INTERNATIONAL FINANCIAL MANAGEMENT.

The basic principles of financial management viz., raising of funds on most economical terms and their effective utilization; are same, both for domestic as well as international concerns. However, an international concern (MNC) faces higher degree of risk as compared to domestic concern because it operates in more than one country and its operations involve multiple foreign currencies. Hence, foreign exchange risk management is an additional aspect in case of International Financial Management, which occupies a major attention of finance manager of a MNC. Beside MNCs, foreign exchange risk management is also important in case of international trade (i.e. export-import). During the recent years, the importance of international financial management has increased because of: Increase in the volume of international trade. Globalization of businesses. Increase in movement of capital & labour with lesser restrictions. Increase in speed of communication & transport. Emergence of international capital & money markets.

FOREIGN EXCHANGE RISK MANAGEMENT

Foreign Currency v/s. Foreign Exchange Currency of a foreign country is foreign currency. While, foreign exchange includes foreign currency and drafts, bills, letters of credit, travelers cheques, etc. denominated & payable in foreign currency. Foreign Exchange Risk / Exposure Although risk & exposure are used interchangeably, the two are different. Exposure is a measure of the sensitivity of the value of a financial item (asset, liability or cash flow) to changes in the relevant risk factor (such as, exchange rate, interest rate, etc.). While risk is the measure of variability of the value of the item attributable to the risk factor. For instance, an Indian company was involved in huge imports & exports from and to US during 1998. In 1998, Re/$ exchange rate was considerably stable. Now, it can be said that in 1998 the company had significant exposure the Re/$ exchange rate due to the quantum of its transactions; but at the same time the company did not foresee any significant risk on this account because the exchange rate was relatively stable. Thus, the magnitude of risk is determined by the magnitude of exposure and degree of variability in relevant risk factor. Foreign Exchange Exposure

Accounting Exposures

Operating/ Economic Exposures

Transaction Exposure

Translation Exposure

Contingent Exposure

Competitive Exposure

Accounting Exposure: - It relates to items that currently appear on the Balance Sheet and Income Statement of the company. Transaction Exposure: It arises when a currency has to be converted to make/receive payments for goods & services, repay loan or pay interest or receive the same and pay/receive dividend payments. Importers and exporters are subjected to transactions exposure. It is also known as contractual exposure because of uncertainty involved In the value of assets & liabilities (which are contractually fixed), when they are Liquidated. 19

Translation Exposure: It is the exposure on assets & liabilities appearing in the Balance Sheet but yet to be liquidated. It is also known as Balance Sheet Exposure. Between two balance sheet dates, it may alter the NAV and gearing ratio. It typically arises when a MNC prepares consolidated financial statements for which it has to translate the trial balance of its foreign subsidiaries in terms of parent companys home currency. Suppose an Indian parent company has a subsidiary in UK. At the beginning of a F.Y., the net assets of subsidiary amounted to 10,00,000 pounds sterling. On that date spot rate of exchange was Rs.50. At the end of the F.Y., the net assets of the subsidiary increased to 12,50,000 pounds sterling. However, the spot rate on that date had declined to Rs.38. Thus, in terms of Rupees the company suffered a translation loss as the net assets of its subsidiary had declined from Rs.500 lacks to Rs.475 lacks. Operating/Economic Exposure:- Unanticipated exchange rate changes also have significant impact on future cash flows from operations. Even if a firm is not directly involved in cross border transactions, it faces indirect exchange rate exposure, which is known as Operating Exposure. Changes in exchange rates will most likely have an impact on its customers, suppliers and competitors which in turn will force the firm to alter its operations & strategies. Though this is not a direct foreign exchange exposure but the underlying economic factors may become a risk factor. Contingent Exposure: It is short-lived. For instance, a firm has submitted a tender bid on an equipment supply contract (to a foreign company). Till the time he is awarded or denied the contract, he face contingent exposure. Once contract is awarded, transaction exposure will arise. Competitive Exposure: it is long-lived and focus is on long-run survival. For instance, a Japanese exporter who operates in a Swiss market can increase his market share merely by reducing the Swiss prices of his products, if Swiss franc gains against yen, with no loss of yen income. Conversely, if Swiss franc weakens against yen, the Swiss company, a potential competitor to the Japanese exporter, can profit indirectly from currency losses of Japanese exporter. Thus, though the Swiss company is not directly exporting but business competition can be generated on account of strength of currency of competitors. Such types of economic risks are not reported in accounts and are Perhaps unhedgable.

Foreign Exchange Market It is the market where foreign currencies are bought & sold. It broadly comprises of: Customer Market It comprises of transactions between banks (authorized dealers) and their customers. Such transactions are of two types, viz., Ready delivery & Forward delivery. Interbank Market It comprises of: Transactions between different banks in the same center/country. Transactions between banks in a country and their correspondents and overseas branches.

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Transactions of the central bank of one country with central banks of other countries. Interbank foreign exchange dealings are of four types: Cash- same day delivery Tom- delivery on immediately succeeding working day Spot- delivery on second successive working day Forward- delivery beyond second successive working day Foreign Exchange Rates & Quotations Different sets of exchange rates are applied for various types of foreign exchange transactions as under: (1) TT Selling Rate:- It is applicable for all clean remittances outside India i.e., the bank undertakes only currency transfers by way of issuance of DD, MT, TT, etc in terms of foreign currency. The bank does not perform any other function such as handling documents, etc. TT Selling Rate = Base Rate + Exchange Margin Base rate is the Interbank selling rate. Exchange margin is the profit margin that the A.D. may load subject to the conditions specified by FEDAI. (2) Bill Selling Rate:- It is applied for all outward remittances in respect of import bills payable in India. This rate is a little worse than TT Selling Rate as the bank has to handle documents relating to the transaction. Bill Selling Rate = TT selling rate + Exchange Margin Forward Bill Selling Rate = Forward TT Selling Rate + Exchange Margin Forward TT Selling Rate = Interbank Spot Selling Rate + Forward Premium/ - Forward Discount + Exchange Margin Ex.- A wishes to buy pounds 2 months forward to settle a sight bill. The market rates are: Spot selling: Rs.55.60 2 months: 15 Paise discount Exchange margin is 0.125% for TT selling and 0.15% for bill selling Forward TT selling rate = (55.60-0.15) 1.00125 = Rs.55.52 Forward Bill Selling Rate = 55.52 (1.0015) = Rs.55.60 (3) TT Buying Rate:- It is applied for all clean foreign inward remittances which are payable in India. For e.g., a TT issued by a bank in Australia for USD 10,000 drawn on OBC, New Delhi will be converted into rupees at TT buying rate as the bank in Australia would have already paid the USD in OBC branch at New York. TT Buying Rate = Base Rate Exchange Margin

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(4) Bill Buying Rate:- It is applied for purchase/ discounting of export bills resulting in foreign remittance to India after realization. It is worse than TT buying rate as there is delay between the AD paying the exporter and itself getting paid on presentation of bill to the foreign importer. Also, interest is recovered from the exporter for such period. Bills are of two types: Sight/ demand bills- delay involved in such bill is only the transit period. Time/ usance bills:- delay involved is transit period plus the usance period i.e. the credit period allowed to the importer. Bill Buying Rate = Base Rate + Forward Premium / - Forward Discount - Exchange Margin. NOTE: The forward premium / discount is for transit + usance period; in case of forward bill buying, it is for transit + usance + forward periods. (5) Cross Rates:- It is an exchange rate between two foreign currencies; for eg., in India, FFR/ $, DM /$ are cross rates. A cross rate may be used to ascertain the price of a foreign currency in terms of INR for which direct quotations are not available. If, FFR 7.05 = $ 1 And, Rs.44.53 = $ 1 Then, Rs. (44.53/7.05) = FFR 1 Or, Rs.6.32 = FFR 1 (6) Spot Rate:- It is the prevailing market rate on the day of transaction. (7) Forward Rate:- It is the rate fixed in advance for a transaction which will mature at a specified date or specified period in future. It is at a premium / discount to spot rate. In case of direct quotes, Forward Rate = Spot Rate + Forward Premium/- Forward Discount Types of Quotations: 1. Direct Quotation:- It is the home currency price of one unit of foreign currency. Eg., Rs.44 = $1 2. Indirect Quotation:- It is the foreign currency price of one unit of home currency. E.g.Re.1 = $1/44 = $.0227 Direct quote = 1/ Indirect quote, and vice versa. 3. Bid / Offer:- Bid is the purchase price of a currency quoted by an A.D. Whereas, offer ( or ask rate) is the selling price of a currency quoted by an A.D. Bid for one currency is simultaneously an offer for another currency. For instance, $1 = Rs.44.50/44.55 offer
Two-way quote: Rs 44.50 is bid for $1; at the same time $ 1 is offer for Rs.44.50 or, $.02 is offer for Re.1

bid An authorized dealer gains by keeping his offer for a currency higher than his bid for that currency. Thus, his spread = offer bid. 19

4. Forward Quotations:- Outright forward quotations are quoted in the following manner: 3-month forward: 1$ = Rs.42.25/42.85 However, forward rates for a swap transaction are usually quoted in terms of forward margin (points)/ swap margin (points)/ forward differentials. E.g.Spot $1 = DM2.0886-2.0896 1 month forward 37-35 2 months forward 86-88 Now, 1 month forward rate = 2.0849/2.0861 ($ is at discount in forward) 2 months forward rate = DM2.0972/2.0984 ($ is at premium in forward) RULE: 1. If swap points are low/high, add swap points. 2. If swap points are high/low, deduct swap points. Forward points (premium / discount)/ Interest rate differentials are also expressed in terms of percentages. The formula for its calculation is as follows: Forward premium / discount = F S * 12 * 100 (in case of direct quote) S n Forward premium / discount = S F * 12 * 100 (in case of indirect quote) F n NOTE: Forward premiums do not equal forward discount always. Forward / swap points are determined by the following factors: Supply-demand for the currency for the settlement date. Market view about future developments. Interest rate differentials between the two countries. In free market economies, interest rate differentials between two currencies is the most dominant factor in determining the forward points.

Some Applications of Swaps: 1.Swap contracts are frequently used in interbank market to offset positions created in outright forwards done with non-bank customers. It is very difficult to find counter parties with matching opposite needs to cover the original position by an opposite outright forward. E.g.- A bank buys one month forward against Rs. from a customer. It has created a long position on and short position in Rs. To square its position, it will buy a swap contract in the interbank market (buy spot & sell forward ). One leg of the swap contract viz., sell forward offsets its original position against customer. While, to counteract the other leg (viz., buy spot) the bank shall undertake the spot sale which will offset its position.

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2.A firm with uncertain timing of foreign currency payables/receivables can use swaps as an alternative to option forwards. E.g.- A firm enters into a 3-month forward contract to purchase DEM on 1/6/00. By late August, it comes to know that the shipment will not arrive before 30/9/00. On 31/8/00, it can execute a swap of sell spot & buy 1-month forward. The DEM received against original contract can be utilized to deliver against the spot leg of the swap contract. 3. Another application of swaps is in the roll-over forward contracts discussed in detail herein after. International Parity Relationships In an efficient forex market: Exchange rates adapt expeditiously to new information. It is not possible for investors (speculators) to earn abnormal profits. Information is available to all players free of cost. Arbitrage activity shall eliminate disparities in exchange rates. It will also ensure that the exchange-adjusted prices of similar goods will be equal in all countries. This economic behavior is referred to as law of one price. In a highly competitive forex market, free from government intervention, both spot and forward exchange rates are affected by current expectation of future events. They change in expectation of change in interest rates. Interest rates are influenced by inflation rates. If we assume forex markets are efficient, then interest rates, inflation rates and exchange rates will have equilibrium relationships, which are expressed in the four types of international parity relationships: 1) Interest Rate Parity Theorem 2) Purchasing Power Parity Theorem 3) Fisher Effect 4) Expectations Theory Interest Rate Parity:It states that exchange rate of two countries will be affected by their interest rate differentials. Due to arbitrage, high interest rate on a currency is offset by the forward discount and low interest rate is offset by forward premium. In an international capital market, where no restrictions exist, the investor will borrow in the country with low rate of interest (as a result demand of that currency will increase causing forward premium on that currency), convert the borrowed amount into the currency on which higher rate of interest is prevailing and then invest it in that country ( supply gets increased causing depreciation of that currency). This activity will generate arbitrage profits for him. Soon , other market players will also join in this activity leading to diminishing arbitrage profits and ultimately arbitrage profits shall be eliminated fully when equilibrium is reached in terms of interest rate parity. Thus, in equilibrium, Interest Rate Differential = Exchange Rate Differential (1+Rd) = F d/f = S f/d (1+Rf) S d/f F f/d 19

OR,

Rd Rf = F d/f - S d/f (1+Rf) S d/f

Ex- Current interest rate of US and India are 8% and 12% respectively. Hence interest rate differential shall be, 1+0.12 = 1.037 i.e., forward premium on dollar = 1.037-1.000 =.037 or3.7% 1+0.08 Or using the alternative formula, 0.12 0.08 = .037 1 + 0.08 If spot rate is Rs.42.64 = $1, calculate forward rate for 3 months. Forward Rate = Spot Rate + Forward premium (for 3 months) Forward premium (for 3 months) = 3.7% / 4 = 0.925% Hence, Forward rate (for 3 months) = 42.64 + 42.64*.925% = 42.64 + 0.39 = Rs.43.03 Purchasing Power Parity:In equilibrium, expected difference in inflation rates of the two countries equals expected movement in spot rates of exchange between the currencies of the two countries. The currency of the country with high inflation rate shall depreciate and, vice-versa. Inflation Rate Differential = Current Spot Rate & Expected Spot Rate Differential (1 + I d) = E d/f = S f/d (1 + I f) S d/f E f/d OR, it can be stated as , I d I f = E d/f S d/f (1 + I f) S d/f Ex- France and Denmark are having annual inflation rates of 5% and & 7% respectively. The current spot exchange rate is DM 18.50/ FFR. What is the expected spot rate after 1 year? 1.07 = E d/f 1.05 18.50 E d/f = DM 18.85 / FFR Fisher Effect:The nominal interest rate will be higher when a higher inflation rate is expected and vice versa. The fisher effect is expressed as follows: Nominal Intt. Rate = Real Intt. Rate + Expected Rate of Inflation (1+ N) = (1+ R) (1+ I)

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In an efficient international capital market, the real rate of return in two countries shall equate due to arbitrage. Thus, the difference in nominal rates of interest will adjust exactly for the difference in inflation rates of the two countries. This is known as International Fisher Effect. Nominal Intt. Rate Differential = Expected Inflation Rate Differential (1+Rd) = E (1 + I d) (1+Rf) E (1 + I f) OR, Rd Rf = (1+Rf) IdIf (1 + I f)

Ex- Suppose Intt. Rate is 11% and 9% in Germany and U.K. respectively. The expected inflation rate in Germany is 5%. Then the expected inflation rate if U.K. shall be: 1.11 = 1.05 1.09 E(1+I f ) E (1+I f) = 1.031 E (I f ) = 1.031-1 = 0.031 or 3.1 % Expectations Theory:As interest rate differential equals expected inflation rate differential (international fisher effect) , we can say that IRP = PPP. Consequently, F d/f = E d/f S d/f S d/f F d/f - S d/f = E d/f S d/f S d/f S d/f

OR,

Expected future spot rate depends on market expectation. When the forward rate of a currency is higher than its expected future spot rate, then market participants will tend to sell that currency forward. This will cause a fall in its forward rate until it equals the expected future spot rate of that currency. The same will apply on reverse side. The expectation theory, thus, states that forward rate of a currency is the best possible forecaster of its expected future spot rate. Tools for Hedging Foreign Exchange Rate Risk Hedging means undertaking a transaction to offset the foreign currency exposure arising out of firms usual operations. For this, various tools, techniques & financial instruments (derivatives) are available. These are discussed in detail herein below: 1.Spot Contract:It is a contract to buy/sell a specified amount of foreign currency at the prevailing spot rate. The actual delivery may be done upto 2 days following the date of contract. Thus, it covers the exposure upto 2 days in advance. 19

2.Forward Contract:In India, two types of forward exchange contracts are prevalent, viz., Fixed/Outright Forward Contract Option Forward Contract

Fixed Forward Contract: It is a contract to buy/sell a specified amount of currency at a specified rate (known as forward rate) at a specified future date. The expected cost of forward contract is the difference between forward rate and expected spot rate on the settlement date. In the Indian foreign exchange market, holder of a forward contract can ask for settling the contract before maturity (early delivery), cancel the contract on or before the maturity date or ask for extension of the contract maturity. However, extension of forward contract is not permitted since 15/01/1995 as per RBI guidelines. The holder can cancel the contract and rebook it. Option Forward Contract: When exact timing of foreign currency inflows/outflows is not certain, though the amount is known, bank offers option forward contracts in which the rate & amount of exchange are fixed but the delivery date is not fixed. The customer can, at his option, take/make delivery on any day between the two fixed dates, i.e., start of contract/a date after that and end of contract. The time gap between these two dates is known as option period. Now, we will see the mechanism of early delivery and cancellation of forward contracts in detail in the successive pages.

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3. Currency Options:As against forwards and futures which provide two-sided hedge, the currency option hedges one-sided risk only i.e., adverse movement of foreign currency prices. Currency option gives the right but no obligation to the buyer of the option to sell (put option) or to buy (call option) a specific amount of foreign currency at a predetermined price called strike price. The buyer of the option has to pay an option premium to the option writer i.e., bank. The option premium is normally paid upfront to the writer. American Option option can be exercised at any time within the period of option. European Option option can be exercised on the specified expiry date. Note:- A call option buyer will exercise his option only if market price > strike price. An option may be: Exchange Traded Option (ETO), which is a standardized option, listed & traded on an organized exchange. Over-the-counter Option (OTCO) is a non-standardized option that is created primarily keeping in mind the user specific needs. Option premium depends upon: (1) Difference between exercise price & spot price. (2) Maturity period. (3) Volatility of price movements. (4) Interest rates. (5) Supply & demand for options. 4.Currency Futures Contract:A future contract is a standardized agreement that calls for delivery of a currency at some specified future date. These are tailor-made contracts and sold in an organized exchange, such as, Chicago International Money Market. All the transactions are done through clearing house of the Exchange. A future buyer is said to be in long position and a future seller is said to be in short position. Major Features of Futures (Forward v/s. Future): (1) Organized Exchange: - Unlike forward contracts which are traded in an OTC market, futures are traded on organized exchanges (just like stock market) which provides liquid market of futures. (2) Standardization: - Forward contracts are tailor-made to the buyers requirements. In the futures contract, the amount of currency covered by one future contract and maturity day, both are standardized by the exchange on which that future is traded. (3) Clearing House: - The clearinghouse of the futures exchange interacts itself between the buyer and the seller. Thus, all transactions are with clearinghouse, not directly between the purchaser and the seller. While in case of forwards, the transaction is between the buyer and seller, the A.D. being one party to the contract. There is no clearinghouse involved.

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(4) Margins: - Only member of clearinghouse of the futures exchange can trade in futures on the exchange. The general public uses the services of such members as brokers to trade on their behalf. The member is required to deposit a margin with the clearinghouse to perform trading. A member acting on behalf of a client, in turn requires the client to deposit a margin with the member. (5) Marking to Market: - At the end of each working day, the futures contract is marked to market, i.e., valued at closing price. Margin accounts of those who made losses are debited and those who earned gains are credited. Accordingly, losers have to bring more margin and gainers can draw off excess margin. E.g.- X buys a June delivery future on 14th April at a price of $1.60 per. The futures contract is for $1,00,000. On April 15th, at the end of the day, the settlement price is $1.62 = 1. X made a gain of 2 cents per or $1250 per contract. This will be credited to Xs margin a/c. Obviously; someone with a short position lost a matching amount. As against the above, in forwards, the gain or loss arise only on maturity. There are no intermediate cash flows. (6) Actual Delivery is Rare: - As against forwards where delivery of underlying currency is almost certain; in case of futures actual delivery takes place in less than 1% of the contracts traded. Futures are used as hedging device and as a way of betting on price movements. Hedging with Currency Futures: If a firm has a receivable (asset account) in Currency A, it should go short in futures i.e., it should sell futures contracts in A. Obviously, the firm cannot gain from an appreciation of A since the gain on receivable will be eaten away by loss on futures; however his exposure to risk is reduced/eliminated. 5. Financial Swaps: Financial swaps are an asset-liability management technique, which permit a borrower to access one market and then exchange the liability for another type of liability. Investors can exchange one type of asset for another with a preferred income stream. Swaps , by themselves, are not a funding instrument; they are a device to obtain the desired form of financing indirectly which otherwise might be inaccessible or too expensive. All swaps involve exchange of a series of periodic payments between two parties, usually through an intermediary which is a financial institution/bank. The two major type of financial swaps are : (a) Currency Swaps; and (b) Interest Rate Swaps. (a) CURRENCY SWAPS: A currency swap is a contract in which two counter-parties exchange specific amounts of two different currencies at the outset, exchange interest payments in the two currencies over the term of the swap and re-exchange principals at maturity. E.g.- An exporter enters into a long-term contract (5 years) with German company. By virtue of the contract, he will receive DM 2 million every 6 months against the goods exported by him. He wants to lock the dollar value of his DM revenues. He enters into a currency swap contract with a bank under which he will receive USD 1 million against DM 2 million over the coming 5 years time. 19

(b)INTEREST RATE SWAPS: It is a simple agreement between the two parties to exchange series of interest payments, each calculated using a different rate index, but applied to a common notional principal amount for an agreed period of time. The most common form interest rate swap is fixed to floating interest rate swap and vice-versa. Besides, a basis swap is used by entities with liabilities tied to one floating index (say, LIBOR) and financial assets tied to another floating rate index (say, MIBOR). Each swap leg is linked to FLR index, e.g., LIBOR v/s Prime. How do swap create advantage? (1) Commercial Need: Banks may use interest rate swap as a mechanism of interest rate risk management. Suppose, a bank pays on its deposits floating rate of interest (say, MIBOR) and receives interest in advances at fixed rate @13.5%. In case MIBOR increases, its spread will decline. To cover itself, it can undertake an interest rate swap on its fixed rate loan. It is offered a swap rate of MIBOR+2.62%, which will ensure it a spread of 2.62% (floating to fixed). (2) Comparative Advantage: It create advantage for all the parties engaged in swap; this has been illustrated below with the help of an example: A company (X) with higher credit rating will pay less to raise funds than a company (Y) with lower rating. The gap between the two companies interest rates is known as Credit Quality Spread (CQS). Usually, this CQS is greater in respect of FLR borrowings than it is for FXR borrowings. The difference in CQS of FLRs & FXRs is the reason why interest rate swap can be carried between the two companies. Of course, there is an intermediary viz., swap dealer. Company X Company Y LIBOR + .50 % LIBOR + 2 % 7.5 % 8.3 % Absolute Advantage Company X (both FXR and FLR) Credit Quality Spread 150 basis points 80 basis points

Comparative Advantage Company X : FLR Company Y : FXR Hence, Company X shall raise loan at LIBOR+.50%, while Company Y at 8.3%. However, their interest rate choice is just opposite for hedging their pattern of income. Swap deal will take place as follows:

Co. X

floating to fixed LIBOR to 6.8%

Swap Dealer

fixed to floating 6.5%to LIBOR

Co. B

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Each party in the swap deal will gain by taking advantage of market imperfection. Company X: Cash outflow to lenders (LIBOR+0.5%) Cash inflow from swap dealer LIBOR Cash outflow to swap dealer - (6.8%) Net outflow (7.3%) Loan available in FXR 7.5% Swap gain 0.2% Company Y: Cash outflow to lenders (8.3%) Cash inflow from swap dealer 6.5% Cash outflow to swap dealer - (LIBOR) Net outflow (LIBOR+1.8%) Loan available in FLR LIBOR+2% Swap gain 0.2% Swap Dealer: Cash outflow to X (LIBOR) Cash inflow from X 6.8% Cash inflow from Y LIBOR Cash outflow to Y (6.5%) Net gain 0.3% 6.Arbitrage: It is, in essence, not a method of hedging foreign exchange risk; rather it is a method of making profits from foreign exchange transactions. It is a process of buying and selling currencies simultaneously in more than one market, thereby leading to equilibrium in all markets. Arbitrage may be of space & time arbitrage. The profits accruing from the arbitrage process are the result of: Difference in exchange rates at two different exchange centers; Difference, due to interest yield, which can be earned at different exchanges. Types of Arbitrage: (a) Arbitraging between Banks: - All banks in a market do not necessarily have identical quotes for a given pair of currencies at a given point of time. Hence, it may be possible for an active market player to do arbitraging and make some gain. E.g.- Banks A & B are quoting Rs/$ as follows: A 45.50/60 B 45.38/48 Such a situation gives rise to arbitrage opportunity. Dollars can be bought from Bank B and sold to Bank A for a profit of Re.02 per $ without any risk or commitment of capital. However, this arbitrage opportunity will disappear very fast because markets are efficient and alert market players will quickly spot and exploit arbitrage opportunities. (b) Inverse Quotes and Two-Point Arbitrage: - Two-point arbitrage means buying a currency in one market and selling it at a higher price in another market. It is also known as space arbitrage. 19

E.g.- A bank in Denmark quotes DM/USD: 1.4955/4962 and a bank in New York quotes USD/DM: 0.6695/6699. To see whether an arbitrage opportunity exists or not, we will calculate Denmark banks implied USD/DM rate which comes to 0.6684/6687. Thus, there exists an arbitrage opportunity; an alert market participant can make a gain of 0.0008 per dollar by purchasing DM @ 0.6687 from the Denmarks bank and sell them @ 0.6695 to New Yorks bank. Note that, Implied USD/DM bid = 1/ (DM/USD) ask , and vice versa. (c) Cross-Rates and Three-Point Arbitrage: - In three-point arbitrage, three currencies are involved. Start with currency A, sell it for currency B, sell currency B for currency C and finally sell Currency C back for Currency A ending up with more amount of currency A than you began with. JPY/USD : 110.25/111.10 CAD/USD : 1.6520/1.6530 At the same time, a Toronto bank quoted: JPY/ CAD : 68.30/69.00 Now, implied JPY/CAD rate of New York bank will be 66.74/67.21 Thus, there exist an arbitrage opportunity if we choose JPY as our start currency because New York banks ask rate (implied) for JPY/CAD is lower than Toronto banks bid rate for JPY/CAD In New York bank: JPY 111.10 $1 CAD 1.6520 E.g.- A New York bank quoted:

In Toronto bank: CAD1.6520 68.30*1.6520=JPY 112.8316 Thus, arbitrage profit = JPY112.8316 JPY111.10 = JPY1.7316 Or, we can say 1.7316/111.10 = 0.0156 per yen

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