The Foreign Exchange Market

Mai Thu Hien

Faculty of Banking and Finance
Foreign Trade University

The foreign exchange market

• The foreign exchange market provides:
 the physical and institutional structure through which
the money of one currency is exchanged for that of
another country,
 The determination rate of exchange between
currencies
 where foreign exchange transactions are physically
completed.
• Foreign exchange means the money of a foreign country;
that is, foreign currency bank balances, banknotes,
checks and drafts.
• A foreign exchange transaction is an agreement between
a buyer and a seller that a fixed amount of one currency
will be delivered for some other currencies at a specified
2
date.

Geography
• The foreign exchange market spans the globe, with
prices moving and currencies trading somewhere every
hour of every business day.
• As the next exhibit will illustrate, the volume of currency
transactions ebbs and flows across the globe as the
major currency trading centers open and close
throughout the day.

1
 4

Measuring Foreign Exchange Market: Average Electronic

Conversations Per Hour
25,000

20,000

15,000

10,000

5,000
Greenwich Mean
Time
0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24

10 AM Lunch Europe Asia Americas London Afternoon 6 pm Tokyo

In Tokyo In Tokyo opening closing open closing in America In NY opens

Source: Federal Reserve Bank of New York, “The Foreign Exchange Market in the United States,” 2001, www.ny.frb.org.

Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Functions of the Foreign

Exchange Market
• The foreign exchange market is the mechanism by which
participants:
 Transfer purchasing power between countries
 Obtain or provide credit for international trade
transactions
 Minimize exposure to the risks of exchange rate
changes

2
 Market Participants
• The foreign exchange market consists of two tiers:
 The interbank or wholesale market (multiples of
$1MM US or equivalent in transaction size)
 The client or retail market (specific, smaller amounts)

FOREIGN EXCHANGE MARKET (100%)

INTERBANK (85%) NONINTERBANK (15%)

(wholesale market) (client/retail market)

BANK-CLIENT (14%) CLIENT-CLIENT (1%)

7

Market Participants

• Five broad categories of participants operate within

these two tiers:
 bank and nonbank foreign exchange dealers,
 foreign exchange brokers,
 individuals and firms,
 central banks and treasuries, and
 speculators and arbitragers.

Bank and Nonbank Foreign

Exchange Dealers
• Banks and a few nonbank foreign exchange dealers
operate in both the interbank and client markets.
• The profit from buying foreign exchange at a “bid” price
and reselling it at a slightly higher “offer” or “ask” price.
• Dealers in the foreign exchange department of large
international banks often function as “market makers.”
• These dealers stand willing at all times to buy and sell
those currencies in which they specialize and thus
maintain an “inventory” position in those currencies.

3
 Foreign Exchange Brokers
• Foreign exchange brokers are agents who facilitate
trading between dealers without themselves becoming
principals in the transaction.
• For this service, they charge a commission.
• It is a brokers business to know at any moment exactly
which dealers want to buy or sell any currency.
• Dealers use brokers for their speed, and because they
want to remain anonymous since the identity of the
participants may influence short term quotes.

10

Brokers and Dealers

• BROKERS: A broker is a commissioned agent of a buyer (or seller) who
facilitates trade by locating a seller (or buyer) to complete the desired
transaction. A broker does not take a position in the assets he or she trades
- that is, the broker does not maintain inventories in these assets. The profits
of brokers are determined by the commissions they charge to the users of
their services (either the buyers, the sellers, or both).
• Examples of Brokers: Real estate brokers, stock brokers.
• DEALERS: Like brokers, dealers facilitate trade by matching buyers with
sellers of assets; they do not engage in asset transformation. Unlike brokers,
however, a dealer can and does "take positions" (i.e., maintain inventories)
in the assets he or she trades that permit the dealer to sell out of inventory
rather than always having to locate sellers to match every offer to buy.
• Also, unlike brokers, dealers do not receive sales commissions. Rather,
dealers make profits by buying assets at relatively low prices and reselling
them at relatively high prices (buy low - sell high). The price at which a
dealer offers to sell an asset (the asked price) minus the price at which a
dealer offers to buy an asset (the bid price) is called the bid-ask spread
and represents the dealer's gross profit margin on the asset exchange.
• Examples of Dealers: Used-car dealers, dealers in U.S. government bonds,
and Nasdaq stock dealers.

Source: www.econ.iastate.edu/classes/econ353/tesfatsion/mish2a.htm
11

Individuals and Firms

• Individuals (such as tourists) and firms (such as

importers, exporters and MNEs) conduct commercial
and investment transactions in the foreign exchange
market.
• Their use of the foreign exchange market is necessary
but nevertheless incidental to their underlying
commercial or investment purpose.
• Some of the participants use the market to “hedge”
foreign exchange risk.

12

4
 Individuals and Firms
• Firms and individuals involved in international
commercial and financial transactions
 Exporters receive foreign currency for the sale of their
goods and services
 Exporters use the forex market to sell foreign
currency and buy AUD
 Importers use the forex market to buy foreign
currency (sell AUD) to be used for purchasing imports

13

Central Banks and Treasuries

• Central banks and treasuries use the market to acquire
or spend their country’s foreign exchange reserves as
well as to influence the price at which their own currency
is traded.
• They may act to support the value of their own currency
because of policies adopted at the national level or
because of commitments entered into through
membership in joint agreements such as the European
Monetary System
• The motive is not to earn a profit as such, but rather to
influence the foreign exchange value of their currency in
a manner that will benefit the interests of their citizens.
• As willing loss takers, central banks and treasuries differ
in motive from all other market participants.
14

Speculators and Arbitragers

• Speculators and arbitragers seek to profit from trading in

the market itself.
• They operate in their own interest, without a need or
obligation to serve clients or ensure a continuous
market.
• While dealers seek the bid/ask spread, speculators seek
all the profit from exchange rate changes and arbitragers
try to profit from simultaneous exchange rate differences
in different markets.

15

5
Speculators, Arbitragers and Hedgers

• Hedgers – trade to cover an open position to avoid risk

(i.e. they are risk averse)
• Arbitragers – trade to make a riskless profit by exploiting
forex anomalies (i.e. they are risk neutral)
• Speculators – risk bearers who take decisions involving
open positions to make profits if expectations are correct

16

Transactions
in the Interbank Market
• A Spot transaction in the interbank market is the
purchase of foreign exchange, with delivery and
payment between banks to take place normally, on the
second following business day.
• The date of settlement is referred to as the value date.
• In the interbank market, the standard size trade is about
U.S. $10 million.
• A bank trading room is a noisy, active place.
• The stakes are high.
• The “long term” is about 10 minutes.
• Bid-Ask spreads in the spot FX market:
– increase with FX exchange rate volatility and
– decrease with dealer competition.
17

Transactions
in the Interbank Market
• An outright forward transaction (usually called just
“forward”) requires delivery at a future value date of a
specified amount of one currency for a specified amount
of another currency.
• The exchange rate is established at the time of the
agreement, but payment and delivery are not required
until maturity.
• Forward exchange rates are usually quoted for value
dates of one, two, three, six and twelve months.
• Buying Forward and Selling Forward describe the same
transaction (the only difference is the order in which
currencies are referenced.)

18

6
 Transactions
in the Interbank Market
• A swap transaction in the interbank market is the
simultaneous purchase and sale of a given amount of
foreign exchange for two different value dates.
• Both purchase and sale are conducted with the same
counterparty.
• Some different types of swaps are:
 Spot against forward
 Forward-Forward
 Nondeliverable Forwards (NDF)

19

Market Size

• In April 2001, a survey conducted by the Bank for

International Settlements (BIS) estimated the daily global
net turnover in traditional foreign exchange market
activity to be $1,210 billion.
• This was the first decline observed by the BIS since it
began surveying banks on foreign currency trading in the
1980s.

20

1000

900
Spot
800
Forwards
700 Swaps

600

500

400

300

200

100

0
1989 1992 1995 1998 2001 2004

Source: Bank for International Settlements, “Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity in April 2004,” September 2004, p. 9.

Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

7
800

700 United States

United Kingdom
600 Japan
Singapore
500 Germany
400

300

200

100

0
1989 1992 1995 1998 2001 2004
Source: Bank for International Settlements, “Triennial Central Bank Survoreign Exchange and Derivatives Market Activity in April 2004,” September 2004, p. 13.

Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Because all exchange transactions involve two currencies, percentage

shares total 200%
90
US Dollar
80 Euro
Deutschemark
70
French Franc
60 EMS Currencies
JapaneseYen
50 Pound Sterling
Swiss Franc
40

30

20

10

0
1989 1992 1995 1998 2001 2004
Source: Bank for International Settlements, “Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity in April 2004,” September 2004, p. 11.

Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Foreign Exchange Market

Classification
• The exchange and OTC
• Spot market, forward market, swap market, futures
market and option market

24

8
 Growth of Derivatives Markets
(Figure 5.1)

700
Size of
OTC
600 Market
($ trillion) Exchange
500

400

300

200

100

0
Jun-98 Jun-99 Jun-00 Jun-01 Jun-02 Jun-03 Jun-04 Jun-05 Jun-06 Jun-07 Jun-08

Risk Management and Financial 25

Institutions, 2e, Chapter 5,
Copyright © John C. Hull 2009

Foreign Currency Derivatives

26

Foreign Currency Derivatives

• Financial management of the MNE in the 21st century
involves financial derivatives.
• Derivatives are financial instruments that offer a return
based on the return of some underlying asset.
• These derivatives, so named because their values are
derived from underlying assets, are a powerful tool used
in business today.
• These instruments can be used for two very distinct
management objectives:
 Speculation – use of derivative instruments to take a
position in the expectation of a profit
 Hedging – use of derivative instruments to reduce the
risks associated with the everyday management of
corporate cash flow
27

9
 Derivatives contracts

• A derivative contract is a financial instrument with a return

that is obtained from or derived from the return of another
underlying financial instrument
• Derivatives contracts are created on and traded in two
distinct but related types of markets: exchange traded and
over the counter
 Exchange-traded contracts have standard terms and
features and are traded on an organized derivatives
trading facility.
 Over-the-counter contracts are any transactions created
by two parties anywhere else.

28

Derivatives contracts delivery on the third of wed GBP contract

Exchange-traded Over-the-counter
derivatives contracts derivatives contracts
• Traded in the exchange • Traded off the exchange
through dealers
• Have standardized terms • Do not have standard
(have public standardized terms (have a private and
transactions) customized transaction)

• Default-risk free • Default risk exists (subject

to the possibility that the
other party will default)
• Daily settlement or • Settlement at expiration of
marking to market (refers the contract
to the procedure that the
gains and losses on each
party‘s position are
credited and charged on 29
a daily basis)

Derivatives contracts

• Derivatives contracts can be classified into two general

categories: forward commitments and contingent claims.
 A forward commitment is a contract in which the two
parties enter into an agreement to engage in a
transaction at a later date at a price established at the
start. Three types of forward commitments are
forward contracts, futures contracts and swaps.
 A contingent claim is a derivative contract with a
payoff dependent on the occurence of a future event.
We generally refer to this type of derivatives as
option.

30

10
 Derivatives

Contingent claims Forward commitments

Exchange- Over-the- Exchange- Over-the-

traded counter traded counter

Options Futures Forward

Swaps
b swap
31

The purpose of derivatives markets

• price discovery (provide price information)
• risk management
• market efficiency improvement 1st transparent reflect the price in the market
• trading efficiency (have low transaction cost )

32

Foreign exchange net turnover by market

segment: daily averages, April 2001
Market Turnover in Percentage
segment billions of $ share
Spot market 387 33.0
Forwards 787 66.6
Outright 131 11.0
Swaps 656 55.6
Options (OTC) 60 0.4
Total 1234

Source: Levi (2005),p.53

33

11
 Spot transaction

• In the interbank market, the standard size trade is about

U.S. $10 million.
• A bank trading room is a noisy, active place.
• The stakes are high.
• The “long term” is about 10 minutes.
• Bid-Ask spreads in the spot FX market:
– increase with FX exchange rate volatility and
– decrease with dealer competition.

4-34
McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies,
Inc. All rights reserved.

Foreign currency forward contract

• A foreign currency forward contract is an agreement
between two parties in which one party, the buyer, agrees
to buy from the other party, the seller, a currency at a
future date at a price established at the start of contract.
• The parties to the transaction specify the forward
contract‘s terms and conditions. In this sense, the contract
is said to be customized. Each party is subject to the
possibility that the other party will default.
• The holder of a long forward contract (the long) is
obligated to take delivery of the underlying asset and pay
the forward price at expiration. The holder of a short
forward contract is obligated to deliver the underlying asset
and accept payment of the forward price at expiration.
35

Foreign currency forward contract

• The forward contract hedge locks in a price

• Neither party pays any money at the start

36

12
 Delivery and settlement of
a forward contract
• When a forward contract expires, two possible
arrangements that can be used to settle the obligations
of the parties:
 Delivery: the long will pay the agreed-upon price to the
short, who in turn will deliver the underlying asset to the
long (a deliverable forward contract).
 Cash settlement: permits the long and the short to pay
the net cash value of the position (F-St) on the delivery
date (a cash-settled forward contract or nondeliverable
forwards NDFs).
F
Buyer (the long) Seller (the short)
37
Underlying

Termination of a forward contract

• Until the contract expires
to terminate the contract ealier, need to take the opposite
• Prior to expiration: Assume that the contract calls for delivery rather roles (buyer >< seller) with the same expiration date and
than cash settlement at expiration underlying assets
‒ Enter another forward contract at opposite position expiring at the same time as
the original forward contract (because of price changes in the market during the
period since the original contract was created, this new contract would likely have
a different price). The company may have credit risk if the counterparty on the
long or the short contract fails to pay.
‒ To avoid credit risk, the company contacts the same counterparty with whom
they engaged the original contract. They could agree to cancel both contracts,
the company receives $2. This termination is desirable for both parties because it
eliminates the credit risk. If the initial counterparty is a bank, the company
requests, at the start, that its initial contract be offset and the bank will charge a
fee (= F0 - F1). Note that it is possible that the company might receive a better
price from another counterparty. If that price is sufficiently attractive and the
companty does not perceive the credit risk to be too high, it may choose to deal
with the other counter party.
Long 3 months (40$)

F0 F1 Short 2 months (42$) 38

Forward rate
F 1 i 1 i
 F S i, i* interest rate per annum
S 1  i* 1  i* n
 1 i 
If F is n-year forward rate F  S   
*
1 i 

If F is one-year forward rate 1 i

F S
1  i*

1 i m
If F is 12/m-month forward rate, F S
simple interest rate 1  i* m

13
 Forward margin
Forward (j/i) - Spot(j/i) 360
fi  100%
Spot(j/i) n

n: the number of days between contract date and delivery

date
• f > 0: forward premium, f < 0: forward discount
• fi is forward margin of the currency i with regard to j
(annual percentage)
 fi > 0: the forward premium on the currency i
 fi < 0: the forward discount on the currency i
• fi is annualized percentage difference between the
forward rate and the spot rate (CIP)
• fi is expected change in the spot rate (UIP)

40

Example

Assuming the spot rate SF1.4800/$, a 90-day euro

SF deposit rate of 4.00% per annum, and a 90-day
eurodollar deposit rate of 8.00% per annum,
calculate 90-day forward rate F(SF/$).
F = 1.4655 SF/$
margin = -3,91%

41

Profit from forward contracts

P↑→ the buyer benefits P↑→ the seller benefits
Profit (Payoff) Profit

Price of Price of
underlying underlying
at maturity ST at maturity ST

Long Position Short Position

Payoff = ST - X Payoff = X - ST 42

14
 Forward quotation on a points basis
• The forward rates are quoted in terms of points, also
referred to as cash rate (for maturity up to 1 year) and
swap rate (for two years or longer).

Bid Ask
Outright spot ¥118,27 ¥118,37
plus points (three months) -2,88 -2,87
Outright forward ¥115,39 ¥115,50

288 points (For JPY 1 pip = 0.01 --> 288 points

= 0.01 * 288= 2.88JPY)

Forward point quotation for the Euro and

Japanese Yen
Euro: Spot & Forward ($/€) Yen: Spot & Forward (¥/$)
Term Mid rates Bid Ask Mid rates Bid Ask
Spot 1.0899 1.0897 1.0901 118.32 118.27 118.37
1w 1.0903 3 4 118.23 -10 -9
Cash 1 mo 1.0917 17 19 117.82 -51 -50
rates 6 mo 1.1012 112 113 115.45 -288 -287
1 yr 1.1143 242 245 112.50 -584 -581
Swap 2 yr 1.1401 481 522 106.93 -1150 -1129
rates 5 yr 1.2102 1129 1276 92.91 -2592 -2490

Mid rates are the numerical average of bid and ask

Source: Eiteman (2010),p.150

Outright Foward Quotations on the

U.S.Dollar/British Pound in the Financial Press

The Wall Street Journal

US$ Equivalent Currency per US$

Thu Wed Thu Wed

U.K. (pound) 1.8410 1.8343 .5432 .5452

One-month forward 1.8360 1.8289 .5447 .5468

Six-months forward 1.8120 1.8048 .5519 .5541

Source: Eiteman (2007), p.193

15
 Figure 23.1 Spot and Forward Prices in
Foreign Exchange

Foreign currency futures

• A foreign currency futures contract is an alternative to a
forward contract that calls for future delivery of a
standard amount of foreign exchange at a fixed time,
place and price.
• It is similar to futures contracts that exist for commodities
such as cattle, lumber, interestbearing deposits, gold,
etc.
• In the US, the most important market for foreign currency
futures is the International Monetary Market (IMM), a
division of the Chicago Mercantile Exchange.

47

Foreign currency futures

• Contract specifications are established by the exchange

on which futures are traded.
• Major features that are standardized are:
 Contract size
 Method of stating exchange rates
 Maturity date
 Last trading day
 Collateral and maintenance margins
 Settlement
 Commissions
 Use of a clearinghouse as a counterparty

48

16
 Foreign Currency Futures
• Foreign currency futures contracts differ from forward
contracts in a number of important ways:
 Futures are standardized in terms of size while forwards
can be customized
 Futures have fixed maturities while forwards can have
any maturity (both typically have maturities of one year
or less)
 Trading on futures occurs on organized exchanges
while forwards are traded between individuals and
banks
 Futures have an initial margin that is marked to market
on a daily basis while only a bank relationship is needed
for a forward
 Futures are rarely delivered upon (settled) while
49
forwards are normally delivered upon (settled)

Exchanges Trading Futures

• Eurex (Germany and Switzerland)

• Chicago Mercantile Exchange
• Chicago Board of Trade
• LIFFE (London)
• BM&F (Brazil)
• New York Mercantile Exchange
• Tokyo Commodity Exchange
• and many more

50

Widely Traded Financial Futures Contracts

Source: Mishkin (2006) 51

17
 Widely Traded Financial Futures Contracts

Source: Mishkin (2006) 52

Marking to Market
Your balance

Initial
margin

Maint.
margin

margin call time

Example of a Futures Trade

(page 27-29)

• An investor takes a long position in 2 December

gold futures contracts on June 5
– contract size is 100 oz.
– futures price is US$1250
– initial margin requirement is
US$6,000/contract
– maintenance margin is US$4,500/contract

Options, Futures, and Other 54

Derivatives, 8th Edition,
Copyright © John C. Hull 2012

18
 loss 9$x100oz = -1,800 for 2 contracts
Marking to market

Day Trade Settle Daily Cumul. Margin Margin

Price ($) Price ($) Gain ($) Gain ($) Balance ($) Call ($)
1 1,250.00 12,000
1 1,241.00 −1,800 − 1,800 10,200
2 1,238.30 −540 −2,340 9,660
….. ….. ….. ….. ……
6 1,236.20 −780 −2,760 9,240
7 1,229.90 −1,260 −4,020 7,980 4,020
8 1,230.80 180 −3,840 12,180
….. ….. ….. ….. ……
16 1,226.90 780 −4,620 15,180

Options, Futures, and Other

Derivatives, 8th Edition, 55
Copyright © John C. Hull 2012

Example
A GBP futures contract at the CME on 18 Dec 2003
• Opening price $1.6002/£
• Contract value £62,500
• Standard margin: $2,000
• Maintenance level/margin: $1,500

Source: Levi (2007), p.71 56

Example

Consider a hypothetical futures contract in which the

current price is $212. The initial margin requirement is
$10, and the maintenance margin requirement is $8. You
go long 20 contracts and meet all margin calls but do not
withdraw any excess margin.
A. When could there be a magin call?
B. Complete the table
C. How much your total gains or losses by the end of
day 6?

19
Day Beginning Funds Futures Price Gain/ Ending
Balance Deposited Price Change Loss Balance
0 212
1 211
2 214
3 209
4 210
5 204
6 202

Example
• 5-Jun: Purchase 2 gold futures contracts at COMEX
– Delivery in Dec
– Futures price: $400
– Quantity: 100 ounces
– Initial deposit: $2000/contract
– MM: $1500/contract
– No withdrawal on the deposit
• Estimate the margin call with respect to change in gold
price
• Calculate the profit/loss from this operation

Futures Price Gain/loss Acc.Results Margin Margin call

400
397
396.1
398.2
397.1
396.7
395.4
393.3
393.6
391.8
392.7
387
387
388.1
388.7
391
392.4

20
 Foreign currency options
• A foreign currency option is a contract giving the option
purchaser (the buyer) the right, but not the obligation, to
buy or sell a given amount of foreign exchange at a fixed
price per unit for a specified time period (until the maturity
date)
• There are two basic types of options, puts and calls.
 A call is an option to buy foreign currency
 A put is an option to sell foreign currency
• The buyer of an option is termed the holder, while the
seller of the option is referred to as the writer or grantor.
• An American option gives the buyer the right to exercise
the option at any time between the date of writing and the
expiration or maturity date.
• An European option can be exercised only on its
expiration date. 61

62

Foreign currency options

• Every option has three different price elements:

 The exercise or strike price – the exchange rate at
which the foreign currency can be purchased (call) or
sold (put).
 The premium – the cost, price, or value of the option
itself- usually paid in advance by the buyer to the
seller. An option‘s value at expiration is called its
payoff.
 The underlying or actual spot exchange rate in the
market.

63

21
The concept of moneyness of an option

• For Put Options

 In-the-Money = Spot Price is below Option Strike
(Exercise) Price
 Out-of-the Money = Spot Price is above Option Strike
(Exercise) Price
 At-the-Money = Spot Price and Strike (Exercise) Price
are the same
• For Call Options
 In-the-Money = Spot Price is above Option Strike
(Exercise) Price
 Out-Of-the-Money = Spot Price is below Option Strike
(Exercise) Price
 At-The Money = Spot Price and Option Strike
(Exercise) Price are the same
64

Example

A contract is traded at the spot price of $1,170

Strike price Spot price Calls Puts

1,175 > 1,170 OTM ITM
1,170 = 1,170 ATM ATM
1,165 < 1,170 ITM OTM

65

Profit/loss for a call option buy: pay premium (long)

sell: gain ... (short)
• Spot price > Strike price: the buyer would excercise the
option and possesses an unlimited profit potential.
• Spot price < Strike price: the buyer would choose not to
excercise the option and his total loss would be limited to
only what he paid for the option (limited loss potential).
• Strike price < Spot price < break-even price: the gross
profit earned on excercising the option and selling the
underlying currency covers part (but not all) of the
premium cost.

66

22
 +C
0
-C

S
X X+C

67

Profit/loss for a put option

• Spot price < Strike price: the buyer would excercise the
option and has unlimited profit potential (up to a
maximum of strike price minus primium, when spot price
would be zero)
• Spot price > Strike price: the buyer would choose not to
excercise the option and so would lose only the premium
paid for the option (limited loss potential).
• Break-even price < Spot price < Strike price: the buyer
will recoup part (but not all) of the premium cost, the
writer will lose part, but not all, of the premium received

68

X-P

P
0
-P

-(X-P)

S
X-P X

69

23
 Profit and Loss for the Buyer of a
Call Option
• Buyer of a call:
– Assume purchase of August call option on Swiss
francs with strike price of 58½ ($0.5850/SF), and a
premium of $0.005/SF
– At all spot rates below the strike price of 58.5, the
purchase of the option would choose not to exercise
because it would be cheaper to purchase SF on the
open market
– At all spot rates above the strike price, the option
purchaser would exercise the option, purchase SF at
the strike price and sell them into the market netting a
profit (less the option premium)

Copyright © 2007 Pearson Addison-Wesley.

All rights reserved.

out of money -> not into the contract

in the money -> into the contract
strike price -> decide whether into the contract - gain/loss = 0

Profit and Loss for the Buyer of a Call strike price = agreed price to buy
Option on Swiss francs
“At the money”
Profit
(US cents/SF)
Strike price TH1: spot market price: 59.5 => agree to exercise the
“Out of the money” “In the money” long call contract to buy at 58.5 lower than spot market price => in
+ 1.00 the money (profit = 0.5, 0.5 cents per premium)
+ 0.50
Unlimited profit

0 Spot price
57.5 58.0 58.5 59.0 59.5
Limited loss
(US cents/SF)
TH2: spot market price: 58.75 => agree to exercise the
- 0.50
Break-even price contract to buy at 59.0 lower than spot market price => out
- 1.00 of the money (loss = 0.25 cents per premium)
Loss not agree to exercise the contract => out of the money =>
The buyer of a call option on SF, with a strike price of 58.5 cents/SF, has a limited loss of 0.50 cents/SF at spot rates less
than 58.5 (“out of the money”), and an unlimited profit potential at spot rates above 58.5 cents/SF (“in the money”).
loss = 0.5 cents per premium
Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

TH3: spot market price: 57.5 => agree to exercise the

contract to buy at 58.5 higher than spot market price =>
out of the money (loss = 1.5 cents per premium in total)
=> choose to not exercise the contract to lose only 0.5
premium

Exhibit 8.4 Buying a Call Option on

Swiss Francs (long call)

72
Profit = (Spot Rate – Strike Price) - Premium

24
 Profit and Loss for the Writer of
a Call Option
• Writer of a call:
– What the holder, or buyer of an option loses, the writer
gains
– The maximum profit that the writer of the call option can
make is limited to the premium
– If the writer wrote the option naked, that is without owning
the currency, the writer would now have to buy the
currency at the spot and take the loss delivering at the
strike price
– The amount of such a loss is unlimited and increases as
the underlying currency rises
– Even if the writer already owns the currency, the writer will
experience an opportunity loss
Copyright © 2007 Pearson Addison-Wesley.
All rights reserved.

Profit and Loss for the Writer of a Call receive the premium in advance
Option on Swiss francs
Profit
“At the money”
Strike price
profit long call = loss short call
(US cents/SF)

+ 1.00

+ 0.50 Break-even price

Limited profit

0 Spot price
57.5 58.0 58.5 59.0 59.5 (US cents/SF)
- 0.50 Unlimited loss

- 1.00
short call
Loss

The writer of a call option on SF, with a strike price of 58.5 cents/SF, has a limited profit of 0.50 cents/SF at spot
rates less than 58.5, and an unlimited loss potential at spot rates above (to the right of) 59.0 cents/SF.
Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Exhibit 8.5 Selling a Call Option on

Swiss Francs (short call)

75
Profit (loss) = Premium – (Spot Rate – Strike Price)

25
 Profit and Loss for the Buyer of a
Put Option
• Buyer of a Put:
– The basic terms of this example are similar to those just
illustrated with the call
– The buyer of a put option, however, wants to be able to sell the
underlying currency at the exercise price when the market price
of that currency drops (not rises as in the case of the call option)
– If the spot price drops to $0.575/SF, the buyer of the put will
deliver francs to the writer and receive $0.585/SF
– At any exchange rate above the strike price of 58.5, the buyer of
the put would not exercise the option, and would lose only the
$0.05/SF premium
– The buyer of a put (like the buyer of the call) can never lose
more than the premium paid up front

Copyright © 2007 Pearson Addison-Wesley.

All rights reserved.

Profit and Loss for the Buyer of a Put Option TH1: sell 58.5, paid already 0.5 for premium
on Swiss francs => receive 58 cents
Profit
“At the money”
Strike price
spot market price = 58
(US cents/SF)
“In the money” “Out of the money”
=> break-even point
+ 1.00

+ 0.50 Profit up TH2: sell 58.5, buy 57.5 => pay 0.5 for premium, price
to 58.0
0 Spot price difference = 1 => profit = 0.5 (in the money)
57.5 58.0 58.5 59.0 59.5 (US cents/SF)
Limited loss
- 0.50
Break-even long put
price in the money -> into the contract
- 1.00
out of the money -> not into the contract
Loss
The buyer of a put option on SF, with a strike price of 58.5 cents/SF, has a limited loss of 0.50 cents/SF at spot rates
greater than 58.5 (“out of the money”), and an unlimited profit potential at spot rates less than 58.5 cents/SF (“in the
money”) up to 58.0 cents.
Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Exhibit 8.6 Buying a Put Option on

Swiss Francs (long put)

78 Profit = (Strike Price – Spot Rate) - Premium

26
 Profit and Loss for the Writer of
a Put Option
• Seller (writer) of a put:
– In this case, if the spot price of francs drops below
58.5 cents per franc, the option will be exercised
– Below a price of 58.5 cents per franc, the writer will
lose more than the premium received fro writing the
option (falling below break-even)
– If the spot price is above $0.585/SF, the option will
not be exercised and the option writer will pocket the
entire premium

Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Profit and Loss for the Writer of a Put Option

on Swiss francs
“At the money”
Profit
Strike price
(US cents/SF)

+ 1.00
Break-even
+ 0.50 price short put
Limited profit
0 Spot price
57.5 58.0 58.5 59.0 59.5
(US cents/SF)
Unlimited loss
- 0.50 up to 58.0

- 1.00

Loss
The writer of a put option on SF, with a strike price of 58.5 cents/SF, has a limited profit of 0.50 cents/SF at spot rates
greater than 58.5, and an unlimited loss potential at spot rates less than 58.5 cents/SF up to 58.0 cents.
Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Exhibit 8.7 Selling a Put Option on

Swiss Francs (short put)

81 Profit (loss) = Premium – (Strike Price – Spot Price)

27
 Call or Put
If price

Long Call Short Put

X

Long Put Short Call

82
X

Call Option position

ST ≤ X ST > X
Option value at expiration (payoffs) CT
Long Call CT = max (0, ST – X)
0 *(OTM) ST – X (ITM)
Short Call -CT = -max (0, ST – X)
0 X - ST
Profit P
Long Call CT – C0 = max (0, ST – X) – C0
-C0 ST - X– C0
Short Call -CT + C0
C0 X - ST + C0
Breakeven point Maximum profit Minimum loss
Long Call ST* = X + C0 ∞ C0
Short Call ST* = X + C0 C0 ∞
C0 : call option premium
*/: C T cannot sell for less than zero because that would mean that the option seller would have to pay the
option buyer. A buyer would not pay more than zero because the option will expire an instant later with no
value). Special case: ST = X  option is treated as OTM because the option is 0 at expiration.

Example
Call option: exercise price: USD2000, premium C =
USD81.75.
• Determine the value at expiration and profit for a buyer
under two outcomes: the price of underlying at expiration
is USD1900 and 2100
• Determine the maximum profit and loss to the buyer
• Determine the breakeven price of the underlying at
expiration
• Graph the value at expiration and the profit

28
 Put Option position
ST < X ST ≥ X
Option value at expiration (payoffs) PT
Long Put PT = max (0, X – ST)
X – ST (ITM) 0 *(OTM)
Short Put -PT = -max (0, X – ST)
0 ST - X
Profit P
Long Put PT – P0 = max (0, X – ST) – P0
X – ST – P0 -P0
Short Put -PT + P0
Breakeven point Maximum profit Minimum loss
Long Put ST* = X - P0 X - P0 P0
Short Put ST* = X - P0 P0 X - P0
P0 : put option premium
*/: P T cannot be worth less than zero because the option seller would have to pay the option buyer. It
cannot be worth more than zero because the buyer would not pay for a position that, an instant later, will
be worth nothing. Special case: ST = X  option is treated as OTM because the option is 0 at expiration.

Example
Put option: Exercise price USD2000, premium P =
USD79.25.
• Determine the value at expiration and profit for a buyer under
two outcomes: the price of underlying at expiration is
USD1900 and 2100
• Determine the maximum profit and loss to the buyer
• Determine the breakeven price of the underlying at expiration
• Graph the value at expiration and the profit

Swiss Franc Option Quotation

(U.S. Cents/SF)
Calls - Last Puts - Last
Option & Strike Aug Sep Dec Aug Sep Dec
Underlying price
58.51 58 0.71 1.05 1.28 0.27 0.89 1.81
58.51 58½ 0.50 - - 0.50 0.99 -
58.51 59 0.30 0.66 1.21 0.90 1.36 -
Each option =SF62,500. The August,
Spot rate 58½ means September, and December listings are
the option maturities or expiration dates.
$0.5850/SF Source: Eiteman (2007), p.214

87

29
 Option Pricing and Valuation

• Premium = Intrinsic value + Time value

• Intrinsic value is the financial gain if the option is exercised
immediately.
• The time value of an option exists because the price of the
underlying currency, the spot rate, can potentially move
further and further into the money between the present time
and the option’s expiration date.
• On the date of maturity, an option will have a value equal to its
intrinsic value (zero time remaining means zero time value,
time value = 0

88

Exhibit 8.8
Analysis of Call
Option on
British Pounds
with a Strike
Price = $1.70/£

89

Intrinsic Value, Time Value & Total Value for a Call Option on British
Pounds with a Strike Price of $1.70/£
Option Premium
(US cents/£)
-- Valuation on first day of 90-day maturity --
6.0
5.67
Total value
5.0

4.0 4.00
3.30

3.0

2.0 1.67
Time value Intrinsic
1.0
value

0.0
1.66 1.67 1.68 1.69 1.70 1.71 1.72 1.73 1.74

Copyright © 2007 Pearson Addison-Wesley. Spot rate ($/£)

All rights reserved.

30
 Intrinsic value

• For a call option:

Intrinsic value = Spot price – Strike price
 Intrinsic value = 0: if the strike price > the spot price
 Intrinsic value > 0: if the spot price > the strike price
• For a put option:
Intrinsic value = Strike price – Spot price
 Intrinsic value = 0: if the strike price < the spot price
 Intrinsic value > 0: if the spot price < the strike price

91

Exhibit 8.9 The Intrinsic, Time, and Total Value Components

of the 90-Day Call Option
on British Pounds at Varying Spot Exchange Rates

92
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.

Exhibit 8.10 Decomposing Call Option

Premiums: Intrinsic Value and Time
Value

93
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.

31
 Exhibit 8.12 Foreign Exchange Implied Volatility for Foreign Currency
Options, January 30, 2008

94
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.

The option-pricing formula

C  F  Nd1   E  Nd2  erd T

2
 F   
ln       T
E  2 
d1 
 T

d 2  d1    T

P  F  N d1   1  E  N d 2   1 e  rd T
95

Currency option pricing sensitivity

• The pricing of any currency option combines six elements

(factors influencing currency option prices):
 Present spot rates
 Time to maturity
 Forward rates
 Interest differential (US dollar interest rates and foreign
currency interest rates)
 Volatility (standard deviation of daily spot price
movements)

96

32
 Currency option pricing sensitivity

Call Put

Strike price - +

Time to maturity + +

Interest differential - +

Volatility + +

Forward rates + -

Spot rates + -

97

Currency option pricing sensitivity

• Forward rate sensitivity:
 Standard foreign currency options are priced
around the forward rate because the current spot
rate and both the domestic and foreign interest
rates are included in the option premium
calculation
 The option-pricing formula calculates a subjective
probability distribution centered on the forward rate
 This approach does not mean that the market
expects the forward rate to be equal to the future
spot rate, it is simply a result of the arbitrage-
pricing structure of options
 The larger the difference between the forward rate
and the spot rate, the higher the call option
premium and the lower the put option premium.
98

Currency option pricing sensitivity

• Spot rate sensitivity (delta):
 The sensitivity of the option premium to a small change
in the spot exchange rate is called the delta
 delta = Δ premium / ∆Spot rate
delta = ($0,038/£-$0,033/£)/($1,71/£-$1,70/£)=0,5
 The higher the delta, the greater the probability of the
option expiring in-the-money
 For a call option, option values increase with the
increase of the spot rate.
 For a put option, option values increase with the
decrease of the spot rate.
99

33
 Currency option pricing sensitivity

• Time to maturity – value and deterioration (theta):

 Time to maturity is the amount of time left in an
option before it expires
 The expected change in the option premium from a
small change in the time to expiration is termed theta
 theta = Δ premium / ∆time
 Option values increase with the length of time to
maturity
 A trader will normally find longer-maturity option
better values, giving the trader the ability to alter an
option position without suffering significant time
value deterioration

100

Theta: Option Premium Time Value

Deterioration
Option Premium
(US cents/£) A Call Option on British Pounds: Spot Rate = $1.70/£
7.0
In-the-money (ITM)
6.0
call ($1.65 strike price)
5.0

4.0
At-the-money (ATM)
3.0
call ($1.70 strike price)
2.0
Out-of-the-money (OTM)
1.0 call ($1.75 strike price)

0.0
90 80 70 60 50 40 30 20 10 0
Copyright © 2007 Pearson Addison-Wesley. Days remaining to maturity
All rights reserved. theta= (ct3,3/£-ct3,28)/(90-89)=0,02

Currency option pricing sensitivity

• Sensitivity to volatility (lambda):

 Option volatility is defined as the standard deviation
of daily percentage changes in the underlying
exchange rate
 Volatility is important to option value because of an
exchange rate’s perceived likelihood to move either
into or out of the range in which the option will be
exercised
 lambda = Δ premium / Δ volatility

102

34
 Currency option pricing sensitivity
• Volatility is viewed in three ways:
 Historic
 Forward-looking
 Implied
• Because volatilities are the only judgmental component
that the option writer contributes, they play a critical role
in the pricing of options.
• All currency pairs have historical series that contribute to
the formation of the expectations of option writers.
• In the end, the truly talented option writers are those with
the intuition and insight to price the future effectively.
• Traders who believe that volatilities will fall significantly
in the nearterm will sell (write) options now, hoping to
buy them back for a profit immediately volatilities fall,
causing option premiums to fall. 103

Currency option pricing sensitivity

• Sensitivity to changing interest rate differentials (rho and
phi):
 Currency option prices and values are focused on the
forward rate
 The forward rate is in turn based on the theory of
Interest Rate Parity
 Interest rate changes in either currency will alter the
forward rate, which in turn will alter the option’s
premium or value
• A trader who is purchasing a call option on foreign
currency should do so before the domestic interest rate
rises. This timing will allow the trader to purchase the
option before its price increases.

104

Currency option pricing sensitivity

• The expected change in the option premium from a small
change in the domestic interest rate (home currency) is
the term rho.
rho = Δ premium / Δ US $ interest rate
• The expected change in the option premium from a small
change in the foreign interest rate (foreign currency) is
termed phi.
phi = Δ premium / Δ foreign interest rate

105

35
Interest Differentials and Call Option
Premiums
Option Premium (US cents/£)
8.0
A Call Option on British Pounds: Spot Rate = $1.70/£
7.0

6.0 ITM call ($1.65 strike price)

5.0

4.0
ATM call ($1.70 strike price)
3.0

2.0
OTM call ($1.75 strike price)
1.0

0.0
-4.0 -3.0 -2.0 -1.0 0 1.0 2.0 3.0 4.0 5.0
Interest differential: iUS$ - i £ (percentage)
Copyright © 2007 Pearson Addison-Wesley.
All rights reserved.

Currency Option Pricing Sensitivity

• The sixth and final element that is important to option

valuation is the selection of the actual strike price.
• A firm must make a choice as per the strike price it
wishes to use in constructing an option (OTC market).
• Consideration must be given to the tradeoff between
strike prices and premiums.

Copyright © 2007 Pearson Addison- 1-107

Wesley. All rights reserved.

Option Premiums for Alternative

Strike Rates
Option Premium
(US cents/£)
7.0 Current spot rate = $1.70/£

6.0

5.0
OTM Strike rates
4.0

3.0 ITM Strike rates

2.0

1.0

0.0
1.66 1.67 1.68 1.69 1.70 1.71 1.72 1.73 1.74 1.75
Copyright © 2007 Pearson Addison-Wesley.
All rights reserved. Call strike price (U.S. dollars/£)

36
 Summary of Option Premium
Components

Copyright © 2007 Pearson Addison-Wesley. 1-109

All rights reserved.

Foreign currency swaps

• A swap is an agreement between two parties to exchange a
series of future cash flows. It is an over-the-counter
transaction consisting of a series of forward contracts
(usually a spot transaction plus a forward transaction in the
reverse direction).
• A foreign currency swap is an agreement to buy and sell
foreign exchange at pre-specified exchange rates, where
the buying and selling are seperated in time.
 A swap-in Canadian consists of an agreement to buy Canadian
dollars spot, and also an agreement to sell Canadian dollars
forward.
 A swap-out Canadian consists of an agreement to sell Canadian
dollars spot and to buy Canadian dollars forward.
 A forward-forward swap involves two forward transactions to buy
Canadian dollars for 1-month forward and sell Canadian dollars for
2-months forward.
 A rollover swap is the one that the purchase and sale are seperated
by only one day.
110

1. Sell $ spot for £

2. Buy $ forward
A B
1. Sell £ spot for $
2. Buy £ forward
At present, A has $ and needs £ At present, B needs $
After 3 months, A needs $ After 3 months, B has $ and needs £

111

37
 Example
Sport rate S(VND/USD) = 17,750-17,800
i$ = 4%/year
iVND = 8%/year
Today A has export receipts in USD and needs
VND for domestic payments. After 3 months, A
needs USD for import payments.
In contrast, B needs USD for import payments
at present and in 3 months, B receives USD
from the export contract and will sell this export
receipt for VND.

112

The payment on a currency swap

• In a currency swap, each party makes payments to the
other in different currencies.
• A currency swap can have:
 One party pay a fixed rate in one currency and the
other pay a fixed rate in the other currency (a fixed-for-
fixed currency swap)
 Both pay a floating rate in their respective currencies (a
floating-for-floating-rate currency swap)
 The first party pay a fixed rate in one currency and the
second party pay a floating rate in the other currency (a
fixed-for-floating-rate currency swap)
 The first party pay a floating rate in one currency and
the second party pay a fixed rate in the other currency
(a floating-for-fixed currency swap)
• The notional principal is usually exchanged at the
beginning and at the end of the life of the swap, although113
this exchange is not mandatory.

A fixed-for-fixed curency swap

114

38
 Firm USD AUD
AA 10% 7%
BB 9% 8%

115

116

Swap point and outright forward

Spot (Can$/$) 6-month Outright forward

swap
1.3965-70 23-27 1.3988-97
(1.3965+23)-(1.3970+27)
1.3965-70 27-23 (1.3938-47)
(1.3965-27)-(1.3970-23)
Swap points/rate

Source: Levi (2005), chapter 3

117

39
 Hedging using forward

• Suppose that it is September and an importer considers

that the GBP is likely to increase in value over the next 3
months. Assuming that the importer will have to pay
GBP100,000 for its import contract. The importer can
hedge by purchasing forward GBP 100,000 at the
forward price of USD2.0. Suppose that the importer’s
expectation is correct and the price of GBP rises/falls to
USD 2.2/1.8 by December.

John Hull

Hedging using options

• Consider an investor who in May of a particular year

owns 1000 Microsoft shares. The share price is USD28
per share. The investor is concerned about a possible
share price decline in the next two months and wants
protection. The investor could buy ten July put option
contracts on Microsoft at CBOT with a strike price of
USD27.50, which is selling at USD1.

John Hull

Hedging using forward and options

• Suppose that it is September and an importer considers

that the GBP is likely to increase in value over the next 3
months. The GBP price is currently USD 1.9 and a 3-
month call option with a strike price of USD 2.05 is
currently selling for USD0.05. Assuming that the
importer will have to pay GBP100,000 for its import
contract. There are two possible alternatives. One
alternative is to purchase forward GBP 100,000 at the
forward price of USD2.0, the other involves the purchase
of 4,000,000 call options. Suppose that the importer’s
expectation is correct and the price of GBP rises/falls to
USD 2.2/1.8 by December.

John Hull

40
 Foreign currency speculation
• Speculation is an attempt to profit by trading on
expectations about prices in the future.
• Speculators can attempt to profit in the:
 Spot market – when the speculator believes the
foreign currency will appreciate in value
 Forward market – when the speculator believes the
spot price at some future date will differ from today’s
forward price for the same date
 Futures market – if a speculator buys a futures
contract, they are locking in the price at which they
must buy that currency on the specified future date or
vice versa.
 Options markets – extensive differences in risk
patterns produced depending on purchase or sale of
put and/or call. 121

Speculation using spot and forward

contracts
Spot rate S($/SF)=0.5851
Six-month forward F($/SF)=0.5760
A speculator has $100,000 with which to speculate and
believes that in six months the spot rate will be
$0.6000/SF.

122

Speculation using forward

Hans Schmidt uses $10 million to speculate on the euro

a) b)
Assumptions Values Values
Initial investment (funds available) $10,000,000 $10,000,000
Current spot rate (US$/€) $0.8850 $0.8850
30-day forward rate (US$/€) $0.9000 $0.9000
Expected spot rate in 30 days (US$/€) $0.8440 $0.9440

123

41
 Speculation using futures

The Mexican peso futures contract traded on the

Chicago Mercantile Exchange is for 500,000 new
Mexican Peso (MXN).
Define the speculator transactions if he believes the
Mexican peso will fall/rise in value versus the
U.S.dollar by March, using the March settle price on
the Mexican peso futures of $0.10958/Ps.
Suppose the spot exchange rates at maturity (by
March) are $0.09500/Ps and $0.11000/Ps.

124

Speculation using spot and futures

A speculator in February thinks that the GBP will

strengthen relative to the USD over the next two
months and prepare to speculate GBP 250,000. He
can purchase GBP250,000 in the spot market at the
price of USD2.0470 in the hope that the GBP can be
sold later at a higher price or can take a long position
in four CME April contracts in GBP at the price of
USD2.0410 . The initial margin requirement is
assumed to be USD 5,000 per contract. Suppose that
the exchange rate rises/falls to USD2.1/2.0 in April.

125
John Hull

Speculation using spot and options

Suppose that it is October and a speculator considers

that the GBP is likely to increase in value over the next 2
months. The GBP price is currently USD 2 and a 2-month
call option with a strike price of USD 2.05 is currently
selling for USD0.05. Assuming that the speculator is
willing to invest USD 2,000. There are two possible
alternatives. One alternative is to purchase GBP 1,000,
the other involves the purchase of 40,000 call options.
Suppose that the speculator’s hunch is correct and the
price of GBP rises/falls to USD 2.2/1.8 by December.

126
John Hull

42
 Arbitrage
• Spatial/Two-point arbitrage
• Triangular/Three-point arbitrage

127

Spatial/Two-point arbitrage
h and f are any two currencies.
sh/f : the exchange rate of currency f with currency h in H
financial centre (price of currency f in terms of currency h).
sf/h : the exchange rate of currency h with currency f in F
financial centre
The consistency/neutrality condition: sh/f . Sf/h = 1
sh/f .sf/h ≠ 1: arbitrage opportunity
• Foreign exchange arbitrage is the act of profiting from
differences between the exchange rates of foreign exchange.
• Spatial arbitrage refers to an arbitrage transaction that is
conducted in two different markets, or seperated by space.

128

Example

The exchange rate in Tokyo is ¥98.5000/$.

The exchange rate in New York is ¥98.3000/$.
Calculate arbitrage profit when the arbitrageur has $,
which is equivalent to ¥100 million.

129

43
 Example
• Example:
Bank C Bid Ask Bank D Bid Ask
NZ$ $.635 $.640 NZ$ $.645 $.650
Buy NZ$ from Bank C @ $.640, and sell it to
Bank D @ $.645. Profit = $.005/NZ$.

Example

London £0.6064-80/€
Frankfurt €1.6244-59/£
Define arbitrage opportunity?

131

Three-point/triangular arbitrage
h, f and m are any three currencies.
sf/m : price of currency m in terms of currency f.
sh/f : price of currency f in terms of currency h.
sh/m: price of currency m in terms of currency h.
The cross rate: sf/m= sh/m/sh/f
With sh/f = 1/sf/n, we have sf/m= sh/m/sh/f = sf/h.sh/m
With sf/m= 1/sm/f, we have sf/m= sf/h.sh/m or 1/sm/f = sf/h .sh/m
Then sf/h . sh/m .sm/f= 1 or sh/m . sm/f . sf/h=1
The consistency/neutrality condition: sf/m= sf/h.sh/m
sf/m /sf/h ≠ sh/m: arbitrage opportunity

Triangular arbitrage involves more than two currencies

and/or markets
132

44
 Example
Barclays Bank quotes $1.6410/£
Deutsche Bank quotes €1.3510/£
Citibank quotes $1.3223/€
Calculate arbitrage profit of a market trader with
$1,000,000.

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Example
• Example: Bid Ask
British pound (£) $1.60/£ $1.61/£
Malaysian ringgit (MYR) $.200/MYR $.202/MYR
£ MYR8.1/£ MYR8.2/£
Buy £ @ $1.61, convert @ MYR8.1/£, then sell MYR @
$.200. Profit = $.01/£. (MYR8.1/£$0.2/MYR=$1.62/£)

Example
Bid Ask
£ $1.60/£ $1.61/£
MYR $.200/MYR $.202/MYR
£ MYR8.1/£ MYR8.2/£

$
Value of MYR in $
Exchange MYR for $ at Value of £ in $
$0.2/MYR Buy £ for $ at $1.61/£
(MYR50310=$10062) ($10000=£6221)

MYR £

Value of £ in MYR
Exchange £ for MYR at MYR8.1/£
(£6221=MYR50310)

• When the exchange rates of the currencies are not in equilibrium,

triangular arbitrage will force them back into equilibrium.

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