Foreign Exchange Markets

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CHAPTER 16

• Foreign Exchange Markets

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Foreign Exchange Market

• What is the foreign exchange market?
• Who are the major participants?

3
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

4
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)

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Foreign Exchange Market
6
Foreign Exchange Market

• An exchange rate is either a spot rate or a
  forward rate
• Spot rate (S)
• Forward rate (F)

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Foreign Exchange Market

• How are exchange rates quoted? There are two
  types of quotations
• Direct
• Indirect

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International Arbitrage

• We will look at three types of international
  arbitrage
• Locational arbitrage
• Triangular arbitrage
• Covered interest arbitrage

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Locational Arbitrage

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

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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

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Triangular Arbitrage

• What is triangular arbitrage?
• When is it possible?
• What is a cross exchange rate

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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

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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)

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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
• 6258.10 5062.50 real

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Triangular Arbitrage

• 3. Reconvert to home currency (dollar)
• 5062.50.20 1012.50
• Arbitrage profit 12.50

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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?

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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? Lets see.

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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
• 2,160,0000.55 1,188,000
• So, was CIA worthwhile?

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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

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Government Intervention in Foreign Exchange
Markets

• How do governments intervene
• Direct Intervention
• Sterilized
• Unsterilized