Chp 1

Currency Exchange Rates

organization
Foreign exchange quotations
Arbitrage
Forward quotes

Currency Abbreviations
Abbreviations are used to refer to the various
currencies. These abbreviations could be
commonly used symbols or official three-letter
codes.
Financial newspapers such as the Financial Times
generally use symbols, while traders use threeletter codes. Symbols include $ (U.S. dollar),
( Japanese yen), (euro), (British pound), A$
(Australian dollar), and Sfr (Swiss franc).
Three-letter codes for the same currencies are
USD, JPY, EUR, GBP, AUD, and CHF.
We will alternatively use in this book (as done in
the real world) the various currency
abbreviations that are commonly encountered.
For example, the Japanese yen can be referred to
as , JPY, or yen.

Foreign exchange quotations

A currency exchange rate is the rate used
to exchange two currencies. An exchange
rate states the price of one currency in
terms of units of another currency.
Examples: $:, :$, :$
Note: the notation in this new edition of
the text has changed relative to previous
editions. /---- the number of euros
per pound

Quote Convention used in this text

All quotes in this text will be presented as
a:b = S
where a is the quoted currency
b is the currency in which the price is expressed
S is the price of the quoted currency a in units of

currency b
For example, $: = 130 means the U.S. dollar is
quoted at 130 Japanese yen () per dollar. Or the
U.S. dollar is priced at 130 yen.

 Basic principles
1. All currencies are quoted against the U.S.
dollar, although there are such regional exceptions
as the yen in Asia and the euro and pound in
Europe.
Basic exchange rate

Cross exchange rate

From the quotation of two

currencies against the U.S. dollar,
one can derive the cross-exchange
rate between the two currencies

 For example, bank A gives the following quotations

:$ = 1.3364
$: = 123.52
Calculate the euro in yen (:) rate:

(:$) ($:) = 1.3364 123.52 = 165.07

The resulting quotation is: : = 165.07. One
euro is worth 165.07 yen.
For example, bank B gives the following quotations for

the Korean won and the Brazilian real:

$: won = 928.350
$: R$ = 1.9094
Calculate the R$:won rate:
($:won) ($:R$) = 928.35/1.9094 = 486.20
The resulting quotation is: R$:won = 486.20.
One Brazilian Real is worth 486.50 won.

Fill in the missing exchange rates in the

following table.
Euro

US dollar Yen

British
pound

1.3 euro

0.013 euro

2 euro

US dollar

Yen

British
pound

Euro

Euro

US
Yen
dollar

British
pound

Euro

1.3 euro 0.013

euro

2 euro

US dollar

$0.77

$1.54

Yen

Yen
Yen 100 1
76.92

Yen 153.85

British
pound

0.5

0.65

$0.01

0.0065

Conclusions:
(a:b) (b:c) = a:c
(a:b) (a:c) = c :b

2. The Forex convention specifies rates for all

currencies per dollar (as in $:) except for the
pound and the euro.

 More on quotation conventions

direct exchange rate
quotation are made in terms of the amount of local
or domestic currency(DC) required to purchase one
unit of foreign currency(FC).
e.g. 100 yen per dollar
appreciation and depreciation

indirect exchange rate

traders quote the amount of foreign currency
required to purchase one unit of home
currency.
All exchange rate with dollar are usually given as direct
rates, but there are two exception that give the
indirect rates, The British pound and The euros.

 On July 1, the British pound () is

quoted as :$ = 1.80.
Is this a direct or indirect quote from

the viewpoint of an American and a

British investor?
A month later, the exchange rate moved
to :$ = 1.90. Which currencies
appreciated or depreciated?

American terms
the dollar price of one unit of the second
currency is referred to as American terms, a
direct quote in terms of U.S..

European terms
The amount of second currency per U.S. dollar
is called European terms, an indirect quote
from the U.S. perspective.
other conventions
quotation are given with 5 digits.
Forex quotes always include a BID PRICE and
an ASK PRICE/OFFER PRICE, and there is
no commission or fee added on a trade

 Bid-ask(offer) quotes and spread

The Forex market is organized like an international OverThe-Counter market.
Bid price

It is the price at which the dealer is

willing to buy the quoted currency in
exchange for the second currency

Ask price It is price at which the dealer is willing

to sell the base currency in exchange
for the second currency.
The difference between the bid and ask price is
called the spread.
Midpoint price: (bid+ask)/2

Quote in U.S.

Bid

Ask

Direct (:$)

$0.9836

$0.9839

Indirect ($:)

1.0164

1.0167

Two principles
The a:b ask exchange rate is the reciprocal of

the b:a bid exchange rate.

The a:b bid exchange rate is the reciprocal of
the b:a ask exchange rate.

Indirect quotation =

1
Direct quotation

spread

A pip stands for price interest point and represents

the smallest price fluctuation in the currency price. It
is equivalent to the tick on stock markets.
E.g. :$ = 1.3015 1.3019. The spread equals 4 pips.

Bid-ask spread = ask price bid price

ask price
Example
Suppose bid price for = $1.52,
ask price = $1.60.
Spread = (1.60 1.52) = .05 or 5%
1.60


The
The difference
difference isis the
the
spread
spread (gain)
(gain)

The following factors will affect spread

Trade volume
Market condition

Arbitrage
Cross-rate calculations with Bid-Ask spreads
(FC2 FC1)ask=(DC FC1)ask * (FC2 DC)ask
(FC2 FC1)bid=(DC FC1)bid * (FC2 DC)bid
Direct ask (FC DC) = 1 / Indirect bid (DC
FC)
Direct bid (FC DC) = 1 / Indirect ask (DC
FC)
Notation: DC=domestic currency, FC=foreign

currency

Two check to be made correctly

Look at the symbols
Make sure that you maximize the bid-ask
spread

 An arbitrage could be created if it were

profitable to buy from one bank and sell to
another bank.
Arbitrage aligns exchange rate quotations
throughout the world
For example, the $: rate must be the same, at

a given instant, in Frankfurt, Paris and New

York.
There are two types of arbitrage with exchange rate
Bilateral arbitrage
Triangular arbitrage

 Bilateral arbitrage
The law of one price
Equivalent assets sell for the same price,
exchange rate quotes in two countries should be
same within a transaction cost band.
the bid-ask spread in one country should be aligned
with the bid-ask spread in the other. If not, a
bilateral arbitrage opportunity exists.
Suppose
London
1=US$ 1.4815 ~ 1.4825
NewYork l =US$ 1.4845 ~ 1.4855

Arbitrage Example
Consider the following three banks each providing
a $: quote :
Bank A
Bank B
Bank C
122.25-35
122.40-45
122.25-45
Does an arbitrage opportunity exist?
One could buy dollars from Bank A for 122.35 yen
per dollar and simultaneously sell them to Bank B
for 122.40 yen per dollar. A small gain, but it is
riskless and does not require any invested capital.
1 - 24

Triangular arbitrage
It occurs if the quoted exchange rate between the
two currencies is higher or lower than the crossrate implied by the exchange rate of the two
currencies against the third currency.
You observe these rates:
Tokyo $
120.00
NYC $: SFr 1.6000
Zurich SFr: 80.00

Triangular arbitrage involves 3 steps

Pick the cross rate currency
Determine whether the cross-rate bid-ask quotes are in

line with the direct quotes by determining whether it is

cheaper to buy foreign currency directly or indirectly
If not, an arbitrage opportunities exists.
If transaction costs are ignored
Check whether (FC1:DC)*(DC:FC2) *(FC2:FC1) =1
Transaction costs
Check whether quoted and cross-rate bid-ask
spreads overlap for any currency out of our three
currencies.
If you have rate 1 [bid1, ask1] and rate 2 [bid2,
ask2] such that ask2<bid1, buy at ask2 and sell at
bid1.

Triangular Arbitrage Example

You observe these quotes below. Is any currency arbitrage possible?

Calculate cross-rates and compare with the quoted rates

Forward quotes
Spot exchange rates are quoted for delivery two
business days after the transaction is concluded
Forward exchange rate foreign exchange
traders quote exchange rates for delivery
further than two days in the future.
in other words, contract a commitment is
irrevocable made on the transaction date, but
delivery take places later, on a date set in the
contract.

Forward exchange rates are often quoted as a premium

or discount

Forward premium
Nominal value in the forward exchange market is

higher than in the spot exchange market

Forward discount
Nominal value in the forward exchange market is

lower than in the spot exchange market

Given an exchange rate of y x, the annualized
forward premium on y

Forward rate - Spot rate

12

Spot rate

No.months forward

You observe the following: Spot USD/EUR=1.4570-76,

and 6-months forward USD/EUR=1.4408-34. Is EUR
trading at a premium or discount relative to the
USD? Compute the annualized forward
discount/premium.

Interest rate parity: The forward discount and

the interest rate differential
Interest rate parity
it is a relationship linking spot exchange rate,
forward exchange rate and interest rate.
for two currencies, FC and DC, the IRP is that
the forward discount equals the discounted
interest rate differential between the two
currencies.

FFC DC - S / S = (rDC - rFC)/

(1+rFC)

Riskless Arbitrage: Covered Interest Parity

Spot: $: = 0.8000
One year interest rate ($): 10%
One year interest rate (): 14%
Time 0

Borrow at 10%

Time 1

Buying a
forward
contract
Spot $: ?

U.S.D

F $: =0.8080
Euros
Lend at 14%

1+r$ = S /F (1+r)
F / S = (1+r) / (1+r $)
(F- S) / S = (r - r $) / (1+ r $)
ra rb
Forward rate Spot rate

Spot rate

1 ra

Spot exchange rate = S a: b

Forward Quotations with Bid-Ask Spreads

- Example
On the Forex market, you notice the
following quotes:
Spot: $: = 105.00 105.50
One year interest rate ($): 3 4%
One year interest rate (): - 1%
What should be the quote for the one year
forward exchange rate $:?

 Solution:

FASK

1.04
105.50
109.174
1.005

FBID

1.035
105.00
107.6
1.01

Thus, the forward quotation is

$:: 107.60 109.174
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