The Foreign Exchange Market

Concepts
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 ! working days", it is called a forward rate. # trader may $uote 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 $uantity of a stated foreign currency at the rate of exchange fixed at the time of making the contract.

4. Swap Transaction: # swap transaction in the foreign exchange market is combination of a spot and a forward in the opposite direction. Thus a bank will buy D&' spot against (SD and simultaneously enter into a forward transaction with the same counter party to sell D&' against (SD against the mark coupled with a )*+ day forward sale of (SD against the mark. #s the term ,swap- implies, it is a temporary exchange of one currency for another with an obligation to re.erse 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. O er Rate: The offer rate denotes the number of units of a currency a bank will want to be paid when it sells a currency. !. Bid " O er Rate: The bid offer /ate 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. 0id and #sk will always be from a bank-s point of .iew. Thus #10"bid will denote the number of units of # the bank will pay when it buys one unit of 0 and #10"ask will mean the number of units of # the bank will want to be paid in order to sell one unit of 0. #. $uropean %uote: The $uotes are gi.en as number of units of a currency per (SD. Thus D&'%.2)321(SD is a &uropean $uote.

&. '(erican %uotes: #merican $uotes are gi.en as number of dollars per unit of a currency. Thus (SD*.42321D&' is an #merican $uote. 1).Direct %uotes5 In a country, direct $uotes are those that gi.e unit of the currency of that country per unit of a foreign currency. Thus I6/ 72.**1(SD is a direct $uote in India. 11.*ndirect %uote: Indirect or /eciprocal 8uotes are stated as number of units of a foreign currency per unit of the home currency. Thus (SD 7.92)*1I6/ %** is an indirect $uote in India. 12.'r+itra,e: #rbitrage may be defined a san operation that consists in deri.ing a profit without risk from a differential existing between different $uoted rates. It may result from ! currencies, also known as, geographical arbitrage or from 7 currencies, also known as, triangular currencies.

Descriptive questions
1.-.at is orei,n e/c.an,e (ar0et1 $/plain t.e unctions. 'nswer: 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. The foreign exchange market is the market in which currencies are brought and sold against each other it is the largest market in the world. The foreign exchange market also known, as forex market is an o.er+the+ counter market, this means that there is no single market place or an organi:ed exchange like a stock exchange. The traders sit in the foreign exchange dealing room of ma;or commercial banks around the world, they communicate with each other through telephone telex computer terminals and other electronic menace of communication. They are four main participants in the foreign exchange market. %. 0roker !. 0ankers 7. <orporations 4. <entral bank. Bankers5 large commercial banks operating either at retail le.el for indi.idual exporters and corporations or at wholesale le.el in the Inter0ank market.

Central bank5 central banks of .arious countries that inter.ene in order to maintain or to influence the exchange rate of their currencies within a certain range as also to execute the orders of go.ernment. Individual brokers or corporations5 bank dealers often used brokers to stay anonymous since the identity of banks can influence short+term course.

Foreign Exchange Flow

&xports <orporations

0roker

0ank

0roker

0ank

0roker

<orporations

Imports

2.$la+orate t.e structure o t.e orei,n e/c.an,e (ar0et and co(pare it wit. t.e orei,n e/c.an,e o *ndia 'nswer: The =oreign exchange market may be broadly classified into +5 Wholesale market and Retail market .

F O R E IG

E ! " H A

G E M A R K E T

W H O L E SA L E M A R K E T

R E T A IL M A R K E T

W>?@&S#@& '#/A&T primary price maker" The wholesale market is also referred to as interbank market the a.erage transaction si:e in this market is .ery small. Participants: Commercial banks, Corporations and Central bank Among these participants, primary price maker or professional dealer make a two way market to each other B their clients, i.e. on re$uest they will $uote a two+way price B be prepared to take either the buy or sell side .This group mainly include commercial bank but some large in.estment dealer B a few large corporation ha.e also assumed the role of primary dealers. Crimary price makers perform an important role in taking positions off the hands of another dealer or corporate customer B then offsetting these by doing an opposite deal with another entity which has a matching re$uirement.

Among #rimar$ #rice maker there is a kin% o& tiering '

MULTINATIONAL BANK

(deal in large number of currencies & in large amount without using broker )

LARGE BANKS
deal in small number of currencies B use the ser.ices of broker "

LOCAL INSTITUTION

market in a small number of ma;or currencies against home currency " /&T#I@ '#/A&T Secondary price maker " It is the market in which tra.elers B tourists exchange one currency for another in the form of currency notes B tra.eler-s che$ues. Total turno.er B transaction si:e is .ery small. The bid+ask spread is large. The secondary price maker make foreign exchange prices but do not make a two way market . =oreign currency brokers =oreign currency brokers act as middlemen between two market makers. Their main function is to pro.ide information to market making banks about

prices at which there are firm buyers B sellers in a pair of currencies. The broker hunts around for an appropriate counterparty Eanother bank + B collects commission on conclusion of deal. 0anks may also use brokers to ac$uire information about the general state of the market e.en when they do not ha.e a specific deal in mind. The important thing is brokers do not sell or buy on their own account. Crice takers Crice takers are those take the prices $uoted by primary price makers B buy or sell currencies for their own purposes but do not make a market themsel.es. @arge corporations are the price taker who use the foreign exchange market for a .ariety of purposes related to their operations. They do not take acti.e positions in the market to profit from exchange rate fluctuations. <entral bank <entral bank of .arious countries such as /0I in India" inter.ene in the market from time to time to attempt to mo.e exchange rates in a particular direction. In case of limited flexibility systems like &'S, these inter.entions are obligatory when inter.entions are reached. In other cases though there is no commitment to defend any particular rate, a central bank may still inter.ene to influence market sentiment. The str(ct(re o& &oreign exchange market in In%ia The foreign exchange market in India may broadly said to ha.e 7 segments or layers )* =irst layer consists of the "entral +ank i.e. R,I - the A(thori.e% %ealers /A0s1. #Ds are mostly commercial banks B=inancial institutions such as ID0I, I<I<I B the tra.el agent like Thomas cook.

Second layer is the inter +ank segment in which #Ds deal with each other. Third layer is in which #Ds deal with their cor#orate c(stomers . In retail market in addition to #Ds there are moneychangers who are allowed to deal in foreign currencies. =ull fledged money changers are allowed to buy B sell foreign currency B restricted money changers are allowed only to buy. The daily turn o.er in the foreign exchange market is currently estimated to be between (S F %.2+ 7 billion. The most important centre is 'umbai whereas other acti.e centres are Delhi, <alcutta, <hennai, <ochin B 0angalore Indian market also has accredited brokers who match buyers B sellers. =&D#I i.e. =oreign &xchange Dealer-s #ssociation of India has made it mandatory to route deals between two #Ds through brokers .

7.-rite a note on *nter +an0 dealin, #nswer5 Crimary dealers $uote two E way prices and are willing to deal either side, i.e. they buy and sell the base currency up to con.entional amounts at those prices. >owe.er, in interbank markets this is a matter of mutual accommodation. # dealer will be shown a two+way $uote only if he 1 she extends the pri.ilege to fellow dealers when they call for a $uote. <ommunications between dealers tend to be .ery terse. # typical spot transaction would be dealt as follows5 0#6A # 5 G 0ank # calling. Hour price on mark E dollar please.I

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0#6A 0 5 G =orty forty eight.I 0#6A # 5 G Ten dollars mine at forty eight.I 0ank # dealer identifies and asks himself for 0-s D&'1(SD. 0ank # is dealing at %.424*1%.424D. The first of these, %.424*, is bank 0-s price for buying (SD against D&' or its bid for (SDJ it will pay D&' %.424* for e.ery (SD it buys. The second %.424D, is its selling or offer price for (SD, also called ask priceJ it will charge D&' %.424D for .ery (SD it sells. The difference between the two, *.***D or D points is bank 0-s bid E offer or bid E ask spread. It compensates the bank for costs of performing the market making function including some profit. 0etween dealers it is assumed that the caller knows the big figure, .i:. %.42. 0ank 0 dealer therefore $uotes the last two digits points" in her bid offer $uote .i:. 4* E 4D. 0ank # dealer whishes to buy dollars against marks and he con.eys this in the third line which really means G I buy ten million dollars at your offer price of D&' %.424Dper (S dollar.I 0ank 0 is said to ha.e been GhitI on its offer side. If the bank # dealer wanted to sell say 2 million dollars, he would instead said G=i.e dollars yours at fortyI. 0ank 0 would ha.e been GhitI on its bid side. When a dealer # calls another dealer 0 and asks for a $uote between a pair of currencies, dealer 0 may or may not wish to take on the resulting position on his books. If he does, he will $uote 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 Gwarehousing the dealI. If he does not wish to warehouse the deal, he will immediately call a dealer <, get his $uote and show that $uote to #. If # does a deal, 0 will immediately offset it with <. This is known as Gback+to+
%%

backI dealing. 6ormally, back+to+back deals are done when the client asks for a $uote on a currency, which a dealer does not acti.ely trade. In the interbank market deals are done on the telephone. Suppose bank # wishes to buy the 0ritish pound sterling against the (SD. # trader in bank # might call his counterpart in bank 0 and asks for a price $uotation. If the price is acceptable they will agree to do the deal and both will enter the details+ the amount bought1sold, the price, the identity of the counter party, etc.+in their respecti.e banks- computeri:ed record systems and go to the next transaction. Subse$uently, written confirmations will be sent containing all the details. ?n the day of the settlement, bank # will turn o.er a (S dollar deposit to bank 0 and 0 will turn o.er a sterling deposit to #. 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 .ery rapidly. In a normal two+way market, a trader expects Gto be hitI on both sides of his $uote amounts. That is in the pound E dollar case abo.e. ?n a normal business day the trader expects to buy and sell roughly e$ual amounts of pounds 1 dollars. The bank margin would then be the bid E ask spread. 0ut suppose in the course of trading the trader finds that he is being hit on one side of hiss $uote much more often than the other side. In the pound E dollar example this means that he is buying many more pounds that he selling or .ie .ersa. This leads to a trader building up a position. If he has sold 1 bough t more pounds than he has bought1 sold he is said to ha.e a net short position 1 long position in pounds. Ki.en the .ariability of exchange rates, maintaining a large net short or long position in pounds of %******. The pound suddenly appreciates from say F%.32** to F%.32!*. This implies that the banks liability increases by F!*** F*.**!* per pound for % million pounds. ?f course pound
%!

depreciation would ha.e resulted in a gain. Similarly a net long position leads to a loss if it has to be co.ered at a lower price and a gain if at a higher price. 0y co.ering a position we mean undertaking transactions that will reduce the net position to :ero. # trader net long in pounds must sell pounds to co.er a net short must buy pounds. # potential gain or loss from a position depends upon the si:e of the position and the .ariability of exchange rates. 0uilding and carrying such net positions for a long duration would be e$ui.alent to speculation and banks exercise tight control o.er their traders to pre.ent such acti.ity. This is done by prescribing the maximum si:e of net positions a trader can build up during a trading day and how much can be carried o.ernight. When a trader reali:es that he is building up an undesirable net position he will ad;ust his bid ask $uotes in a manner designed to discourage on type of deal and encourage the opposite deal. =or instance a trader who has o.erbought say D&' against (SD, will want to discourage further sellers of marks and encourage buyers. If his initial $uote was say D&'1(SD %.32** E %.32%* he might mo.e it to %.32*D E %.32%D i.e offer more marks per (SD 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 :ero E sum game, i.e. gains made by one trader are reflected in losses made by another. >owe.er when central banks inter.ene, it is possible for banks as a group to gain or lose at the expense of the central bank. 0ulk of the trading of the con.ertible currencies. Takes place against the (S dollar. Thus $uotations for Deutschemarks, Swiss =rancs, yen, pound sterling etc will be commonly gi.en against the (S dollar. If a corporate customer wants to buy or sell yen against the D&', a cross rate will be worked out from the D&'1(SD and LCH1(SD $uotation. ?ne reason for using a common currency called the .ehicle currency" for all $uotations is to economi:e on the number of
%7

exchange rates. With %* currencies 24 two+way $uotes will be needed. 0y using a common currency to $uote against, the number is reduced to 9 or in general n E %ss. #lso by this means the possibility of triangular arbitrage is minimi:ed. >owe.er some banks speciali:e in gi.ing these so called cross rates.

4.De ine t.e 2alue date and classi 3 t.e transactions into spot and orward transactions +ased on 2alue date 'nswer: 2al(e 0ate5 # 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. Settlement location: To effect the transfers, the banks in the countries of the two currencies in.ol.ed must be open for business. The rele.ant countries are called settlement locations. 0ealing locations: The location of the two banks in.ol.ed in the trade is dealing locations which need not be the same as the settlement locations. <lassification of transaction based on .alue date
T$#es o& transaction

<ash E T M *

Tom E T M%

Spot E T M !

=orward E TM7

<ash E Where T represents the current day when trading takes place and n represents number of days. "ash E <ash rate or /eady 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 M *. When the deli.ery is made
%4

on the day of the contract is booked, it is called a Telegraphic Transfer or cash or .alue E day deal. Tom E 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 TM %. S#ot E When the exchange of currencies takes place on the second day after the date of the deal TM!", it is called as spot rate. The spot rate is the rate $uoted for current foreign E currency transactions. It applies to interbank transactions that re$uire deli.ery on the purchased currency within two business days in exchange for immediate cash payment for that currency. =or e. g. a @ondon bank sells yen against dollar to a Caris bank on 'onday, %st march, the @ondon bank will turn o.er yen deposit in Lapan to the Caris bank on Wednesday and the Caris bank will turn o.er F deposit in (S to the @ondon bank on same day i. e. 7 rd march, Wednesday. If the 7rd march is holiday in any bank in dealing location or settlement location deposit will takes place on next business day. For3ar% EThe forward rate is a contractual rate between a foreign E exchange trader and the trader-s client for deli.ery of foreign currency sometime in the future. >ere rate of transaction is fixed on transaction date for transactions in future. Standard forward contract maturities are %,!,7,), 9, and %! months. e. g. % month forward purchase of pounds against dollars on %st Lan. Value date is arri.ed as follows5 Value date for spot transaction5 7rd Lan.

%2

Value date for forward transaction5 7rd Lan M % calendar month N 7rd =eb If the 7rd =eb. is holiday in any bank in dealing location or settlement location deposit will takes place on next business date. 0ut this must not take you for next month, for e. g. if .alue date is =eb !D is .alue date and it is ineligible your cannot shift it to %st 'arch it must be rolled back to =eb !3. Swap5 # swap transactions in the foreign exchange market is combination of spot and forward transaction. Thus a bank will buy deutchemarks spot against (S dollar and simultaneously enter into forward transaction with the same counterparty to sell deutchemarks against (S dollar.

2.De ine ar+itra,e and e/plain t.e di erent t3pes o ar+itra,e.

#nswer5 Sometimes companies deal in foreign exchange to make a profit, e.en though the transaction is not connected to any other business purpose, such as trade flows or in.estment flows. (sually, howe.er, this type of foreign E exchange acti.ities is more likely to be persuaded by foreign E exchange traders and in.estors. ?ne type of profit E seeking acti.ity is arbitrage, which is the purchase of foreign currency on one market for immediate resale on another market in a different country" in order to profit from a price discrepancy. >ence, arbitrage may be defined as an operation that consists in deri.ing a profit without risk from a differential existing between different $uoted rates. It may result from two currencies also known as geographical arbitrage" or from three currencies also known as triangular arbitrage".

%)

Interest arbitrage in.ol.es in.esting in foreign E bearing instruments in foreign exchange in an effort to earn a profit due to interest E rates differentials. =or example, a trader may in.est F %*** in the (nited States for ninety days or con.ert F%*** into 0ritish pounds, in.est the money in the (nited Aingdom for ninety days and then con.ert the pounds back into dollars. The in.estor would try to pick the alternati.e that would be the highest yielding at the end of ninety days. 0ut !peculation is the buying or the selling of the commodity i.e. foreign currency, where the acti.ity contains both the element of risk and the chances of a greater profit. Speculators are important in the foreign E exchange market because they spot trends and try to take ad.antage of them. Thus they can be a .aluable source of both supply and demand for a currency. #s a protection against risk, foreign E exchange transactions can be used to hedge against a potential loss due to an exchange E rate change.

S#ot 4(otations) Ar+itraging +et3een ,anks5 Though one hears the term Gmarket rateI, it is not true that all banks will ha.e identical $uotes for a gi.en pair of currencies at a gi.en point of time. The rates will be close to each other but it may be possible for a corporate customer to sa.e some money by shopping around.

In5erse 6(otes an% 7 ' #oint ar+itrage 5 The arbitrage transaction that in.ol.e buying a currency in one market and selling it at a higher price in another market is called "wo # point Arbitrage. =oreign exchange

%3

markets $uickly eliminate two E point arbitrage opportunities if and when they arise. "ross rates an% 8 ' #oint ar+itrage5 The term three # point arbitrage refers to the kind of transaction where one starts with currency #, sell it for 0, sell 0 for < and finally sell < back for # ending up with more # than one began with. &fficient foreign exchange markets do not permit risk + less arbitrage profit of this kind.

(merical Exam#les $. An Arbitrage between two Currencies. Suppose two traders # and 0 are $uoting the following rates5 Trader # Caris" Trader 0 6ew Hork" ==r 2.2*%!1(SF (S F *.%D%31==r We assume that the buying and selling rates for these traders are the same. We find out the reciprocal rate of the $uote gi.en by the trader 0, which is ==r 2.2*7) 1 (S F N %1*.%D%3" .# combiste buys, say, (S F %*,*** from the trader # by paying ==r 22,*%!. Then he sells these (S F to trader 0 and recei.es ==r 22,*7). in the process he gains ==r !4 N22,*7) + 22,*%!". Since, in practice buying and selling rates are likely to be different, so the $uotation is likely to be as follows5 Trader # Trader 0
%D

==r 2.42**1(S F + ==r 2.2*%! (S F (S F *.%3D21==r + (S F *.%D%31 ==r These rates mean that trader # would be willing to buy one unit of (S dollar by paying ==r 2.42 while he would sell one (S dollar for ==r 2.2*%. The same holds true for the corresponding figures of trader 0. 0ut this process would tend to increase the selling rate at the trader # because of the increase in demand of (S dollars and the re.erse would happen at the trader 0 because of increased supply of (S dollars. This would lead to an e$uilibrium after some time. %.An Arbitrage between three currencies Suppose two traders, both located at 6ew Hork are $uoting as follows5 Trader # Trader 0 F *.)*1S= F *.)*1S=r F *.2% D' F *.2! D' Since three currencies are in.ol.ed here, we find the cross rates between S=r and D' as well. These are5 S=r *.D21D' N *.2%1*.)*" at the trader # and S=r *.D)31D' N *.2!1*.)*" at the trader 0. Thus, the situation looks like as follows5 Trader # Trader 0 F *.)*1S=r F *.)*1S=r F *.2%1D' F *.2!1D'

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S=r *.D21D' S=r *.D)31 D' >ence what are the arbitrage possibilitiesO There is no arbitrage gain possible between the (S F and the Swiss franc. The following two arbitrages are, howe.er possible. a. Deutschmarks against the (S F is being $uoted at the trader 0. So buy D'-s from the trader # and sell them to trader 0. b. 0uy D'-s against S=r-s from the trader # and sell them to the trader 0.

6. &xamine clearly the different types of forward transactions and describe discount and premium e.aluation in forward $uotations. O(tright &or3ar% 6(otation) Some of the ma;or currencies $uoted in the forward market are Deutschmarks, Cound sterling, Lapanese yen, Swiss franc, <anadian dollar etc. they are generally $uoted in terms of (S dollars. <urrencies may be $uoted in terms of one, three, six months and one year forward. 0ut enterprises may obtain form banks $uotations for different periods. #s mentioned earlier, the spot market is for foreign E exchange transactions within two business days. >owe.er, some transactions maybe entered into on one day but not completed until after two business days. =or example, a =rench exporter of perfume might sell perfume to an (S importer with immediate deli.ery but payment not re$uired for thirty days. The (S importer is obligated

!*

to pay in francs in thirty days and may enter into a contract with a trader to deli.er francs in thirty days at a forward rate, a rate today for future deli.ery. Thus the forward rate is the rate $uoted by foreign E exchange traders for the purchase or sale of foreign exchange in the future. "he 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 $uoted 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 follows5 For3ar% %isco(nt9 #remi(m : For3ar% mi% ' S#ot mi% ; <79n ; <== S#ot mi% Where n indicates the number of months forward. When =wd rate P Spot rate, it implies premium. =wd rate Q Spot rate, it implies discount. In the case of forward market, the arbitrage operates in the differential of interest rates and the premium or discount on exchange rates. (merical #ro+lems %. Spot %+month 7+months )+months ==r1(SF" 2.!7!%1!74* !21!* 4*17! !*1!) In outright terms these $uotes would be expressed as below5 'aturity 0id10uy Sell1?ffer1#sk Spread Spot ==r 2.!7!% per (S F ==r 2.!74* per (S F *.**%9
!%

%+month ==r 2.!!9) per (S F ==r 2.!7!* per (S F *.**!4 7+months ==r 2.!!D% per (S F ==r 2.!7*D per (S F *.**!3 )+months ==r 2.!74% per (S F ==r 2.!7)) per (S F *.**!2 It may be noted that in the forward deals of one month and 7 months, (S F is at discount against the =rench franc while ) months forward is at a premium. The first figure is greater than the second both in one month and three months forward $uotes. Therefore, these $uotes are at a discount and accordingly these points ha.e been subtracted from the spot rates to arri.e at outright rates. The re.erse is the case for ) months forward. !. We take an example of a $uotation for the (S F against /upees, gi.en by a trader in 6ew Delhi. Spot %+month 7+months )+months /s 7!.%*%*+/s7!.%%** !!21!32 7**172* 7321422 Spread *.**9* *.**2* *.**2* *.**D* The outright rates from these $uotations will be as follows5 'aturity 0id10uy Sell1?ffer1#sk Spread Spot /s 7!.%*%* per (S F /s 7!.%%** per (S F *.**9* %+month /s 7!.%!72 per (S F /s 7!.%732 per (SF *.*%4* 7+months /s 7!.%7%* per (S F /s 7!.%42* per (S F *.*%4* )+months /s 7!.%7D2 per (S F /s 7!.%222 per (S F *.*%3* >ere we notice that the (S F is at a premium for all three forward periods.
!!

#lso, it should be noted that the spreads in forward rates are always e$ual to the sum of the spread of the spot rate and that of the corresponding forward points. 4u(erical pro+le(s and solutions 1. On a particular date t.e ollowin, D$567 spot 8uote is o+tained ro( a +an0: "1.6225635 a9 $/plain t.is 8uotation. in $uestion, the initial figure i.e. %.)!!2 being the bid rate and the latter being the ask rate. #lso it shows the number of D&' used to buy or sell one (S dollar i.e. the bank will pay %.)!!2 D&' for each (S dollar it buys and will want to be paid %.)!72 D&' for each (S dollar it sells. #ns. The abo.e $uotation shows the bid rate and the ask rate of the currencies

+9

:o(pute i(plied in2erse 8uote. F1D&' becomes *.)%291)7 %1%.)!72 N *.)%29 and %1 %.)!!2 N *.)%)7"

#ns. When D&'1F is %.)!!2172, the implied in.erse $uote is5

c9

'not.er +an0 8uoted 76D$5 ).615465&. *s t.ere an ar+itra,e1 * so .ow would it wor01

#ns. Suppose 0ank # $uotes F1D&' *.)%24129 and 0ank 0 $uotes F1D&' *.)%291)7. 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 gi.en case as a potential buyer would end up buying a D&' at *.)%29 F from 0ank # and would ha.e

!7

to sell it to 0ank 0 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 possible5 F1D&' *.)%24 0ank # 29 0ank 0 )7

2. T.e ollowin, 8uotes are o+tained ro( t.e +an0s: Ban0 ' FFr67 spot i. 4.&5!)6#) Ban0 B 4.&5!#6&)

*s t.ere an ar+itra,e opportunities be

#ns. There is no arbitrage opportunity in this case. This can represented diagrammatically as5 ==r1F 4.923* 3D D* 9*

0ank # 0ank 0

The $uotes are o.erlapping each other hence pre.enting an arbitrage. The buyer will go into a loss if he buys from bank # at 4.92D* ==r since he would ha.e to sell it to bank 0 for 4.923D ==r undergoing a loss of *.***! ==r. +9 -.at 0ind o (ar0et will it result into1 #ns. This will result into a one E way market.
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c9 -.at (i,.t +e t.e reason or t.is1 #ns. # one E way market may be created when a bank wants to either encourage the seller of dollars and discourage buyers or .ice E .ersa. In this case, 0ank # wants to encourage buyers of dollars and discourage sellers of the same thus creating a net long positioning dollars. #t the same time 0ank 0 wants to encourage the sellers of dollars and discourage buyers thus creating a net short position in dollars. >ence the outcome would be that 0ank # will be confronted largely with buyers of (S dollars and few sellers while for 0ank 0 the re.erse case will hold true. &.entually, it would mean that regular clients of 0ank 0 wanting to buy dollars can sa.e some money by going to 0ank # and .ice E .ersa.

3. *n ;ondon a dealer 8uotes: D$56 <=B spot 3.525)655 >=?6 <=B spot 1#).))#)61#1.))3) a9 -.at do 3ou e/pect t.e >=?6 D$5 rate to +e in Fran0 urt1 #ns. In @ondon5 D&'1 KC0 spot 7.2!2*122 LCH1 KC0 spot %D*.**D*1%D%.**7* Therefore, LCH1 D&' N 0% #% #! 0! Rwhere 0% + %D*.**D* #% E %D%.**7* 0! + 7.2!2* #! E 7.2!22S N %D*.**D* 7.2!22 %D%.**7* 7.2!2*

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N 2%.*2DD 1 2%.74D7 LCH1 D&' It is assumed that the LCH1 D&' rate in =rankfurt will also approximately be the same as in @ondon. Therefore, the LCH1 D&' rate in =rankfurt is 2%.*2DD 1 2%.74D7.

+9

Suppose t.at in Fran0 urt 3ou ,et a 8uote: >=?6 51.153)6 51.225). *s t.ere an ar+itra,e opportunit3O

D$5 spot

#ns.

When in @ondon5 LCH1 D&' 2%.*2DD 1 2%.74D7 and In =rankfurt5 LCH1 D&' 2%.%27*1 2%.!!2*

There is no arbitrage opportunity as the $uotes o.erlap each other and the buyer will stand to make a loss. If he buys in =rankfurt where % D&' is 2%.!!2* LCH and sells it in @ondon for 2%.*2DD LCH, he makes a loss of *.%))!LCH. Diagrammatically it can be represented as5

LCH1 D&' 2%.*2DD =rankfurt @ondon

.%27*

.!!2*

.74D7

4. T.e ollowin, 8uotes are o+tained in 4ew ?or0: 1.5##)6 &) 1" (ont. orward 1)6 5

D$567 spot

!)

2" (ont. orward 2)6 1) 3" (ont. orward 3)6 15 :alculate t.e outri,.t orward rates. #ns. While obser.ing the forward $uotations, it is clear that the (S 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 are5 D&'1F spot + %.2DD*1 9* % E month forward + %.2D3*1 D2 ! E month forward + %.2D)*1 D* 7 E month forward + %.2D2*1 32

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