Workshop Questions

The Foreign
Exchange Market

I Conceptual Questions

1. Value Date: The settlement of a transaction takes place by transfers of

deposits between two parties. The day on which these transfers are
effected is called the Settlement Date or the Value Date.

2. Spot Rate: When the exchange of currencies takes place on the second

working day after the date of the deal, it is called spot rate.

3. Forward Transactions: If the exchange of currencies takes place after

a certain period from the date of the deal (more than 2 working days), it is
called a forward rate. A trader may quote a forward transaction for any
future date. It is a binding contract between a customer and dealer for the
purchase or sale of a specific quantity of a stated foreign currency at the
rate of exchange fixed at the time of making the contract.

4. Swap Transaction: A swap transaction in the foreign exchange

market is combination of a spot and a forward in the opposite direction.

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 Thus a bank will buy DEM spot against USD and simultaneously enter
into a forward transaction with the same counter party to sell DEM
against USD against the mark coupled with a 60- day forward sale of
USD against the mark. As the term ‘swap’ implies, it is a temporary
exchange of one currency for another with an obligation to reverse it at a
specific future date.

5. Bid Rate: The bid rate denotes the number of units of a currency a
bank is willing to pay when it buys another currency.

6. Offer Rate: The offer rate denotes the number of units of a currency a

bank will want to be paid when it sells a currency.

7. Bid - Offer Rate: The bid offer Rate is the rate which states both, the

price which is the bank is willing to pay to buy other currencies and the
price the bank expects when it sells the same currency. Bid and Ask will
always be from a bank’s point of view. Thus (A/B)bid will denote the
number of units of A the bank will pay when it buys one unit of B and
(A/B)ask will mean the number of units of A the bank will want to be
paid in order to sell one unit of B.

8. European Quote: The quotes are given as number of units of a

currency per USD. Thus DEM1.5675/USD is a European quote.

9. American Quotes: American quotes are given as number of dollars

per unit of a currency. Thus USD0.4575/DEM is an American quote.

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 10.Direct Quotes: in a country, direct quotes are those that give unit of

the currency of that country per unit of a foreign currency. Thus INR
35.00/USD is a direct quote in India.

11.Indirect Quote: Indirect or Reciprocal Quotes are stated as number of

units of a foreign currency per unit of the home currency. Thus USD
3.9560/INR 100 is an indirect quote in India.

12.Arbitrage: Arbitrage may be defined a san operation that consists in

deriving a profit without risk from a differential existing between

different quoted rates. It may result from 2 currencies, also known as,
geographical arbitrage or from 3 currencies, also known as, triangular
currencies.

II Descriptive questions

1. What is foreign exchange?

In a business setting, there is a fundamental difference between making
payment in the domestic market and making payment abroad. In a domestic
transaction, only one currency is used while in a foreign transaction, two or
more currencies maybe used.
Suppose an U.S importer has agreed to purchase a certain quantity of
Indian spices and to pay the Indian exporter Rs. 1000000 for it. How would he
go about doing this? He would have to pay the amount in dollars, which will be
equivalent to its existing rate in rupees at a decided date. That is why the foreign
exchange market comes into existence so that such transactions become
possible and easier.

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 The special checks and other instruments for making payment abroad are
referred to collectively as foreign exchange. In other words, Foreign exchange
includes currencies and other instruments of payment denominated in
currencies.

2. Elaborate the structure of the foreign exchange market

and compare it with the foreign exchange of India

The major participants in the foreign exchange markets are commercial

banks; foreign exchange brokers and other authorized dealers, and the monetary
authorities. It is necessary to understand that the commercial banks operate at
retail level for individual exporters and corporations as well as at wholesale
levels in the inter – bank market. The foreign exchange brokers involve either
individual brokers or corporations. Bank dealers often use brokers to stay
anonymous since the identity of banks can influence short – term quotes. The
monetary authorities mainly involve the central banks of various countries,
which intervene in order to maintain or influence the exchange rate of their
currencies within a certain range and also to execute the orders of the
government.
It is important to recognize that, although the participants themselves may
be based within the individual countries, and countries may have their own
trading centers, the market itself is world – wide. The trading centers are in
close and continuous contact with one another, and participants will deal in
more than one market.
Primarily, exchange markets function through telephone and telex. Also,
it is important to note that currencies with limited convertibility play a minor

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role in the exchange market. Besides this, only a small number of countries
have established their full convertibility of their currencies for full transactions.

The foreign exchange market in India consists of 3 segments or tires. The

first consists of transactions between the RBI and the authorized dealers. The
latter are mostly commercial banks. The second segment is the interbank market
in which the AD’s deal with each other. And the third segment consists of
transactions between AD’s and their corporate customers.
The retail market in currency notes and travelers cheques caters to
tourists. In the retail segment in addition to the AD’s there are moneychangers,
who are allowed to deal in foreign currencies. The Indian market started
acquiring some depth and features of well functioning market e.g. active market
makers prepared to quote two-way rates only around 1985. Even then 2 - way
forward quotes were generally not available. In the interbank market, forward
quotes were even in the form of near – term swaps mainly for AD’s to adjust
their positions in various currencies.
Apart from the AD’s currency brokers engage in the business of matching
sellers with buyers. In the interbank market collecting a commission from both.
FEDAI rules required that deals between AD’s in the same market centers must
be effected through accredited brokers.

3. Write a note on Inter bank dealing

Primary dealers quote two – way prices and are willing to deal either
side, i.e. they buy and sell the base currency up to conventional amounts at
those prices. However, in interbank markets this is a matter of mutual

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accommodation. A dealer will be shown a two-way quote only if he / she
extends the privilege to fellow dealers when they call for a quote.
Communications between dealers tend to be very terse. A typical spot
transaction would be dealt as follows:
BANK A : “ Bank A calling. Your price on mark – dollar please.”
BANK B : “ Forty forty eight.”
BANK A : “ Ten dollars mine at forty eight.”

Bank A dealer identifies and asks himself for B’s DEM/USD. Bank A is
dealing at 1.4540/1.4548. The first of these, 1.4540, is bank B’s price for buying
USD against DEM or its bid for USD; it will pay DEM 1.4540 for every USD it
buys. The second 1.4548, is its selling or offer price for USD, also called ask
price; it will charge DEM 1.4548 for very USD it sells. The difference between
the two, 0.0008 or 8 points is bank B’s bid – offer or bid – ask spread. It
compensates the bank for costs of performing the market making function
including some profit. Between dealers it is assumed that the caller knows the
big figure, viz. 1.45. Bank B dealer therefore quotes the last two digits (points)
in her bid offer quote viz. 40 – 48.
Bank A dealer whishes to buy dollars against marks and he conveys this
in the third line which really means “ I buy ten million dollars at your offer
price of DEM 1.4548per US dollar.”
Bank B is said to have been “hit” on its offer side. If the bank A dealer
wanted to sell say 5 million dollars, he would instead said “Five dollars yours at
forty”. Bank B would have been “hit” on its bid side.
When a dealer A calls another dealer B and asks for a quote between a
pair of currencies, dealer B may or may not wish to take on the resulting
position on his books. If he does, he will quote a price based on his information
about the current market and the anticipated trends and take the deal on his
books. This is known as “warehousing the deal”. If he does not wish to

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warehouse the deal, he will immediately call a dealer C, get his quote and show
that quote to A. If A does a deal, B will immediately offset it with C. This is
known as “back-to-back” dealing. Normally, back-to-back deals are done when
the client asks for a quote on a currency, which a dealer does not actively trade.
In the interbank market deals are done on the telephone. Suppose bank A
wishes to buy the British pound sterling against the USD. A trader in bank A
might call his counterpart in bank B and asks for a price quotation. If the price
is acceptable they will agree to do the deal and both will enter the details- the
amount bought/sold, the price, the identity of the counter party, etc.-in their
respective banks’ computerized record systems and go to the next transaction.
Subsequently, written confirmations will be sent containing all the details. On
the day of the settlement, bank A will turn over a US dollar deposit to bank B
and B will turn over a sterling deposit to A. The traders are out of the picture
once the deal is agreed upon and entered in the record systems. This enables
them to do deals very rapidly.
In a normal two-way market, a trader expects “to be hit” on both sides of
his quote amounts. That is in the pound – dollar case above. On a normal
business day the trader expects to buy and sell roughly equal amounts of pounds
/ dollars. The bank margin would then be the bid – ask spread.
But suppose in the course of trading the trader finds that he is being hit
on one side of hiss quote much more often than the other side. In the pound –
dollar example this means that he is buying many more pounds that he selling or
vie versa. This leads to a trader building up a position. If he has sold / bough t
more pounds than he has bought/ sold he is said to have a net short position /
long position in pounds. Given the variability of exchange rates, maintaining a
large net short or long position in pounds of 1000000. The pound suddenly
appreciates from say $1.7500 to $1.7520. This implies that the banks liability
increases by $2000 ($0.0020 per pound for 1 million pounds. Of course pound
depreciation would have resulted in a gain. Similarly a net long position leads to

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a loss if it has to be covered at a lower price and a gain if at a higher price. (By
covering a position we mean undertaking transactions that will reduce the net
position to zero. A trader net long in pounds must sell pounds to cover a net
short must buy pounds. A potential gain or loss from a position depends upon
the size of the position and the variability of exchange rates. Building and
carrying such net positions for a long duration would be equivalent to
speculation and banks exercise tight control over their traders to prevent such
activity. This is done by prescribing the maximum size of net positions a trader
can build up during a trading day and how much can be carried overnight.
When a trader realizes that he is building up an undesirable net position
he will adjust his bid ask quotes in a manner designed to discourage on type of
deal and encourage the opposite deal. For instance a trader who has overbought
say DEM against USD, will want to discourage further sellers of marks and
encourage buyers. If his initial quote was say DEM/USD 1.7500 – 1.7510 he
might move it to 1.7508 – 1.7518 i.e offer more marks per USD sold to the bank
and charge more marks per dollar bought from the bank.

Since most of the trading takes place between market making banks, it is
a zero – sum game, i.e. gains made by one trader are reflected in losses made by
another. However when central banks intervene, it is possible for banks as a
group to gain or lose at the expense of the central bank.
Bulk of the trading of the convertible currencies. Takes place against the US
dollar. Thus quotations for Deutschemarks, Swiss Francs, yen, pound sterling
etc will be commonly given against the US dollar. If a corporate customer wants
to buy or sell yen against the DEM, a cross rate will be worked out from the
DEM/USD and JPY/USD quotation. One reason for using a common currency
(called the vehicle currency) for all quotations is to economize on the number of
exchange rates. With 10 currencies 54 two-way quotes will be needed. By using
a common currency to quote against, the number is reduced to 9 or in general n

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– 1ss. Also by this means the possibility of triangular arbitrage is minimized.
However some banks specialize in giving these so called cross rates.

4. Define the value date and classify the transactions into

spot and forward transactions based on value date
A settlement of any transaction takes place by transfers of deposits
between the two parties. The day on which these transactions are effected is
called the settlement date or the value date. To effect the transfers, the banks in
the countries of the two currencies involved must be open for business. The
relevant countries are called settlement locations. The location of the two
banks involved in the trade is dealing locations, which need not be the same as
the settlement locations. When we talk about settlements, they are usually of
the following types:

Cash – T+0
Tom – T+1
Spot – T+2
Forward – T + n

Where T represents the current day when trading takes place and n
represents number of days, usually after two business days but mostly at least
after one month.

• Cash – Cash rate or Ready rate is the rate when the exchange of
currencies takes place on the date of the deal itself. There is no delay in
payment at all, therefore represented by T + 0. When the delivery is made
on the day of the contract is booked, it is called a Telegraphic Transfer or
cash or value – day deal.

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 • Tom – It stands for tomorrow rate, which indicates that the exchange of
currencies takes place on the next working day after the date of the deal,
and therefore represented by T+ 1.

• Spot – When the exchange of currencies takes place on the second day
after the date of the deal (T+2), it is called as spot rate. The spot rate is
the rate quoted for current foreign – currency transactions. It applies to
interbank transactions that require delivery on the purchased currency
within two business days in exchange for immediate cash payment for
that currency.

• Forward – If the exchange of currencies takes place after a certain period

after the date of the deal (more than two working days), it is called
forward rate. The forward rate is a contractual rate between a foreign –
exchange trader and the trader’s client for delivery of foreign currency
sometime in the future, after at least two business days but usually after at
least one month. Standard forward contract maturities are 1,2,3,6, 9, and
12 months.

5. Define arbitrage and explain the different types of

arbitrage.
Sometimes companies deal in foreign exchange to make a profit, even
though the transaction is not connected to any other business purpose, such as
trade flows or investment flows. Usually, however, this type of foreign –
exchange activities is more likely to be persuaded by foreign – exchange traders
and investors. One type of profit – seeking activity is arbitrage, which is the
purchase of foreign currency on one market for immediate resale on another

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market (in a different country) in order to profit from a price discrepancy.
Hence, arbitrage may be defined as an operation that consists in deriving a
profit without risk from a differential existing between different quoted rates. It
may result from two currencies (also known as geographical arbitrage) or from
three currencies (also known as triangular arbitrage).

Interest arbitrage involves investing in foreign – bearing instruments in

foreign exchange in an effort to earn a profit due to interest – rates differentials.
For example, a trader may invest $ 1000 in the United States for ninety days or
convert $1000 into British pounds, invest the money in the United Kingdom for
ninety days and then convert the pounds back into dollars. The investor would
try to pick the alternative that would be the highest yielding at the end of ninety
days.

But Speculation is the buying or the selling of the commodity i.e.

foreign currency, where the activity contains both the element of risk and the
chances of a greater profit. Speculators are important in the foreign –
exchange market because they spot trends and try to take advantage of them.
Thus they can be a valuable source of both supply and demand for a currency.
As a protection against risk, foreign – exchange transactions can be used to
hedge against a potential loss due to an exchange – rate change.

 Spot Quotations:

• Arbitraging between Banks: Though one hears the term “market

rate”, it is not true that all banks will have identical quotes for a given
pair of currencies at a given point of time. The rates will be close to

11
 each other but it may be possible for a corporate customer to save some
money by shopping around.

• Inverse quotes and 2 – point arbitrage: The arbitrage transaction that

involve buying a currency in one market and selling it at a higher price
in another market is called Two – point Arbitrage. Foreign exchange
markets quickly eliminate two – point arbitrage opportunities if and
when they arise.

• Cross rates and 3 – point arbitrage: The term three – point arbitrage
refers to the kind of transaction where one starts with currency A, sell it
for B, sell B for C and finally sell C back for A ending up with more A
than one began with. Efficient foreign exchange markets do not permit
risk - less arbitrage profit of this kind.

Numerical Examples

1. An Arbitrage between two Currencies.

Suppose two traders A and B are quoting the following rates:

Trader A (Paris) Trader B (New York)

FFr 5.5012/US$ US $ 0.1817/FFr

We assume that the buying and selling rates for these traders are the
same. We find out the reciprocal rate of the quote given by the trader B, which
is FFr 5.5036 / US $ (= 1/0.1817) .A combiste buys, say, US $ 10,000 from the

12
trader A by paying FFr 55,012. Then he sells these US $ to trader B and receives
FFr 55,036. in the process he gains FFr 24 (=55,036 - 55,012).

Since, in practice buying and selling rates are likely to be different, so the
quotation is likely to be as follows:

Trader A Trader B

FFr 5.4500/US $ - FFr 5.5012 US $ US $ 0.1785/FFr - US $

0.1817/ FFr

These rates mean that trader A would be willing to buy one unit of US
dollar by paying FFr 5.45 while he would sell one US dollar for FFr 5.501. The
same holds true for the corresponding figures of trader B.

But this process would tend to increase the selling rate at the trader A
because of the increase in demand of US dollars and the reverse would happen
at the trader B because of increased supply of US dollars. This would lead to an
equilibrium after some time.

2.An Arbitrage between three currencies

Suppose two traders, both located at New York are quoting as follows:

Trader A Trader B

$ 0.60/SF $ 0.60/SFr

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 $ 0.51 DM $ 0.52 DM

Since three currencies are involved here, we find the cross rates between
SFr and DM as well. These are:

SFr 0.85/DM (= 0.51/0.60) at the trader A and SFr 0.867/DM (=

0.52/0.60) at the trader B. Thus, the situation looks like as follows:

Trader A Trader B

$ 0.60/SFr $ 0.60/SFr

$ 0.51/DM $ 0.52/DM

SFr 0.85/DM SFr 0.867/ DM

Hence what are the arbitrage possibilities?

There is no arbitrage gain possible between the US $ and the Swiss franc.

The following two arbitrages are, however possible.

 Deutschmarks against the US $ is being quoted at the trader B. So

buy DM’s from the trader A and sell them to trader B.

 Buy DM’s against SFr’s from the trader A and sell them to the
trader B.
6. Examine clearly the different types of forward transactions and describe
discount and premium evaluation in forward quotations.

 Outright forward quotation:

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 Some of the major currencies quoted in the forward market are
Deutschmarks, Pound sterling, Japanese yen, Swiss franc, Canadian dollar etc.
they are generally quoted in terms of US dollars. Currencies may be quoted in
terms of one, three, six months and one year forward. But enterprises may
obtain form banks quotations for different periods.

As mentioned earlier, the spot market is for foreign – exchange

transactions within two business days. However, some transactions maybe
entered into on one day but not completed until after two business days. For
example, a French exporter of perfume might sell perfume to an US importer
with immediate delivery but payment not required for thirty days. The US
importer is obligated to pay in francs in thirty days and may enter into a contract
with a trader to deliver francs in thirty days at a forward rate, a rate today for
future delivery.

Thus the forward rate is the rate quoted by foreign – exchange traders for
the purchase or sale of foreign exchange in the future. The difference between
the spot and the forward rates is known as either the forward discount or the
forward premium on the contract. If the domestic currency is quoted on a direct
basis and the forward rate is greater than the spot rate, the foreign currency is
selling at a premium. It is calculated as follows:

Forward discount/ premium = Forward mid – Spot mid * 12/n * 100

Spot mid

Where n indicates the number of months forward.

When Fwd rate > Spot rate, it implies premium.
Fwd rate < Spot rate, it implies discount.

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In the case of forward market, the arbitrage operates in the differential of
interest rates and the premium or discount on exchange rates.

Numerical problems

1. Spot 1-month 3-months 6-months

(FFr/US$) 5.2321/2340 25/20 40/32 20/26

In outright terms these quotes would be expressed as below:

Maturity Bid/Buy Sell/Offer/Ask Spread

Spot FFr 5.2321 per US $ FFr 5.2340 per US $ 0.0019

1-month FFr 5.2296 per US $ FFr 5.2320 per US $ 0.0024

3-months FFr 5.2281 per US $ FFr 5.2308 per US $ 0.0027

6-months FFr 5.2341 per US $ FFr 5.2366 per US $ 0.0025

It may be noted that in the forward deals of one month and 3 months, US
$ is at discount against the French franc while 6 months forward is at a
premium. The first figure is greater than the second both in one month and three
months forward quotes. Therefore, these quotes are at a discount and
accordingly these points have been subtracted from the spot rates to arrive at
outright rates. The reverse is the case for 6 months forward.

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2. We take an example of a quotation for the US $ against Rupees, given by a
trader in New Delhi.

Spot 1-month 3-months 6-months

Rs 32.1010-Rs32.1100 225/275 300/350 375/455

Spread 0.0090 0.0050 0.0050 0.0080

The outright rates from these quotations will be as follows:

Maturity Bid/Buy Sell/Offer/Ask Spread

Spot Rs 32.1010 per US $ Rs 32.1100 per US $ 0.0090

1-month Rs 32.1235 per US $ Rs 32.1375 per US$ 0.0140

3-months Rs 32.1310 per US $ Rs 32.1450 per US $ 0.0140

6-months Rs 32.1385 per US $ Rs 32.1555 per US $ 0.0170

Here we notice that the US $ is at a premium for all three forward periods.

Also, it should be noted that the spreads in forward rates are always equal
to the sum of the spread of the spot rate and that of the corresponding forward
points.

Numerical problems and solutions

1. On a particular date the following DEM/$ spot quote is

obtained from a bank: -1.6225/35
a) Explain this quotation.

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Ans. The above quotation shows the bid rate and the ask rate of the currencies
in question, the initial figure i.e. 1.6225 being the bid rate and the latter
being the ask rate. Also it shows the number of DEM used to buy or
sell one US dollar i.e. the bank will pay 1.6225 DEM for each US
dollar it buys and will want to be paid 1.6235 DEM for each US dollar
it sells.

b) Compute implied inverse quote.

Ans. When DEM/$ is 1.6225/35, the implied inverse quote is:
$/DEM becomes 0.6159/63
(1/1.6235 = 0.6159 and 1/ 1.6225 = 0.6163)

c) Another bank quoted $/DEM 0.6154/59. Is there an

arbitrage? If so how would it work?
Ans. Suppose Bank A quotes $/DEM 0.6154/59 and Bank B quotes $/DEM
0.6159/63. There is no arbitrage opportunity since the main purpose of
doing an arbitrage is making a profit without any risk or commitment
of capital. This doesn’t exist in the given case as a potential buyer
would end up buying a DEM at 0.6159 $ from Bank A and would have
to sell it to Bank B at the same price since that would be the only way
of not making any losses. It is clear form the diagram shows that shows
no arbitrage is possible:

$/DEM 0.6154 59 63

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 Bank A Bank B

2. The following quotes are obtained from the banks:

Bank A Bank B
FFr/$ spot 4.9570/80 4.9578/90

a) Is there an arbitrage opportunities

Ans. There is no arbitrage opportunity in this case. This can be
represented diagrammatically as:

FFr/$ 4.9570 78 80 90

Bank A
Bank B

The quotes are overlapping each other hence preventing an

arbitrage. The buyer will go into a loss if he buys from bank A at 4.9580 FFr
since he would have to sell it to bank B for 4.9578 FFr undergoing a loss of
0.0002 FFr.

b) What kind of market will it result into?

Ans. This will result into a one – way market.

c) What might be the reason for this?

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 Ans. A one – way market may be created when a bank wants to either
encourage the seller of dollars and discourage buyers or vice – versa. In
this case, Bank A wants to encourage buyers of dollars and discourage
sellers of the same thus creating a net long positioning dollars. At the
same time Bank B wants to encourage the sellers of dollars and
discourage buyers thus creating a net short position in dollars. Hence the
outcome would be that Bank A will be confronted largely with buyers of
US dollars and few sellers while for Bank B the reverse case will hold
true. Eventually, it would mean that regular clients of Bank B wanting to
buy dollars can save some money by going to Bank A and vice – versa.

3. In London a dealer quotes: DEM/ GPB spot 3.5250/55

JPY/ GPB spot 180.0080/181.0030
a) What do you expect the JPY/ DEM rate to be in Frankfurt?
Ans. In London: DEM/ GPB spot 3.5250/55
JPY/ GPB spot 180.0080/181.0030
Therefore, JPY/ DEM = B1 A1 [where B1 - 180.0080
A2 B2 A1 – 181.0030
B2 - 3.5250
A2 – 3.5255]
= 180.0080 181.0030
3.5255 3.5250

= 51.0588 / 51.3483 JPY/ DEM

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 It is assumed that the JPY/ DEM rate in Frankfurt will also approximately
be the same as in London. Therefore, the JPY/ DEM rate in Frankfurt is
51.0588 / 51.3483.

b) Suppose that in Frankfurt you get a quote: JPY/ DEM spot

51.1530/ 51.2250.
Is there an arbitrage opportunity?
Ans. When in London: JPY/ DEM 51.0588 / 51.3483 and
In Frankfurt: JPY/ DEM 51.1530/ 51.2250
There is no arbitrage opportunity as the quotes overlap each other and the
buyer will stand to make a loss. If he buys in Frankfurt where 1 DEM is
51.2250 JPY and sells it in London for 51.0588 JPY, he makes a loss of
0.1662JPY. Diagrammatically it can be represented as:

JPY/ DEM 51.0588 .1530 .2250 .3483

Frankfurt

London

4. The following quotes are obtained in New York: DEM/$

spot 1.5880/ 90
1- month forward 10/ 5
2- month forward 20/ 10
3- month forward 30/ 15

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 Calculate the outright forward rates.
Ans. While observing the forward quotations, it is clear that the US dollar is
at discount in the forward market since the points corresponding to the
bid price are higher than those corresponding to the ask price.
Therefore, the forward points will be subtracted form the spot rate
figure. Thus, the outright rates are:

DEM/$ spot - 1.5880/ 90

1 – month forward - 1.5870/ 85
2 – month forward - 1.5860/ 80
3 – month forward - 1.5850/ 75

Text Book Questions

The Foreign
Exchange Market
I. Explain the following terms:

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 1. Bid rate: The bid rate denotes the number of units of a currency a bank

is willing to pay when it buys another currency.

2. Offer rate: The offer rate denotes the number of units of a currency a

bank will want to be paid when it sells a currency

3. Bid offer spread: The difference between the ask and bid rates. E.g.

[(DEM/USD)ask – (DEM/USD)bid]

4. Value date: The settlement of a transaction takes place by transfers of

deposits between two parties. The day on which these transfers are
effected is called the Settlement Date or the Value Date.

5. Swap transaction: A swap transaction in the foreign exchange market

is combination of a spot and a forward in the opposite direction. Thus a

bank will buy DEM spot against USD and simultaneously enter into a
forward transaction with the same counter party to sell DEM against USD
against the mark coupled with a 60- day forward sale of USD against the
mark. As the term ‘swap’ implies, it is a temporary exchange of one
currency for another with an obligation to reverse it at a specific future
date.

II Explain the terms:

a) European quotes: The quotes are given as number of units of a currency

per USD. Thus DEM1.5675/USD is a European quote.

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b) American quotes: American quotes are given as number of dollars per

unit of a currency. Thus USD0.4575/DEM is an American quote

c) Direct quotes: In a country, direct quotes are those that give unit of the
currency of that country per unit of a foreign currency. Thus INR 35.00/USD
is a direct quote in India.

d) Indirect quotes: Indirect or Reciprocal Quotes are stated as number of

units of a foreign currency per unit of the home currency. Thus USD
3.9560/INR 100 is an indirect quote in India.

e) On a particular day at 11.00 am, the following DEM/$ spot

quote is obtained from a bank 1.6225/35.
a). Explain this quotation.
Ans. The above quotation shows the bid rate and the ask rate of the currencies
in question, the initial figure i.e. 1.6225 being the bid rate and the latter being
the ask rate. Also it shows the number of DEM used to buy or sell one US
dollar i.e. the bank will pay 1.6225 DEM for each US dollar it buys and will
want to be paid 1.6235 DEM for each US dollar it sells.

b) Compute implied inverse quote.

Ans. When DEM/$ is 1.6225/35, the implied inverse quote is:

$/DEM becomes 0.6159/63
(1/1.6235 = 0.6159 and 1/ 1.6225 = 0.6163)

c). Another bank quoted $/DEM 0.6154/59. Is there an

arbitrage? If so how would it work?

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Ans. Suppose Bank A quotes $/DEM 0.6154/59 and Bank B quotes $/DEM
0.6159/63. There is no arbitrage opportunity since the main purpose of doing an
arbitrage is making a profit without any risk or commitment of capital. This
doesn’t exist in the given case as a potential buyer would end up buying a DEM
at 0.6159 $ from Bank A and would have to sell it to Bank B at the same price
since that would be the only way of not making any losses. It is clear form the
diagram shown below that shows no arbitrage is possible:

$/DEM 0.6154 59 63
Bank A Bank B

III. The following quotes are obtained from the banks:

Bank A Bank B
FFr/$ spot 4.9570/80 4.9578/90

a) Is there an arbitrage opportunities

Ans. There is no arbitrage opportunity in this case. This can be
represented diagrammatically as:

FFr/$ 4.9570 78 80 90

Bank A
Bank B
The quotes are overlapping each other hence preventing an arbitrage. The buyer
will go into a loss if he buys from bank A at 4.9580 FFr since he would have to
sell it to bank B for 4.9578 FFr undergoing a loss of 0.0002 FFr.

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 b) What kind of market will it result into?
Ans. This will result into a one – way market.

c) What might be the reason for this?

Ans. A one – way market may be created when a bank wants to either
encourage the seller of dollars and discourage buyers or vice – versa. In this
case, Bank A wants to encourage buyers of dollars and discourage sellers of
the same thus creating a net long positioning dollars. At the same time Bank
B wants to encourage the sellers of dollars and discourage buyers thus
creating a net short position in dollars. Hence the outcome would be that
Bank A will be confronted largely with buyers of US dollars and few sellers
while for Bank B the reverse case will hold true. Eventually, it would mean
that regular clients of Bank B wanting to buy dollars can save some money
by going to Bank A and vice – versa.

IV. The buyer rate for SFr spot in New York is $ 0.5910. A
corporate treasurer is going to buy SFr in Zurich at SFr/$ 1.6650
and sell them in New York. Will he make a profit? If yes, then
how much?
Ans. The steps involved in this process are as follows:
i. Buys 1.6650SFr at Zurich by paying 1$
ii. Sells 1.6650 SFr at New York and gets 0.9840$ [0.5910*1.6650]
Thus, gives 1$ and gets 0.9840$.
Therefore loss inculcated is $0.016.

V. In London a dealer quotes: DEM/ GPB spot 3.5250/55 JPY/

GPB spot 180.80/181. 30
a) What do you expect the JPY/ DEM rate to be in Frankfurt?

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Ans. In London: DEM/ GPB spot 3.5250/55
JPY/ GPB spot 180.80/181.30
Therefore, JPY/ DEM = B1 A1 [where B1 - 180.80
A2 B2 A1 – 181.30
B2 - 3.5250
A2 – 3.5255]
= 180.80 181.30
3.5255 3.5250
= 51.2835/ 51.4326 JPY/ DEM
It is assumed that the JPY/ DEM rate in Frankfurt will also approximately be
the same as in London. Therefore, the JPY/ DEM rate in Frankfurt is 51.2835/
51.4326

b) Suppose that in Frankfurt you get a quote: JPY/ DEM spot

51.1530/ 51.2250.
Is there an arbitrage opportunity?
Ans. When in London A: JPY/ DEM 51. 2835/ 51.4326 and
In Frankfurt B: JPY/ DEM 51.1530/ 51.2250
There exist an arbitrage opportunity, buy from the dealer from Frankfurt
at 51.2550JPY and sell it to the dealer in London at 51.2835JPY making
a profit of 0.0285JPY/DEM without any risk of commitment of capital.
It can be shown as :
At B + DEM -51.2550 JPY
At A -DEM +51.2835 JPY
i. +0.0285JPY

Another arbitrage that is possible is shown as under:

At A buy DEM i.e. –DEM +51.2835 JPY
At B +x -51.2550 JPY

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 X = 51.2835/51.2550 = 1.0006 DEM
Therefore, arbitrage of 0.0006 DEM is possible.

VI. The following quotes are obtained in New York: $/GPB =

1.5275/85
SFr/ $ = 1.5530/35
a. what rates do you expect for SFr/ GPB spot in London?
Ans. In New York $/GPB = 1.5275/85
And SFr/$ =1.5530/35
Therefore GPB/$ =0.6542/0.6547
Also in New York:
SFr/GPB =B1 B2
A2 A1
=1.5275 1.5285
0.6547 0.6542

1. Therefore SFr/GPB = 2.3720/2.3746

It is assumed that the spot rate in London will approximately same as that in
New York. Therefore, in London SFr/GPB spot is assumed to be
2.3720/2.3746.

b. If a London bank quotes 2.3730/40, can you make

arbitrage profits? If so, then how?

Ans. In London SFr/GPB 2.3730/40

In New York SFr/GPB 2.3720/2.3746
In this case, an arbitrage opportunity does not exist. It is clearly
seen below in the diagram:

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 SFr/GPB 2.3720 3730 3740 3746

London
New York

VII. The following quotes are obtained in New York: DEM/$ spot
1.5880/ 90
1- month forward 10/ 5
2- month forward 20/ 10
3- month forward 30/ 15
Calculate the outright forward rates.
Ans. While observing the forward quotations, it is clear that the
US dollar is at discount in the forward market since the points
corresponding to the bid price are higher than

VIII The following quotes are available in Amsterdam:

$/DG spot :0.5875/85
1- month fwd :12/18
2-month fwd :15/25
3- month fwd :20/30
Calculate the outright forward.
Ans. An observation of the figures indicates that the first figure is lower
than the second in all the three forward quotes, implying DG is quoted
at premium in the forward market.
Thus, the points will be added to the corresponding spot
rates. The rates are calculated as shown:
$/DG spot :0.5875/58
1-month fwd :0.5887/0.5903

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 2-month fwd :0.5890/0.5910
3-month fwd :0.5895/0.5915
those corresponding to the ask price. Therefore, the forward points will be
subtracted form the spot rate figure. Thus, the outright rates are:

DEM/$ spot - 1.5880/ 90

1 – month forward - 1.5870/ 85
2 – month forward - 1.5860/ 80
3 – month forward - 1.5850/ 75

International Finance
The Foreign Exchange Market
TYBMS
St. Andrew’s College
Roll. No Name
06 Sowmiya Bhas
08 Jemaya D’cunha
28 Malcolm Pinto
33 Priyanka Sawant
38 Nearose Soares

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