International Finance FINA 5331 Lecture 8: The market for foreign exchange, continued. Read:...
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Transcript of International Finance FINA 5331 Lecture 8: The market for foreign exchange, continued. Read:...
![Page 1: International Finance FINA 5331 Lecture 8: The market for foreign exchange, continued. Read: Chapters 5 Aaron Smallwood Ph.D.](https://reader030.fdocuments.in/reader030/viewer/2022032707/56649e155503460f94afebe2/html5/thumbnails/1.jpg)
International FinanceFINA 5331
Lecture 8: The market for foreign exchange, continued.
Read: Chapters 5
Aaron Smallwood Ph.D.
![Page 2: International Finance FINA 5331 Lecture 8: The market for foreign exchange, continued. Read: Chapters 5 Aaron Smallwood Ph.D.](https://reader030.fdocuments.in/reader030/viewer/2022032707/56649e155503460f94afebe2/html5/thumbnails/2.jpg)
The Bid-Ask Spread
A dealer pricing pounds in terms of dollars would likely quote these prices as 02–08.
Anyone trading $10m knows the “big figure.”… 1.59
USD Bank Quotations
American Terms European Terms
Bid Ask Bid Ask
Pounds 1.5902 1.5908 .6286 .6289
![Page 3: International Finance FINA 5331 Lecture 8: The market for foreign exchange, continued. Read: Chapters 5 Aaron Smallwood Ph.D.](https://reader030.fdocuments.in/reader030/viewer/2022032707/56649e155503460f94afebe2/html5/thumbnails/3.jpg)
The Bid-Ask Spread
Notice that the reciprocal of the direct bid quote gives the ask price:
USD Bank Quotations
American Terms European Terms
Bid Ask Bid Ask
Pounds 1.5902 1.5908 .6286 .6289
![Page 4: International Finance FINA 5331 Lecture 8: The market for foreign exchange, continued. Read: Chapters 5 Aaron Smallwood Ph.D.](https://reader030.fdocuments.in/reader030/viewer/2022032707/56649e155503460f94afebe2/html5/thumbnails/4.jpg)
Sample ProblemA businesswoman has just completed transactions in Italy and England. She is now holding €250,000 and £500,000 and wants to convert to RMB.
Her bank provides this quotation:
GBP/RMB 0.10109 – 0.10112
RMB/EUR 8.2540 – 8.2588
Pounds: ?
Euros: ?
Total: ? What are her proceeds from conversion?
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Proceeds
Pounds: We buy RMB in the market for RMB:
£500,000/0.10112=RMB 4,944,620.25
Euros: We sell euros in the market for euros:
€250,000*8.2540 = RMB 2,063,500
Total: RMB 7,008,120.25
![Page 6: International Finance FINA 5331 Lecture 8: The market for foreign exchange, continued. Read: Chapters 5 Aaron Smallwood Ph.D.](https://reader030.fdocuments.in/reader030/viewer/2022032707/56649e155503460f94afebe2/html5/thumbnails/6.jpg)
Spot FX Trading
In the interbank market, the standard size trade is about U.S. $10 million.
A bank trading room is a noisy, active place.
The stakes are high.
The “long term” is about 10 minutes.
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Cross rates with bid-ask spreads
USD Bank Quotations
American Terms
European Terms
Bid Ask Bid Ask
Pounds 1.5902
1.5908 0.6286 0.6289
RMB 0.1622
0.1630 6.1350 6.1652
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So?
What are the RMB/pound bid and ask prices?
Suppose a trader sells £10,000. How much do they receive?
The trader effectively sells pounds for RMB9.7559.
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What about selling yuan?
Suppose we sell RMB10,000 (buy pound).
We could figure the cross-currency rate, by asking:
- How much do we receive when we first buy dollars with RMB?
RMB10,000*0.1622 = $1,622
- How much do we receive from selling dollar for pounds?
$1,622/1.5908 = £1,019.61.
Effectively RMB ask price for the pound:
10,000/1,019.16= RMB 9.8076
BID/ASK price: 9.7559 – 9.8076
![Page 10: International Finance FINA 5331 Lecture 8: The market for foreign exchange, continued. Read: Chapters 5 Aaron Smallwood Ph.D.](https://reader030.fdocuments.in/reader030/viewer/2022032707/56649e155503460f94afebe2/html5/thumbnails/10.jpg)
Concept of arbitrage
Suppose you are lucky enough to see two currency windows next to each other. At the first window you see the following quote for the euro:
– RMB 8.2455 – 8.2498
At the second window you observe the following:
– RMB 8.2508 – 8.2555
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What?
Can easily profit:– Buy euros at the first bank for RMB8.2498.– Sell them at the second bank for RMB
8.2508.
– Maybe not too realistic. Let’s consider triangular arbitrage:
– Involves three markets. Let’s start with a simple example.
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Triangular Arbitrage
$
£¥
Credit Lyonnais
S($/£)=1.50
Credit Agricole
S(¥/£)=125
Barclays
S(¥/$)=100
Suppose we observe these banks posting these exchange rates.
First calculate the implied cross rates to see if an arbitrage exists.
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Triangular Arbitrage
Barclays
S(¥/$)=100
The implied S(¥/£) cross rate is S(¥/£) = 150
Credit Agricole has posted a quote of S(¥/£)=125 so there is an arbitrage opportunity.
So, how can we make money?
Buy the £ @ ¥125; sell @ ¥150.
$Credit Lyonnais
S($/£)=1.50
Credit Agricole
S(¥/£)=125¥ £
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Triangular Arbitrage
Sell $100,000 for ¥ at S(¥/$) = 100
receive ¥10,000,000
•Sell ¥10,000,000 for £ at S(¥/£) = 125
receive £80,000
Sell £ 80,000 for $ at S($/£) = 1.50
receive $120,000
profit per round trip = $ 120,000- $100,000 = $20,000
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Review: Triangular Arbitrage
¥
€$
Budapest: S(¥/€) =126.8145-127.2045
Madrid
S($/€)=1.29670-1.29675
Tokyo S($/¥)
=0.01002-0.01008
Suppose we observe these banks posting these exchange rates.
First calculate the implied cross rates to see if an arbitrage exists.
![Page 16: International Finance FINA 5331 Lecture 8: The market for foreign exchange, continued. Read: Chapters 5 Aaron Smallwood Ph.D.](https://reader030.fdocuments.in/reader030/viewer/2022032707/56649e155503460f94afebe2/html5/thumbnails/16.jpg)
Review: Triangular Arbitrage
Sell $10,000,000 for ¥ at S($/ ¥) ask = $ 0.01008
receive ¥992,063,492.06
Sell our ¥992,063,492.06 for € at S(¥/ €) = ¥127.2045 receive €7,798,965.38
Sell € 7,798,965.38 for $ at S($/€) =1.29670
receive $10,112,918.41
profit per round trip = $ 10,112.918.41- $10,000,000 = $112,918.41
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Triangular Arbitrage: One more
We want to consider another example with bid-ask spreads.See example in the textbook, with the following quotes:
– Market for pounds: $1.9712-17– Market for euros: $1.4739-44– Market for pounds: €1.3305-10
• Implied price in the third market is 1.3370-77. POUND UNDERVALED!
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Exploit the arbitrage opportunity
Suppose we start with $1,000,000First, we need to get euros so we can buy pounds in the 3rd market.
– Start by selling dollars for euros:• We receive: $1,000,000/1.4744 = €678,242.00
– Sell euros for pounds:• We receive: €678,242.00/1.3310 = £509,573.25
– Finally, sell pounds for dollars• We receive: £509,573.25*1.9712 = $1,004,470.79
PROFIT: $4,470.79.