CHAPTER 15

Foreign Exchange Markets

 Foreign Exchange Market
 What is the foreign exchange market?

 Who are the major participants?

 Foreign Exchange Market
• Characteristics of the foreign exchange
market
• Large number of diverse buyers and sellers
(breadth)
• Significant market activity (buy/sell) with any
change in value (depth)
• Worldwide trading
 Foreign Exchange Market
 What is the exchange rate?
• An exchange rate is the price of a unit of one
currency in terms of another.
 How are exchange rates determined?
• By supply and demand for the most part
(governments also play a role)
Foreign Exchange Market
 Foreign Exchange Market
 An exchange rate is either a spot rate or
a forward rate
• Spot rate (S):

• Forward rate (F):

 Foreign Exchange Market
 How are exchange rates quoted? There
are two types of quotations:
• Direct:

• Indirect:
 International Arbitrage
 We will look at three types of
international arbitrage:
• Locational arbitrage

• Triangular arbitrage

• Covered interest arbitrage

 Locational Arbitrage
 What is locational arbitrage?

 When is locational arbitrage possible?

• Bid price:

• Ask price:

• Locational arbitrage is possible when:


 Locational Arbitrage
 Example:
 British pound quote:
• Bank A Bank B
• Bid price $1.61 per pound $1.63 per pound
• Ask price $1.62 per pound $1.64 per pound
 Profit on $1,000:
• (1000/1.62)*1.63 = $1006.17
• So profit from locational arbitrage is $6.17
 Triangular Arbitrage
 What is triangular arbitrage?

 When is it possible?

• What is a cross exchange rate:

 Triangular Arbitrage
 How is the theoretical cross exchange
rate calculated?
• Value of Currency X in terms of US dollar
• Value of Currency Y in terms of US dollar
 Triangular Arbitrage
 Example:
• 1 British pound = $1.60
• 1 Brazilian real= $0.20
• 1 pound = 8.10 reals
 Theoretical cross rate:
• 1.6/.20 = 8.00 reals per pound
• Thus, triangular arbitrage is possible since the
quoted rate (8.10) differs from the theoretical
(8.00)
 Triangular Arbitrage
• To capitalize on the price discrepancy
(assuming you have $1,000):
• 1. Buy overvalued
• Overvalued currency: pound
• 1,000/1.60 = $625 pounds

• 2. Convert to undervalued
• Undervalued currency: real
• 625*8.10 = 5062.50 real
 Triangular Arbitrage
• 3. Reconvert to home currency (dollar)
• 5062.50*.20 = $1012.50

• Arbitrage profit = $12.50

 Covered Interest Arbitrage
(CIA)
 What is CIA?

 To understand CIA we must understand:

• Interest rate differentials:

• Forward differentials: (F-S/S) * 360/n

• where n is the number of days
 When is CIA possible?
 Covered Interest Arbitrage
 Example:
• US investor with $1,000,000
• US interest rate = 6%
• Mexican interest rate = 8%
• Spot rate: 1 peso = $0.50
• 1 year forward rate: 1 peso =$0.55
 Is CIA possible? Let’s see….
 Covered Interest Arbitrage
 Convert dollars to pesos:
• $1,000,000/0.50 = 2,000,000 pesos
• Invest at 8 percent for 1 year
• 2,000,000* 1.08 = 2,160,000 pesos
 Reconvert to dollars:
• 2,160,000*0.55 = $1,188,000
 So, was CIA worthwhile?
 Government Intervention in Foreign
Exchange Markets

 Why do governments intervene?

• To smooth exchange rates
• To execute objectives of the central banks
• To establish implicit boundaries
 Government Intervention in Foreign
Exchange Markets

 How do governments intervene:

• Direct Intervention

• Sterilized

• Unsterilized
Government Intervention in Foreign
Exchange Markets

• Indirect Intervention
 Summary
 Basics of Foreign Exchange Market
• Characteristics of the market
• Major participants
• Spot versus forward rates
• Types of quotations
 International Arbitrage
 Government Intervention