The Foreign Exchange Market Copyright 2014 by Diane S. Docking1 € KM.

The Foreign Exchange Market

Copyright 2014 by Diane S. Docking 1

€KM

Learning Objectives• What is meant by a foreign exchange rate• What is a spot versus a forward exchange rate• What are the different ways that a foreign exchange

rate can be quoted– (Direct versus Indirect; American versus European)

• What are cross rates• What is foreign exchange risk• How to identify and perform a Triangle arbitrage for

profit


Exchange Rates


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Foreign Exchange

• In the foreign exchange markets—every currency has a price in terms of other currencies

• Foreign Exchange Rate: a price for a currency denominated in another currency.

• Foreign exchange rates are the conversion rates between currencies– Spot rate– Forward rate

Copyright 2014 by Diane S. Docking4

Foreign Exchange Transactions


Spot foreign exchange transaction: 0 1 2 3 mo

Exchange Rate Agreed/Paid + Currency Delivered bybetween Buyer and Seller Seller to Buyer

Forward exchange transaction 0 1 2 3 mo

Exchange Rate Agreed Buyer Pays Forward Pricebetween Buyer and Seller Seller delivers currency

Spot foreign exchange transaction: 0 1 2 3 mo

Exchange Rate Agreed/Paid + Currency Delivered bybetween Buyer and Seller Seller to Buyer

Forward exchange transaction 0 1 2 3 mo

Exchange Rate Agreed Buyer Pays Forward Pricebetween Buyer and Seller Seller delivers currency

The Foreign Exchange Market

• While you can buy small amounts of FX at any currency exchange such as those found in international airports, much larger sums of currencies are bought and sold around the clock on the foreign exchange market.

• The foreign exchange (FX or forex) market:– where currencies are traded,– is a market that is open 24 hours a day during the week,– has no central physical location, and– experiences daily turnover of over $3 trillion.


FX Rate Quotation Conventions

• Direct vs. Indirect quote:• quote is the number of units of local currency

(LC) needed to buy one unit of foreign currency (FC),– #LC/1FC ; e.g., # U.S. dollars per 1 Euro

• quote is the number of units of a foreign currency (FC) needed to buy one unit of LC,– #FC/1LC; e.g., # Euros per $1

• Above examples assume U.S. dollars is the LC– Given a direct quote, we can calculate an indirect

quote, which is the reciprocal of the direct quote


FX Rate Quotation Conventions

• American vs. European quote:• terms - quoting in terms of U.S. dollars

per unit of foreign currency• terms - quoting in terms of the number

of units of the foreign currency per U.S. dollar• If local currency is U.S. dollars, then

Direct quote = American terms and Indirect quote = European terms


9Copyright 2014 by Diane S. Docking

U.S. Dollar Foreign Exchange Rate Quotations

Current foreign exchange rateshttp://www.federalreserve.gov/releases/H10/hist

For example:

One Euro can be purchased for $1.2310, or equivalently,

0.8123 Euros buy one U.S. dollar.

#$/1FCDirect Quote or American Terms

#FC/$1Indirect Quote orEuropean Terms

$1.2310 invert, then reduce 1 € = € $1.2310

€0.8123 $

http://www.federalreserve.gov/releases/H10/hist

http://www.federalreserve.gov/releases/H10/hist

US $ Spot Rates

Copyright 2014 by Diane S. Docking

10

#$/1FCDirect Quoteor American Terms

#FC/$1Indirect Quote orEuropean Terms

US Dollar 1 USD In USD

Euro 0.7518 1.3302

British Pound 0.6576 1.5207

Indian Rupee 60.635 0.01649

Australian Dollar 1.1131 0.8984

Canadian Dollar 1.0277 0.9731

UAE Emirati Dirham 3.6730 0.2723

Swiss Franc 0.9262 1.0796

Chinese Yuan Renminbi 6.1290 0.1632

Malaysian Ringgit 3.2500 0.3077

New Zealand Dollar 1.2524 0.7985

Top 10 July 31, 2013

FX Cross Rates

• Cross Rates• The exchange rate between two countries

other than the U.S. can be inferred from their exchange rates with the U.S. dollar

• The rates thus obtained are known as cross rates


Key Currency Cross Rates

Copyright 2014 by Diane S. Docking

12

Dollar Euro Pound SFranc Peso Yen CdnDlr

Canada 1.0277 1.3670 1.5628 1.1095 0.0807 0.0105 ...

Japan 97.8891 130.2121 148.8636 105.6846 7.6891 ... 95.2539

Mexico 12.7309 16.9347 19.3604 13.7448 ... 0.1301 12.3882

Switzerland 0.9262 1.2321 1.4086 ... 0.0728 0.0095 0.9013

U.K. 0.6576 0.8747 ... 0.7099 0.0517 0.0067 0.6399

Euro 0.7518 ... 1.1432 0.8116 0.0591 0.0077 0.7315

U.S. ... 1.3302 1.5207 1.0796 0.0785 0.0102 0.9731

July 31, 2013 Snapshot of foreign exchange cross rates at 5 p.m. Eastern time.Source: ICAP plc ; historical data prior to 6/9/11: Thomson Reuters http://online.wsj.com/mdc/public/page/2_3023-keyrates.html

http://www.icap.com/market-commentary.aspx

http://online.wsj.com/mdc/public/page/2_3023-keyrates.html

FX Cross Rates


B

C

C

A

CB

CA

B

A

= €1.143248 = €1.1432 £ £

€0.7518 x $1 = €0.7518 =$1 £0.6576 £0.6576

FX Cross Rates (cont.)

• Cross-exchange rates are foreign exchange rates of two currencies relative to a currency.

• Value of one unit of currency A in units of currency B = value of currency A in C divided by value of currency B in C

• Arbitrage assures that the exchange rates will be the same between the countries


B

C

C

A

CB

CA

B

A

FX Cross Rates (cont.)

Arbitrage forces keep cross rates in balance.E.g.: Let the exchange rates at various banks be:

Then, if you have $1: $1 → 1£ → 4€ → $2

WOW a riskless $1 profit. Arbitrage forces will force the exchange rate at BOA from 4€/1£ down to 2€/1£

Then:$1 → 1£ → 2€ → $1


Citibank Bank of America U.S. Bancorp

Foreign Exchange Risk


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FOREIGN EXCHANGE RISK

• Foreign exchange risk, or currency risk, is the risk that a currency’s value may change adversely

• Most exchange rates are a floating rate, which means it changes constantly depending on the quantity supplied and demanded for each currency in the market.


Appreciation/Depreciation

• If depreciation of the domestic currency ($) occurs, then– FC cost more $’s– a _____________ of the $

• If appreciation of the domestic currency ($) occurs– FC costs less $’s– a _____________ of the $



• When a country A’s currency appreciates in value relative to country B’s currency), country A’s goods being sold in country B become more expensive to country B citizens (holding domestic prices constant in the two countries).

• While country B’s goods being sold in country A become cheaper to country A citizens.

• Appreciation of a country’s currency can make it harder for domestic manufacturers to sell their goods abroad

• Exports ; imports ___________



• Conversely, when country A’s currency depreciates in value relative to country B’s currency), country A’s goods being sold in country B become cheaper to country B citizens.

• While country B’s goods being sold in country A become more expensive to country A citizens.

• Depreciation of a country’s currency can make it easier for domestic manufacturers to sell their goods abroad.

• exports ; imports ____________


$/Euro: April 17, 2009 – April 17, 2014http://tools.currenciesdirect.net/currency-chart/


http://tools.currenciesdirect.net/currency-chart/

$/Pound: June 1, 2002 – April 17, 2014 http://tools.currenciesdirect.net/currency-chart/


http://tools.currenciesdirect.net/currency-chart/

Example FX Risk: L-T Purchase Contract with Foreign Currency

Problem:• In May 2XX1, when the exchange rate was $1.35 per euro,

Mason ordered parts for next year’s production from Campco. They agreed to a price of 500,000 euros, to be paid when the parts were delivered in one year’s time.

• One year later, the exchange rate was $1.55 per euro.

• What was the actual cost in dollars for Mason when the payment was due?

• If the price had instead been set at $675,000 (which had equivalent value at the time of the agreement), how many euros would Campco have received?


Solution:• Right now, May 2XX1 cost is $1.35 x 500,000 euros = $675,000• With the price set at 500,000 euros, Mason had to pay

($1.55/euro) (500,000 euros) = ___________one year later May 2XX2

• This cost is $100,000 higher than it would have been if the price had been set in dollars.

Conclusion:• Whether the price was set in euros or dollars, one of the parties would

have suffered a substantial loss. Since neither knows which will suffer the loss ahead of time, each has an incentive to hedge.


Example FX Risk: L-T Purchase Contract with Foreign Currency (cont.)

Example FX Risk: Traveling and Exchange Rates

Problem:• Lina was planning a trip to tour Europe for three weeks. The exchange

rate cost when she was planning was $1.32 per euro. She planned on expenses and souvenir costs in Europe to be about €7,000.

• Five months later, when she actually went on her trip, the exchange rate cost had increased to $1.65 per euro.

• What was Lina’s estimated cost in euros equal to in U.S. dollars at the time of planning?

• How many euros did Lina actually end up having once she was on her trip?

• How could Lina have planned for the differences in exchange rate cost?


Solution:• With her costs being in euros, her dollar equivalent cost at

planning is:($1.32/€) × (€7,000) = ________

• On her trip the cost of euro had increased so her final amount was:($9,240) ÷ ($1.65/€) = _________

• Or($9,240) ×[1/($1.65/€)] = ($9,240) × (€.61/$) = €5,600

• Lina ended up having €1,400 less euros once she got to Europe.


Example FX Risk: Traveling and Exchange Rates (cont.)

Conclusion:• Lina could have looked at rates, and current

rate patterns to estimate the exchange rate cost at her time of the trip to ensure that she had enough money for her costs and souvenirs.

• However, this is the risk of traveling overseas, since rates are so volatile.


Example FX Risk: Traveling and Exchange Rates (cont.)

Example FX Pricing: Triangle Arbitrage for Cross-Rates

• The following quotations are available to you for US dollars ($), Canadian Dollars (CD), and Mexican pesos (Peso). You may either buy or sell at the stated rates:– BancOne: $.76/CD– Imperial Bank: 1.40 pesos/CD– Domino Bank: $.55 / peso

• Given this information, is a triangle arbitrage possible?• If so, explain the steps and compute the profit,

assuming you have an initial US $1,000,000 to use.


Example FX Pricing: Triangle Arbitrage for Cross-Rates (cont.)

• Is it possible?• Evaluate


BancOne ImperialBank

DominoBank

$0.761 CD

1.40 pesos1 CD

$0.551 peso

Cross Rates Theoretical Actual

1.40 pesos1 CD

x $0.551 peso

= $0.771 CD

> $0.761 CD

At Bank One

Therefore, BankOne X-rate is too LOW. So want to take $→CD at BankOne→pesos at Imperial Bank→$ at Domino Bank

YES

Example FX Pricing: Triangle Arbitrage for Cross-Rates

Steps in Triangle Arbitrage


Con

vert

$1

mill

. to

CD

s at

Ban

cOne

@

$0.7

6/CD

= $

1 m

ill. /

0.76

= 1

,315

,789

CD

s

Convert 1,315,789 C

Ds to pesos at Im

perial Bank

@ 1.40 peso/C

D =

1,315,789 CD

s x 1.40 =

1,842,105 pesos

Convert 1,842,105 pesos to $s at Domino Bank @ $0.55/peso = 1,842,105 pesos x 0.55 = $1,013,158

1

2

3

BancOne$ → CD

Imperial BankCD → peso

Domino Bankpeso → $

Riskless Arbitrage Profit: $1,013,158- $1,000,000 $ 13,158

The Foreign Exchange Market Copyright 2014 by Diane S. Docking1 € KM.

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