1. The Foreign Exchange Market Copyright 2014 by Diane S. Docking1 € KM

2. Learning Objectives What is meant by a foreign exchange rate What is a spot versus a forward exchange rate What are the different ways that a foreign exchange rate can be quoted – (Direct versus Indirect; American versus European) What are cross rates What is foreign exchange risk How to identify and perform a Triangle arbitrage for profit Copyright 2014 by Diane S. Docking2

3. Exchange Rates Copyright 2014 by Diane S. Docking3 € KM

4. Foreign Exchange In the foreign exchange markets—every currency has a price in terms of other currencies Foreign Exchange Rate: a price for a currency denominated in another currency. Foreign exchange rates are the conversion rates between currencies – Spot rate – Forward rate Copyright 2014 by Diane S. Docking 4

5. Foreign Exchange Transactions Copyright 2014 by Diane S. Docking5 Spot foreign exchange transaction: 0 1 2 3 mo Exchange Rate Agreed/Paid + Currency Delivered by between Buyer and Seller Seller to Buyer Forward exchange transaction 0 1 2 3 mo Exchange Rate Agreed Buyer Pays Forward Price between Buyer and Seller Seller delivers currency Spot foreign exchange transaction: 0 1 2 3 mo Exchange Rate Agreed/Paid + Currency Delivered by between Buyer and Seller Seller to Buyer Forward exchange transaction 0 1 2 3 mo Exchange Rate Agreed Buyer Pays Forward Price between Buyer and Seller Seller delivers currency

6. The Foreign Exchange Market While you can buy small amounts of FX at any currency exchange such as those found in international airports, much larger sums of currencies are bought and sold around the clock on the foreign exchange market. The foreign exchange (FX or forex) market: – where currencies are traded, – is a market that is open 24 hours a day during the week, – has no central physical location, and – experiences daily turnover of over $3 trillion. Copyright 2014 by Diane S. Docking 6

7. FX Rate Quotation Conventions Direct vs. Indirect quote: quote is the number of units of local currency (LC) needed to buy one unit of foreign currency (FC), – #LC/1FC ; e.g., # U.S. dollars per 1 Euro quote is the number of units of a foreign currency (FC) needed to buy one unit of LC, – #FC/1LC; e.g., # Euros per $1 Above examples assume U.S. dollars is the LC – Given a direct quote, we can calculate an indirect quote, which is the reciprocal of the direct quote Copyright 2014 by Diane S. Docking7

8. FX Rate Quotation Conventions American vs. European quote: terms - quoting in terms of U.S. dollars per unit of foreign currency terms - quoting in terms of the number of units of the foreign currency per U.S. dollar If local currency is U.S. dollars, then Direct quote = American terms and Indirect quote = European terms Copyright 2014 by Diane S. Docking8

9. 9 U.S. Dollar Foreign Exchange Rate Quotations Current foreign exchange rates http://www.federalreserve.gov/releases/H10/hist For example: One Euro can be purchased for $1.2310, or equivalently, 0.8123 Euros buy one U.S. dollar. #$/1FC Direct Quote or American Terms #FC/$1 Indirect Quote or European Terms $1.2310 invert, then reduce 1 € = € $1.2310 €0.8123 $

10. US $ Spot Rates Copyright 2014 by Diane S. Docking 10 #$/1FC Direct Quote or American Terms #FC/$1 Indirect Quote or European Terms US Dollar1 USDIn USD Euro0.75181.3302 British Pound0.65761.5207 Indian Rupee60.6350.01649 Australian Dollar1.11310.8984 Canadian Dollar1.02770.9731 UAE Emirati Dirham3.67300.2723 Swiss Franc0.92621.0796 Chinese Yuan Renminbi6.12900.1632 Malaysian Ringgit3.25000.3077 New Zealand Dollar1.25240.7985 Top 10 July 31, 2013

11. FX Cross Rates Cross Rates The exchange rate between two countries other than the U.S. can be inferred from their exchange rates with the U.S. dollar The rates thus obtained are known as cross rates Copyright 2014 by Diane S. Docking11

12. Key Currency Cross Rates Copyright 2014 by Diane S. Docking12 DollarEuroPoundSFrancPesoYenCdnDlr Canada1.02771.36701.56281.10950.08070.0105... Japan97.8891130.2121148.8636105.68467.6891...95.2539 Mexico12.730916.934719.360413.7448...0.130112.3882 Switzerland0.92621.23211.4086...0.07280.00950.9013 U.K.0.65760.8747...0.70990.05170.00670.6399 Euro0.7518...1.14320.81160.05910.00770.7315 U.S....1.33021.52071.07960.07850.01020.9731 July 31, 2013 Snapshot of foreign exchange cross rates at 5 p.m. Eastern time. Source: ICAP plc ; historical data prior to 6/9/11: Thomson Reuters http://online.wsj.com/mdc/public/page/2_3023-keyrates.html ICAP plc http://online.wsj.com/mdc/public/page/2_3023-keyrates.html

13. FX Cross Rates Copyright 2014 by Diane S. Docking13 = €1.143248 = €1.1432 £ £ €0.7518 x$1 = €0.7518 = $1 £0.6576 £0.6576

14. FX Cross Rates (cont.) Cross-exchange rates are foreign exchange rates of two currencies relative to a currency. Value of one unit of currency A in units of currency B = value of currency A in C divided by value of currency B in C Arbitrage assures that the exchange rates will be the same between the countries Copyright 2014 by Diane S. Docking14

15. FX Cross Rates (cont.) Arbitrage forces keep cross rates in balance. E.g.: Let the exchange rates at various banks be: Then, if you have $1: $1 → 1£ → 4€ → $2 WOW a riskless $1 profit. Arbitrage forces will force the exchange rate at BOA from 4€/1£ down to 2€/1£ Then: $1 → 1£ → 2€ → $1 Copyright 2014 by Diane S. Docking15 CitibankBank of AmericaU.S. Bancorp

16. Foreign Exchange Risk Copyright 2014 by Diane S. Docking16 € KM

17. FOREIGN EXCHANGE RISK Foreign exchange risk, or currency risk, is the risk that a currency’s value may change adversely Most exchange rates are a floating rate, which means it changes constantly depending on the quantity supplied and demanded for each currency in the market. Copyright 2014 by Diane S. Docking17

18. Appreciation/Depreciation If depreciation of the domestic currency ($) occurs, then – FC cost more $’s – a _____________ of the $ If appreciation of the domestic currency ($) occurs – FC costs less $’s – a _____________ of the $ Copyright 2014 by Diane S. Docking18

19. Appreciation/Depreciation When a country A’s currency appreciates in value relative to country B’s currency), country A’s goods being sold in country B become more expensive to country B citizens (holding domestic prices constant in the two countries). While country B’s goods being sold in country A become cheaper to country A citizens. Appreciation of a country’s currency can make it harder for domestic manufacturers to sell their goods abroad Exports ; imports ___________ Copyright 2014 by Diane S. Docking19

20. Appreciation/Depreciation Conversely, when country A’s currency depreciates in value relative to country B’s currency), country A’s goods being sold in country B become cheaper to country B citizens. While country B’s goods being sold in country A become more expensive to country A citizens. Depreciation of a country’s currency can make it easier for domestic manufacturers to sell their goods abroad. exports ; imports ____________ Copyright 2014 by Diane S. Docking20

21. $/Euro: April 17, 2009 – April 17, 2014 http://tools.currenciesdirect.net/currency-chart/ http://tools.currenciesdirect.net/currency-chart/ Copyright 2014 by Diane S. Docking21

22. $/Pound: June 1, 2002 – April 17, 2014 http://tools.currenciesdirect.net/currency-chart/ http://tools.currenciesdirect.net/currency-chart/ Copyright 2014 by Diane S. Docking22

23. Example FX Risk: L-T Purchase Contract with Foreign Currency Problem: In May 2XX1, when the exchange rate was $1.35 per euro, Mason ordered parts for next year’s production from Campco. They agreed to a price of 500,000 euros, to be paid when the parts were delivered in one year’s time. One year later, the exchange rate was $1.55 per euro. What was the actual cost in dollars for Mason when the payment was due? If the price had instead been set at $675,000 (which had equivalent value at the time of the agreement), how many euros would Campco have received? Copyright 2014 by Diane S. Docking 23

24. Solution: Right now, May 2XX1 cost is $1.35 x 500,000 euros = $675,000 With the price set at 500,000 euros, Mason had to pay ($1.55/euro)  (500,000 euros) = ___________one year later May 2XX2 This cost is $100,000 higher than it would have been if the price had been set in dollars. Conclusion: Whether the price was set in euros or dollars, one of the parties would have suffered a substantial loss. Since neither knows which will suffer the loss ahead of time, each has an incentive to hedge. Copyright 2014 by Diane S. Docking 24 Example FX Risk: L-T Purchase Contract with Foreign Currency (cont.)

25. Example FX Risk: Traveling and Exchange Rates Problem: Lina was planning a trip to tour Europe for three weeks. The exchange rate cost when she was planning was $1.32 per euro. She planned on expenses and souvenir costs in Europe to be about €7,000. Five months later, when she actually went on her trip, the exchange rate cost had increased to $1.65 per euro. What was Lina’s estimated cost in euros equal to in U.S. dollars at the time of planning? How many euros did Lina actually end up having once she was on her trip? How could Lina have planned for the differences in exchange rate cost? Copyright 2014 by Diane S. Docking 25

26. Solution: With her costs being in euros, her dollar equivalent cost at planning is: ($1.32/€) × (€7,000) = ________ On her trip the cost of euro had increased so her final amount was: ($9,240) ÷ ($1.65/€) = _________ Or ($9,240) ×[1/($1.65/€)] = ($9,240) × (€.61/$) = €5,600 Lina ended up having €1,400 less euros once she got to Europe. Copyright 2014 by Diane S. Docking 26 Example FX Risk: Traveling and Exchange Rates (cont.)

27. Conclusion: Lina could have looked at rates, and current rate patterns to estimate the exchange rate cost at her time of the trip to ensure that she had enough money for her costs and souvenirs. However, this is the risk of traveling overseas, since rates are so volatile. Copyright 2014 by Diane S. Docking 27 Example FX Risk: Traveling and Exchange Rates (cont.)

28. Example FX Pricing: Triangle Arbitrage for Cross-Rates The following quotations are available to you for US dollars ($), Canadian Dollars (CD), and Mexican pesos (Peso). You may either buy or sell at the stated rates: – BancOne: $.76/CD – Imperial Bank: 1.40 pesos/CD – Domino Bank: $.55 / peso Given this information, is a triangle arbitrage possible? If so, explain the steps and compute the profit, assuming you have an initial US $1,000,000 to use. Copyright 2014 by Diane S. Docking28

29. Example FX Pricing: Triangle Arbitrage for Cross-Rates (cont.) Is it possible? Evaluate Copyright 2014 by Diane S. Docking29 BancOneImperial Bank Domino Bank $0.76 1 CD 1.40 pesos 1 CD $0.55 1 peso Cross RatesTheoreticalActual 1.40 pesos 1 CD x$0.55 1 peso =$0.77 1 CD >$0.76 1 CD At Bank One Therefore, BankOne X-rate is too LOW. So want to take $→CD at BankOne→pesos at Imperial Bank→$ at Domino Bank YES

30. Example FX Pricing: Triangle Arbitrage for Cross-Rates Steps in Triangle Arbitrage Copyright 2014 by Diane S. Docking30 Convert $1 mill. to CDs at BancOne @ $0.76/CD = $1 mill. /0.76 = 1,315,789 CDs Convert 1,315,789 CDs to pesos at Imperial Bank @ 1.40 peso/CD = 1,315,789 CDs x 1.40 = 1,842,105 pesos Convert 1,842,105 pesos to $s at Domino Bank @ $0.55/peso = 1,842,105 pesos x 0.55 = $1,013,158 1 2 3 BancOne $ → CD Imperial Bank CD → peso Domino Bank peso → $ Riskless Arbitrage Profit: $1,013,158 - $1,000,000 $ 13,158