1. Foreign Exchange Markets
CHAPTER 07
Foreign Exchange Markets

2. 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)

5. 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):

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

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

9. Locational Arbitrage What is locational arbitrage?
When is locational arbitrage possible?
Bid price:
Ask price:
Locational arbitrage is possible when:

10. Locational Arbitrage Example: British pound quote: Profit on $1,000:
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 = $
So profit from locational arbitrage is $6.17

11. Triangular Arbitrage What is triangular arbitrage?
When is it possible?
What is a cross exchange rate:

12. 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

13. Triangular Arbitrage Example: Theoretical cross rate:
1 British pound = $1.60
1 Brazilian real= $0.20
1 pound = 8.10 reals
Theoretical cross rate:
1.6/.20 = reals per pound
Thus, triangular arbitrage is possible since the quoted rate (8.10) differs from the theoretical (8.00)

14. 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 = real

15. Triangular Arbitrage 3. Reconvert to home currency (dollar)
*.20 = $
Arbitrage profit = $12.50

16. 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?

17. 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….

18. 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?

19. 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

20. Government Intervention in Foreign Exchange Markets
How do governments intervene:
Direct Intervention
Sterilized
Unsterilized

21. Government Intervention in Foreign Exchange Markets
Indirect Intervention

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