CHAPTER 07 Foreign Exchange Markets Foreign Exchange Market

CHAPTER 07 Foreign Exchange Markets

Foreign Exchange Market w What is the foreign exchange market? w 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 w What is the exchange rate? • An exchange rate is the price of a unit of one currency in terms of another. w How are exchange rates determined? • By supply and demand for the most part (governments also play a role)

Foreign Exchange Market

Foreign Exchange Market w An exchange rate is either a spot rate or a forward rate • Spot rate (S): • Forward rate (F):

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

International Arbitrage w We will look at three types of international arbitrage: • Locational arbitrage • Triangular arbitrage • Covered interest arbitrage

Locational Arbitrage w What is locational arbitrage? w When is locational arbitrage possible? • Bid price: • Ask price: • Locational arbitrage is possible when: w

Locational Arbitrage Example: w British pound quote: w • • Bid price • Ask price w Bank A Bank B $1. 61 per pound $1. 62 per pound $1. 63 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 w What is triangular arbitrage? w When is it possible? • What is a cross exchange rate:

Triangular Arbitrage w How is 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 w Example: • 1 British pound = $1. 60 • 1 Brazilian real= $0. 20 • 1 pound = 8. 10 reals w Theoretical cross rate: • 1. 6/. 20 = 8. 00 reals per pound • Thus, triangular arbitrage is possible since the quoted rate (8. 10) differs from 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) w What is CIA? w To understand CIA we must understand: • Interest rate differentials: • Forward differentials: (F-S/S) * 360/n • where n is the number of days w When is CIA possible?

Covered Interest Arbitrage w Example: • • • w US investor with $1, 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 w Convert dollars to pesos: • $1, 000/0. 50 = 2, 000 pesos • Invest at 8 percent for 1 year • 2, 000* 1. 08 = 2, 160, 000 pesos w Reconvert to dollars: • 2, 160, 000*0. 55 = $1, 188, 000 w So, was CIA worthwhile?

Government Intervention in Foreign Exchange Markets w 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 w How do governments intervene: • Direct Intervention • Sterilized • Unsterilized

Government Intervention in Foreign Exchange Markets • Indirect Intervention

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