.5675/USD is a European quote.

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9. American Quotes:

American quotes are given as number of dollars per unit of a currency. Thus

USD0.4575/DEM is an American quote.

10.Direct Quotes :

In a country, direct quotes are those that give unit of the currency of that

country per unit of a foreign currency. Thus INR 35.00/USD is a direct quote

in India.

11.Indirect Quote:

Indirect or Reciprocal Quotes are stated as number of units of a foreign

currency per unit of the home currency. Thus USD 3.9560/INR 100 is an

indirect quote in India.

12. Arbitrage:

Arbitrage may be defined a san operation that consists in deriving a profit

without risk from a differential existing between different quoted rates. It

may result from 2 currencies, also known as, geographical arbitrage or from

3 currencies, also known as, triangular currencies.

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Descriptive questions 1.What is foreign exchange market? Explain the functions.

Answer:

In a business setting, there is a fundamental difference between making

payment in the domestic market and making payment abroad. In a domestic

transaction, only one currency is used while in a foreign transaction, two or

more currencies maybe used.

The foreign exchange market is the market in which currencies are brought and

sold against each other it is the largest market in the world.

The foreign exchange market also known, as forex market is an over-the-

counter market, this means that there is no single market place or an organized

exchange like a stock exchange. The traders sit in the foreign exchange dealing

room of major commercial banks around the world, they communicate with

each other through telephone telex computer terminals and other electronic

menace of communication.

They are four main participants in the foreign exchange market.

1. Broker

2. Bankers

3. Corporations

4. Central bank.

Bankers: large commercial banks operating either at retail level for individual

exporters and corporations or at wholesale level in the InterBank market.

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Central bank: central banks of various countries that intervene in order to

maintain or to influence the exchange rate of their currencies within a certain

range as also to execute the orders of government.

Individual brokers or corporations: bank dealers often used brokers to stay

anonymous since the identity of banks can influence short-term course.

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Foreign Exchange Flow

Exports Corporations

Broker

Bank

Broker

Bank

Broker Corporations Imports

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2.Elaborate the structure of the foreign exchange market and

compare it with the foreign exchange of India

Answer:

The Foreign exchange market may be broadly classified into -:

Wholesale market and Retail market .

WHOLESALE MARKET (primary price maker)

The wholesale market is also referred to as interbank market the

average transaction size in this market is very small.

Participants: Commercial banks, Corporations and Central bank

Among these participants, primary price maker or professional dealer make a

two way market to each other & their clients, i.e. on request they will quote a

two-way price & be prepared to take either the buy or sell side .This group

mainly include commercial bank but some large investment dealer & a few

large corporation have also assumed the role of primary dealers. Primary price

makers perform an important role in taking positions off the hands of another

dealer or corporate customer & then offsetting these by doing an opposite deal

with another entity which has a matching requirement.

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Among primary price maker there is a kind of tiering –

MULTINATIONAL BANK

(deal in large number of currencies

& in large amount without using broker )

LARGE BANKS

(deal in small number of currencies & use the services of broker )

LOCAL INSTITUTION

(market in a small number of major

currencies against home currency )

RETAIL MARKET (Secondary price maker )

It is the market in which travelers & tourists exchange one currency for another

in the form of currency notes & traveler’s cheques. Total turnover & transaction

size is very small. The bid-ask spread is large. The secondary price maker make

foreign exchange prices but do not make a two way market .

Foreign currency brokers

Foreign currency brokers act as middlemen between two market makers.

Their main function is to provide information to market making banks about

prices at which there are firm buyers & sellers in a pair of currencies. The

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broker hunts around for an appropriate counterparty –another bank - & collects

commission on conclusion of deal. Banks may also use brokers to acquire

information about the general state of the market even when they do not have a

specific deal in mind. The important thing is brokers do not sell or buy on their

own account.

Price takers

Price takers are those take the prices quoted by primary price makers & buy

or sell currencies for their own purposes but do not make a market themselves.

Large corporations are the price taker who use the foreign exchange market for

a variety of purposes related to their operations. They do not take active

positions in the market to profit from exchange rate fluctuations.

Central bank

Central bank of various countries (such as RBI in India) intervene in the

market from time to time to attempt to move exchange rates in a particular

direction. In case of limited flexibility systems like EMS, these interventions are

obligatory when interventions are reached. In other cases though there is no

commitment to defend any particular rate, a central bank may still intervene to

influence market sentiment.

The structure of foreign exchange market in India

The foreign exchange market in India may broadly said to have 3

segments or layers :-

First layer consists of the Central bank i.e. RBI & the Authorized

dealers (ADs). ADs are mostly commercial banks &Financial institutions such

as IDBI, ICICI & the travel agent like Thomas cook.

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Second layer is the inter bank segment in which ADs deal with each

other.

Third layer is in which ADs deal with their corporate customers .

In retail market in addition to ADs there are moneychangers who are

allowed to deal in foreign currencies. Full fledged money changers are allowed

to buy & sell foreign currency & restricted money changers are allowed only to

buy.

The daily turn over in the foreign exchange market is currently

estimated to be between US $ 1.5- 3 billion. The most important centre is

Mumbai whereas other active centres are Delhi, Calcutta, Chennai, Cochin &

Bangalore

Indian market also has accredited brokers who match buyers & sellers.

FEDAI i.e. Foreign Exchange Dealer’s Association of India has made it

mandatory to route deals between two ADs through brokers .

3.Write a note on Inter bank dealing

Answer:

Primary dealers quote two – way prices and are willing to deal either side, i.e.

they buy and sell the base currency up to conventional amounts at those prices.

However, in interbank markets this is a matter of mutual accommodation. A

dealer will be shown a two-way quote only if he / she extends the privilege to

fellow dealers when they call for a quote.

Communications between dealers tend to be very terse. A typical spot

transaction would be dealt as follows:

BANK A : “ Bank A calling. Your price on mark – dollar please.”

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BANK B : “ Forty forty eight.”

BANK A : “ Ten dollars mine at forty eight.”

Bank A dealer identifies and asks himself for B’s DEM/USD. Bank A is dealing

at 1.4540/1.4548. The first of these, 1.4540, is bank B’s price for buying USD

against DEM or its bid for USD; it will pay DEM 1.4540 for every USD it buys.

The second 1.4548, is its selling or offer price for USD, also called ask price; it

will charge DEM 1.4548 for very USD it sells. The difference between the two,

0.0008 or 8 points is bank B’s bid – offer or bid – ask spread. It compensates

the bank for costs of performing the market making function including some

profit. Between dealers it is assumed that the caller knows the big figure, viz.

1.45. Bank B dealer therefore quotes the last two digits (points) in her bid offer

quote viz. 40 – 48.

Bank A dealer whishes to buy dollars against marks and he conveys this in the

third line which really means “ I buy ten million dollars at your offer price of

DEM 1.4548per US dollar.”

Bank B is said to have been “hit” on its offer side. If the bank A dealer wanted

to sell say 5 million dollars, he would instead said “Five dollars yours at forty”.

Bank B would have been “hit” on its bid side.

When a dealer A calls another dealer B and asks for a quote between a pair of

currencies, dealer B may or may not wish to take on the resulting position on his

books. If he does, he will quote a price based on his information about the

current market and the anticipated trends and take the deal on his books. This is

known as “warehousing the deal”. If he does not wish to warehouse the deal, he

will immediately call a dealer C, get his quote and show that quote to A. If A

does a deal, B will immediately offset it with C. This is known as “back-to-

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back” dealing. Normally, back-to-back deals are done when the client asks for a

quote on a currency, which a dealer does not actively trade.

In the interbank market deals are done on the telephone. Suppose bank A wishes

to buy the British pound sterling against the USD. A trader in bank A might call

his counterpart in bank B and asks for a price quotation. If the price is

acceptable they will agree to do the deal and both will enter the details- the

amount bought/sold, the price, the identity of the counter party, etc.-in their

respective banks’ computerized record systems and go to the next transaction.

Subsequently, written confirmations will be sent containing all the details. On

the day of the settlement, bank A will turn over a US dollar deposit to bank B

and B will turn over a sterling deposit to A. The traders are out of the picture

once the deal is agreed upon and entered in the record systems. This enables

them to do deals very rapidly.

In a normal two-way market, a trader expects “to be hit” on both sides of his

quote amounts. That is in the pound – dollar case above. On a normal business

day the trader expects to buy and sell roughly equal amounts of pounds /

dollars. The bank margin would then be the bid – ask spread.

But suppose in the course of trading the trader finds that he is being hit on one

side of hiss quote much more often than the other side. In the pound – dollar

example this means that he is buying many more pounds that he selling or vie

versa. This leads to a trader building up a position. If he has sold / bough t more

pounds than he has bought/ sold he is said to have a net short position / long

position in pounds. Given the variability of exchange rates, maintaining a large

net short or long position in pounds of 1000000. The pound suddenly

appreciates from say $1.7500 to $1.7520. This implies that the banks liability

increases by $2000 ($0.0020 per pound for 1 million pounds. Of course pound

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depreciation would have resulted in a gain. Similarly a net long position leads to

a loss if it has to be covered at a lower price and a gain if at a higher price. (By

covering a position we mean undertaking transactions that will reduce the net

position to zero. A trader net long in pounds must sell pounds to cover a net

short must buy pounds. A potential gain or loss from a position depends upon

the size of the position and the variability of exchange rates. Building and

carrying such net positions for a long duration would be equivalent to

speculation and banks exercise tight control over their traders to prevent such

activity. This is done by prescribing the maximum size of net positions a trader

can build up during a trading day and how much can be carried overnight.

When a trader realizes that he is building up an undesirable net position he will

adjust his bid ask quotes in a manner designed to discourage on type of deal and

encourage the opposite deal. For instance a trader who has overbought say

DEM against USD, will want to discourage further sellers of marks and

encourage buyers. If his initial quote was say DEM/USD 1.7500 – 1.7510 he

might move it to 1.7508 – 1.7518 i.e offer more marks per USD sold to the bank

and charge more marks per dollar bought from the bank.

Since most of the trading takes place between market making banks, it is a zero

– sum game, i.e. gains made by one trader are reflected in losses made by

another. However when central banks intervene, it is possible for banks as a

group to gain or lose at the expense of the central bank.

Bulk of the trading of the convertible currencies. Takes place against the US

dollar. Thus quotations for Deutschemarks, Swiss Francs, yen, pound sterling

etc will be commonly given against the US dollar. If a corporate customer wants

to buy or sell yen against the DEM, a cross rate will be worked out from the

DEM/USD and JPY/USD quotation. One reason for using a common currency

(called the vehicle currency) for all quotations is to economize on the number of

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exchange rates. With 10 currencies 54 two-way quotes will be needed. By using

a common currency to quote against, the number is reduced to 9 or in general n

– 1ss. Also by this means the possibility of triangular arbitrage is minimized.

However some banks specialize in giving these so called cross rates.

4.Define the value date and classify the transactions into spot

and forward transactions based on value date

Answer:

Value Date: A settlement of any transaction takes place by transfers of

deposits between the two parties. The day on which these transactions are

effected is called the settlement date or the value date.

Settlement location: To effect the transfers, the banks in the countries of the

two currencies involved must be open for business. The relevant countries are

called settlement locations.

Dealing locations: The location of the two banks involved in the trade is

dealing locations, which need not be the same as the settlement locations.

Classification of transaction based on value date

Where T represents the current day when trading takes place and n

represents number of days.

Cash – Cash rate or Ready rate is the rate when the exchange of

currencies takes place on the date of the deal itself. There is no delay in

payment at all, therefore represented by T + 0. When the delivery is made

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Types of transaction

Cash – T + 0 Cash –

Tom – T + 1

Spot – T + 2

Forward – T + 3

on the day of the contract is booked, it is called a Telegraphic Transfer or

cash or value – day deal.

Tom – It stands for tomorrow rate, which indicates that the exchange of

currencies takes place on the next working day after the date of the deal,

and therefore represented by T+ 1.

Spot – When the exchange of currencies takes place on the second day

after the date of the deal (T+2), it is called as spot rate. The spot rate is

the rate quoted for current foreign – currency transactions. It applies to

interbank transactions that require delivery on the purchased currency

within two business days in exchange for immediate cash payment for

that currency.

For e. g. a London bank sells yen against dollar to a Paris bank on

Monday, 1st march, the London bank will turn over yen deposit in Japan

to the Paris bank on Wednesday and the Paris bank will turn over $

deposit in US to the London bank on same day i. e. 3rd march,

Wednesday. If the 3rd march is holiday in any bank in dealing location or

settlement location deposit will takes place on next business day.

Forward –The forward rate is a contractual rate between a foreign –

exchange trader and the trader’s client for delivery of foreign currency

sometime in the future. Here rate of transaction is fixed on transaction

date for transactions in future. Standard forward contract maturities are

1,2,3,6, 9, and 12 months.

e. g. 1 month forward purchase of pounds against dollars on 1st Jan.

Value date is arrived as follows:

Value date for spot transaction: 3rd Jan.

Value date for forward transaction:

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3rd Jan + 1 calendar month = 3rd Feb

If the 3rd Feb. is holiday in any bank in dealing location or settlement location

deposit will takes place on next business date. But this must not take you for

next month, for e. g. if value date is Feb 28 is value date and it is ineligible your

cannot shift it to 1st March it must be rolled back to Feb 27.

Swap: A swap transactions in the foreign exchange market is combination

of spot and forward transaction. Thus a bank will buy deutchemarks spot

against US dollar and simultaneously enter into forward transaction with

the same counterparty to sell deutchemarks against US dollar.

5.Define arbitrage and explain the different types of arbitrage.

Answer:

Sometimes companies deal in foreign exchange to make a profit, even though

the transaction is not connected to any other business purpose, such as trade

flows or investment flows. Usually, however, this type of foreign – exchange

activities is more likely to be persuaded by foreign – exchange traders and

investors. One type of profit – seeking activity is arbitrage, which is the

purchase of foreign currency on one market for immediate resale on another

market (in a different country) in order to profit from a price discrepancy.

Hence, arbitrage may be defined as an operation that consists in deriving a

profit without risk from a differential existing between different quoted rates. It

may result from two currencies (also known as geographical arbitrage) or from

three currencies (also known as triangular arbitrage).

Interest arbitrage involves investing in foreign – bearing instruments in foreign

exchange in an effort to earn a profit due to interest – rates differentials. For

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example, a trader may invest $ 1000 in the United States for ninety days or

convert $1000 into British pounds, invest the money in the United Kingdom for

ninety days and then convert the pounds back into dollars. The investor would

try to pick the alternative that would be the highest yielding at the end of ninety

days.

But Speculation is the buying or the selling of the commodity i.e. foreign

currency, where the activity contains both the element of risk and the chances of

a greater profit. Speculators are important in the foreign – exchange market

because they spot trends and try to take advantage of them. Thus they can be a

valuable source of both supply and demand for a currency. As a protection

against risk, foreign – exchange transactions can be used to hedge against a

potential loss due to an exchange – rate change.

Spot Quotations:

Arbitraging between Banks: Though one hears the term “market

rate”, it is not true that all banks will have identical quotes for a given

pair of currencies at a given point of time. The rates will be close to

each other but it may be possible for a corporate customer to save some

money by shopping around.

Inverse quotes and 2 – point arbitrage: The arbitrage transaction that

involve buying a currency in one market and selling it at a higher price

in another market is called Two – point Arbitrage. Foreign exchange

markets quickly eliminate two – point arbitrage opportunities if and

when they arise.

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Cross rates and 3 – point arbitrage: The term three – point arbitrage

refers to the kind of transaction where one starts with currency A, sell it

for B, sell B for C and finally sell C back for A ending up with more A

than one began with. Efficient foreign exchange markets do not permit

risk - less arbitrage profit of this kind.

Numerical Examples

1. An Arbitrage between two Currencies.

Suppose two traders A and B are quoting the following rates:

Trader A (Paris) Trader B (New York)

FFr 5.5012/US$ US $ 0.1817/FFr

We assume that the buying and selling rates for these traders are the same. We

find out the reciprocal rate of the quote given by the trader B, which is FFr

5.5036 / US $ (= 1/0.1817) .A combiste buys, say, US $ 10,000 from the trader

A by paying FFr 55,012. Then he sells these US $ to trader B and receives FFr

55,036. in the process he gains FFr 24 (=55,036 - 55,012).

Since, in practice buying and selling rates are likely to be different, so the

quotation is likely to be as follows:

Trader A Trader B

FFr 5.4500/US $ - FFr 5.5012 US $ US $ 0.1785/FFr - US $

0.1817/ FFr

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These rates mean that trader A would be willing to buy one unit of US dollar by

paying FFr 5.45 while he would sell one US dollar for FFr 5.501. The same

holds true for the corresponding figures of trader B.

But this process would tend to increase the selling rate at the trader A because

of the increase in demand of US dollars and the reverse would happen at the

trader B because of increased supply of US dollars. This would lead to an

equilibrium after some time.

2.An Arbitrage between three currencies

Suppose two traders, both located at New York are quoting as follows:

Trader A Trader B

$ 0.60/SF $ 0.60/SFr

$ 0.51 DM $ 0.52 DM

Since three currencies are involved here, we find the cross rates between SFr

and DM as well. These are:

SFr 0.85/DM (= 0.51/0.60) at the trader A and SFr 0.867/DM (=

0.52/0.60) at the trader B. Thus, the situation looks like as follows:

Trader A Trader B

$ 0.60/SFr $ 0.60/SFr

$ 0.51/DM $ 0.52/DM

SFr 0.85/DM SFr 0.867/ DM

Hence what are the arbitrage possibilities?

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There is no arbitrage gain possible between the US $ and the Swiss franc.

The following two arbitrages are, however possible.

a. Deutschmarks against the US $ is being quoted at the trader B. So

buy DM’s from the trader A and sell them to trader B.

b. Buy DM’s against SFr’s from the trader A and sell them to the

trader B.

6. Examine clearly the different types of forward transactions and describe

discount and premium evaluation in forward quotations.

Outright forward quotation:

Some of the major currencies quoted in the forward market are

Deutschmarks, Pound sterling, Japanese yen, Swiss franc, Canadian dollar etc.

they are generally quoted in terms of US dollars. Currencies may be quoted in

terms of one, three, six months and one year forward. But enterprises may

obtain form banks quotations for different periods.

As mentioned earlier, the spot market is for foreign – exchange transactions

within two business days. However, some transactions maybe entered into on

one day but not completed until after two business days. For example, a French

exporter of perfume might sell perfume to an US importer with immediate

delivery but payment not required for thirty days. The US importer is obligated

to pay in francs in thirty days and may enter into a contract with a trader to

deliver francs in thirty days at a forward rate, a rate today for future delivery.

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Thus the forward rate is the rate quoted by foreign – exchange traders for the

purchase or sale of foreign exchange in the future. The difference between the

spot and the forward rates is known as either the forward discount or the

forward premium on the contract. If the domestic currency is quoted on a direct

basis and the forward rate is greater than the spot rate, the foreign currency is

selling at a premium. It is calculated as follows:

Forward discount/ premium = Forward mid – Spot mid * 12/n * 100

Spot mid

Where n indicates the number of months forward.

When Fwd rate > Spot rate, it implies premium.

Fwd rate < Spot rate, it implies discount.

In the case of forward market, the arbitrage operates in the differential of

interest rates and the premium or discount on exchange rates.

Numerical problems

1. Spot 1-month 3-months 6-months

(FFr/US$) 5.2321/2340 25/20 40/32 20/26

In outright terms these quotes would be expressed as below:

Maturity Bid/Buy Sell/Offer/Ask Spread

Spot FFr 5.2321 per US $ FFr 5.2340 per US $ 0.0019

1-month FFr 5.2296 per US $ FFr 5.2320 per US $ 0.0024

3-months FFr 5.2281 per US $ FFr 5.2308 per US $ 0.0027

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6-months FFr 5.2341 per US $ FFr 5.2366 per US $ 0.0025

It may be noted that in the forward deals of one month and 3 months, US $ is at

discount against the French franc while 6 months forward is at a premium. The

first figure is greater than the second both in one month and three months

forward quotes. Therefore, these quotes are at a discount and accordingly these

points have been subtracted from the spot rates to arrive at outright rates. The

reverse is the case for 6 months forward.

2. We take an example of a quotation for the US $ against Rupees, given by a

trader in New Delhi.

Spot 1-month 3-months 6-months

Rs 32.1010-Rs32.1100 225/275 300/350 375/455

Spread 0.0090 0.0050 0.0050 0.0080

The outright rates from these quotations will be as follows:

Maturity Bid/Buy Sell/Offer/Ask Spread

Spot Rs 32.1010 per US $ Rs 32.1100 per US $ 0.0090

1-month Rs 32.1235 per US $ Rs 32.1375 per US$ 0.0140

3-months Rs 32.1310 per US $ Rs 32.1450 per US $ 0.0140

6-months Rs 32.1385 per US $ Rs 32.1555 per US $ 0.0170

Here we notice that the US $ is at a premium for all three forward periods.

Also, it should be noted that the spreads in forward rates are always equal to the

sum of the spread of the spot rate and that of the corresponding forward points.

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Numerical problems and solutions

1. On a particular date the following DEM/$ spot quote is

obtained from a bank: -1.6225/35

a) Explain this quotation.

Ans. The above quotation shows the bid rate and the ask rate of the currencies

in question, the initial figure i.e. 1.6225 being the bid rate and the latter

being the ask rate. Also it shows the number of DEM used to buy or

sell one US dollar i.e. the bank will pay 1.6225 DEM for each US

dollar it buys and will want to be paid 1.6235 DEM for each US dollar

it sells.

b) Compute implied inverse quote.

Ans. When DEM/$ is 1.6225/35, the implied inverse quote is:

$/DEM becomes 0.6159/63

(1/1.6235 = 0.6159 and 1/ 1.6225 = 0.6163)

c) Another bank quoted $/DEM 0.6154/59. Is there an

arbitrage? If so how would it work?

Ans. Suppose Bank A quotes $/DEM 0.6154/59 and Bank B quotes $/DEM

0.6159/63. There is no arbitrage opportunity since the main purpose of

doing an arbitrage is making a profit without any risk or commitment

of capital. This doesn’t exist in the given case as a potential buyer

would end up buying a DEM at 0.6159 $ from Bank A and would have

to sell it to Bank B at the same price since that would be the only way

of not making any losses. It is clear form the diagram shows that shows

no arbitrage is possible:

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$/DEM 0.6154 59 63

Bank A Bank B

2. The following quotes are obtained from the banks:

Bank A Bank B

FFr/$ spot 4.9570/80 4.9578/90

i. Is there an arbitrage opportunities

Ans. There is no arbitrage opportunity in this case. This can be

represented diagrammatically as:

FFr/$ 4.9570 78 80 90

Bank A

Bank B

The quotes are overlapping each other hence preventing an

arbitrage. The buyer will go into a loss if he buys from bank A at 4.9580 FFr

since he would have to sell it to bank B for 4.9578 FFr undergoing a loss of

0.0002 FFr.

b) What kind of market will it result into?

Ans. This will result into a one – way market.

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c) What might be the reason for this?

Ans. A one – way market may be created when a bank wants to either

encourage the seller of dollars and discourage buyers or vice – versa. In

this case, Bank A wants to encourage buyers of dollars and discourage

sellers of the same thus creating a net long positioning dollars. At the

same time Bank B wants to encourage the sellers of dollars and

discourage buyers thus creating a net short position in dollars. Hence the

outcome would be that Bank A will be confronted largely with buyers of

US dollars and few sellers while for Bank B the reverse case will hold

true. Eventually, it would mean that regular clients of Bank B wanting to

buy dollars can save some money by going to Bank A and vice – versa.

3. In London a dealer quotes: DEM/ GPB spot 3.5250/55

JPY/ GPB spot 180.0080/181.0030

a) What do you expect the JPY/ DEM rate to be in Frankfurt?

Ans. In London: DEM/ GPB spot 3.5250/55

JPY/ GPB spot 180.0080/181.0030

Therefore, JPY/ DEM = B1 A1 [where B1 - 180.0080

A2 B2 A1 – 181.0030

B2 - 3.5250

A2 – 3.5255]

= 180.0080 181.0030

3.5255 3.5250

= 51.0588 / 51.3483 JPY/ DEM

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It is assumed that the JPY/ DEM rate in Frankfurt will also approximately

be the same as in London. Therefore, the JPY/ DEM rate in Frankfurt is

51.0588 / 51.3483.

b) Suppose that in Frankfurt you get a quote: JPY/ DEM spot

51.1530/ 51.2250.

Is there an arbitrage opportunity?

Ans. When in London: JPY/ DEM 51.0588 / 51.3483 and

In Frankfurt: JPY/ DEM 51.1530/ 51.2250

There is no arbitrage opportunity as the quotes overlap each other and the

buyer will stand to make a loss. If he buys in Frankfurt where 1 DEM is

51.2250 JPY and sells it in London for 51.0588 JPY, he makes a loss of

0.1662JPY. Diagrammatically it can be represented as:

JPY/ DEM 51.0588 .1530 .2250 .3483

Frankfurt

London

4. The following quotes are obtained in New York: DEM/$

spot 1.5880/ 90

1- month forward 10/ 5



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Calculate the outright forward rates.

Ans. While observing the forward quotations, it is clear that the US dollar is

at discount in the forward market since the points corresponding to the

bid price are higher than those corresponding to the ask price.

Therefore, the forward points will be subtracted form the spot rate

figure. Thus, the outright rates are:

DEM/$ spot - 1.5880/ 90

1 – month forward - 1.5870/ 85



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Foreign Exchage

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