Mahmood-ur-Rahman Lecturer, BIBM

Foreign Exchange Market

Foreign Exchange Market is the

organizational framework where the various national currencies are bought and sold. Practically it is a worldwide market, which is made up of individuals, commercial banks and other authorized agents.
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Arbitrage
Arbitrage: Locking in a risk less profit from price disequilibria or distortions in different markets.

Arbitrage

Currency Arbitrage:It refers to the purchasing of foreign currency where its price is low and selling it where the price is high.

Arbitrage

Arbitrage may be due to

interest rate differences in two financial centers, which is known as interest arbitrage.

Hedging Hedging: Foreign exchange risks can be avoided or covered by Hedging. This usually involves an agreement today to buy or sell a certain amount of foreign currency at some future date at a rate agreed upon today.
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Speculation

Speculation: It is opposite of hedging. While a hedger seeks to avoid or cover a foreign exchange risk for fear of loss, the speculator accepts or even seeks a foreign exchange risk in the hope of making a profit. Speculation usually occurs in the forward exchange market.
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Covered Interest Arbitrage

Covered Interest Arbitrage: It refers to the transfer of liquid funds from one monetary center and currency to another to take advantage of higher rates of return (or interest) and at the same time the resulting foreign exchange risk is covered or hedged by a forward sale of the foreign currency to coincide with the maturity of the foreign investment.
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Covered Interest Arbitrage: Example

If we desire to capitalize on

relatively high rates of interest in the UK have funds available for 90 days. The interest rate is certain: only the future ER at which we will exchange pounds back to USD is uncertain. The strategy is as follows: 1. On day 1, convert USD into pounds and set up a 90-day deposit in British bank.
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Covered Interest Arbitrage: Example

2. On day 1, engage in forward

contract to sell pounds 90-day forward 3. In 90 days when the deposit matures, convert the pounds to USD at the rate that was agreed upon in the forward contract.

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Covered Interest Arbitrage: Example

Assume the following information: We have USD 8,00,000 to invest The current spot rate of pound is

$1.60 The 90-day forward rate of pound is $1.60 The 90-day interest rate in USA is 2% The 90-day interest rate in UK is 4%
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Covered Interest Arbitrage: Example Based on the information we should proceed as follows: On day 1, convert $8,00,000 to 5,00,000 pounds and deposit in British bank

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Covered Interest Arbitrage: Example On day 1, sell 5,20,000 pound 90day forward. By the time the deposit matures and we will have 5,20,000 pounds. In 90 days when deposit matures, fulfill the forward contract obligation by converting 5,20,000 pounds into $8,32,000
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Impact of CIA
Activity
1. Using USD to purchase pounds in the spot market 2.Engaging in forward contract to sell pounds 3. Investing funds from US to UK

Impact
Upward pressure on the spot rate of pound Downward pressure on the forward rate of the pound Possible upward pressure on US IR and downward pressure on UK IR.

Original value
Spot rate: $1.60 Forward rate: $1.60

Value after being affected by CIA

$1.6200 $1.5888
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Realignment due to Covered Interest Arbitrage

As with other forms of arbitrage,

market forces resulting from CIA will cause a market realignment: Convert $8,00,000 to 4,93,827 pounds ($8,00,000/1.62) Calculate accumulated pounds over 90 days at 4% { 4,93,827 X 1.04} = 5,13,580 pounds
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Realignment due to Covered Interest Arbitrage

Reconvert pound to dollar at

forward rate 0f $ 1.5888 [ 5,13,580 X 1.5888] = $8,15,976 Determine the yield earned fro CIA: [(8,15,976-8,00,000)/8,00,000] = .02 =2%
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SPECULATING ON EXCHANGE RATE MOVEMENTS

Many commercial banks and other

types of firms attempt to capitalize on their speculation of exchange rate movements. To illustrate how a bank may attempt to capitalize on the expected change in a currencys value, assume the following:
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SPECULATING ON EXCHANGE RATE MOVEMENTS

Chicago Bank expects the exchange

rate of the German mark (DM) to appreciate from its present level of $0.50 to $0.52 in 30 days. Chicago Bank is able to borrow $20 million on a short-term basis from other banks.
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SPECULATING ON EXCHANGE RATE MOVEMENTS

Present short-term interest rates (annualized) in the interbank market are as follows: Currency Lending Rate Borrowing Rate Dollars 6.72% 7.2%

German 6.48% 6.96% marks (DM) Because brokers sometimes serve as intermediaries between banks, the lending rate differs from the borrowing rate.

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SPECULATING ON EXCHANGE RATE MOVEMENTS

Given the information, Chicago Bank

could: Borrow $20 million. Convert the $20 million to DM40 million (computed as $20,000,000/$.50). Lend the marks at 6.48 percent annualized, which represents a .54 percent return over the 30-day period [computed as 6.48% X (30/360)].

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 After 30 days, the bank would receive

SPECULATING ON EXCHANGE RATE MOVEMENTS

DM40,216,000 [computed as DM40,000,000(1 + .0054)]. Use the proceeds of the mark loan repayment (on Day 30) to repay the dollars borrowed. The annual interest on the dollars borrowed is 7.2 percent, or .6 percent over 30-day period [computed as 7.2% X (30/60)]. The total dollars necessary to repay the loan is therefore $20,120,000 [computed as $20,000,000 X (1 + .006)].
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SPECULATING ON EXCHANGE RATE MOVEMENTS

Assuming that the exchange rate on Day

30 is $.52 per mark as anticipated, the number of marks necessary to repay the dollar loan is DM38,692,308 (computed as $20,120,000/$.52 per mark). Given that the bank accumulated DM40,216,000 from its mark loan, it would earn a speculative profit of DM1,523,692, which is the equivalent of $792,320 (given a spot rate of $.52 per mark on Day 30).
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SPECULATING ON EXCHANGE RATE MOVEMENTS

This speculative profit was earned

by the bank without using any funds from deposit accounts, since the funds were borrowed through the interbank market.

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SPECULATING ON EXCHANGE RATE MOVEMENTS If Chicago Bank expected that the mark would depreciate, it could attempt to make a speculative profit by taking positions opposite to those described in the previous example. To illustrate, assume that the bank expects an exchange rate of $.48 for the mark on Day 30.
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 It could borrow marks, convert them

SPECULATING ON EXCHANGE RATE MOVEMENTS

to dollars, and lend the dollars out. It could borrow marks, convert them to dollars, and lend the dollars out. On Day 30, it could close out these positions. Using the rates quoted in the previous example, and assuming the bank can borrow DM40 million, the following steps could be taken:
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SPECULATING ON EXCHANGE RATE MOVEMENTS Borrow DM40 million. Convert the DM40 million to $20 million (computed as DM40,000,000 X $.50). Lend the dollars at 6.72 percent, which represents a .56 percent return over the 30-day period. After 30 days, the bank would receive $20,112,000 [computed as $20,000,000 X (1 + .0056)].

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SPECULATING ON EXCHANGE RATE MOVEMENTS Use the proceeds of the dollar loan repayment (on Day 30) to repay the marks borrowed. The annual interest on the marks borrowed is 6.96 percent, or .58% over the 30-day period [computed as 6.96 X (30/360)]. The total marks necessary to repay the loan is therefore DM40,232,000 [computed as DM40,000,000 X (1 + .0056)].
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SPECULATING ON EXCHANGE RATE MOVEMENTS Assuming that the exchange rate on Day 30 is $.48 per mark as anticipated, the number of dollars necessary to repay the mark loan is $19,311,360 (computed as DM40,232,000 X $.48 per mark).
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SPECULATING ON EXCHANGE RATE MOVEMENTS Given that the bank accumulated $20,112,000 from its dollar loan, it would earn a speculative profit of $800,640 (computed as $20,112,0000 $19,311,360).

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