INTERNATIONAL

FINANACE
 Chapter Outline
 Function
Function and
and Structure
Structure of
of the
the FX
FX Market
Market
 The
The

FXSpot
Market
Spot Participants
Market
Market
 Correspondent Banking Relationships

 The
TheSpot Rate Quotations
Forward
Forward Market
Market
 The
 Spot
 The Market
Bid-Ask
Forward RateSpread
Quotations
 Spot FX
 The

Long andTrading
Forward Market
Short Forward Positions

 Cross Exchange
Forward Rate Quotations
Cross-Exchange Rates

 Triangular Arbitrage
Swap Transactions

 Spot Foreign
Forward Exchange Market Microstructure
Premium
 The Forward Market
 The Function and Structure of
the FX Market
 FX Market Participants
 Correspondent Banking Relationships
 FX Market Participants
 The FX market is a two-tiered market:
1. Interbank Market (Wholesale)
• About 700 banks worldwide stand ready to make a
market in foreign exchange.
• Nonbank dealers account for about 20% of the
market.
• There are FX brokers who match buy and sell orders
but do not carry inventory and FX specialists.
2. Client Market (Retail)
 Market participants include international
banks, their customers, nonbank dealers, FX
brokers, and central banks.
 InternationalBanks-around 100to 200 banks
worldwide ‘make a market’ i.e. they stand
willing to buy or sell foreign currency for their
own account.

 Customersbroadly include MNCs, Money

managers and private speculators.
 Circadian Rhythms of the FX
Market
Electronic Conversations per Hour
average peak
45000
40000
35000
30000
25000
20000
15000
10000
5000
0
1:00 3:00 5:00 7:00 9:00 11:00 1:00 15:00 5:00 19:00 9:00 11:00
10 am in Lunch Europe Asia Lunch Americas London New 6 pm in
Tokyo hour in coming in going out hour in coming in going out Zealand NY
Tokyo London coming in
 Correspondent Banking
Relationships
 Large commercial banks maintain demand
deposit accounts with one another which
facilitates the efficient functioning of the
FX market.
 Correspondent Banking Relationships
 Bank A is in London, Bank B is in New York.
 The current exchange rate is £1.00 = $2.00.
 A currency trader employed at Bank A buys
£100m from a currency trader at Bank B for
$200m settled using its correspondent
relationship.

Bank A $200 Bank B

London £100 NYC
 Correspondent Banking
Relationships
Bank A $200 Bank B
London £100 NYC

Assets Liabilities Assets Liabilities

£ deposit at B £300m B’s Deposit$1,000m $ deposit at A$1000m A’s Deposit £300m
£400m $1,200m $1200m £400m
$ deposit at B $800m B’s Deposit £200m £ deposit at A £200m A’s Deposit $800m
$600m £100m £100m $600m
Other Assets £600m Other L&E £600m Other Assets $800m Other L&E $800m
Total Assets £1,300m Total L&E £1,300m Total Assets $2,200m Total L&E$2,200m
Correspondent Banking Relationships
 International commercial banks
communicate with one another with:
 SWIFT: The Society for Worldwide Interbank
Financial Telecommunications.
 CHIPS: Clearing House Interbank Payments
System
 ECHO Exchange Clearing House Limited, the
first global clearinghouse for settling interbank
FX transactions.
 The Spot Market
 Spot Rate Quotations
 The Bid-Ask Spread
 Spot FX trading
 Cross Rates
 Spot Rate Quotations
Direct quotation
 A foreign exchange rate quoted as the domestic
currency per unit of the foreign currency. In other
words, it involves quoting in fixed units of foreign
currency against variable amounts of the domestic
currency.

e.g. Rs 50 = $1
Indirect Quotation
A foreign exchange rate quoted as the foreign currency
per unit of the domestic currency. In an indirect quote,
the foreign currency is a variable amount and the
domestic currency is fixed at one unit.
- e.g. $2 = Rs. 100
 American and European Quote
 A quote can be classified as European or
American only if one of the currencies is the
dollar
 American Quote- number of dollars expressed
per unit of any other currency e.g.$2=1pound
or $ 2.5=Rs.100
 European Quote- no. of units of any other
currency expressed per dollar e.g. Rs.45= $1
 Spot Rate Quotations
USD equiv USD equiv Currency per USD Currency per
Country Friday Thursday Friday USD Thursday

Argentina (Peso) 0.3309 0.3292 3.0221 3.0377

Australia (Dollar) 0.7830 0.7836 1.2771 1.2762

Brazil (Real) 0.3735 0.3791 2.6774 2.6378

Britain (Pound) 1.9077 1.9135 0.5242 0.5226

1 Month Forward 1.9044 1.9101 0.5251 0.5235

3 Months Forward 1.8983 1.9038 0.5268 0.5253

6 Months Forward 1.8904 1.8959 0.5290 0.5275

Canada (Dollar) 0.8037 0.8068 1.2442 1.2395

1 Month Forward 0.8037 0.8069 1.2442 1.2393

3 Months Forward 0.8043 0.8074 1.2433 1.2385

6 Months Forward 0.8057 0.8088 1.2412 1.2364

 Spot Rate Quotations

USD equiv USD equiv Currency per Currency per

Country Friday Thursday USD Friday USD Thursday

Argentina (Peso) 0.3309 0.3292 3.0221 3.0377

Australia (Dollar) 0.7830 0.7836 1.2771 1.2762

Brazil (Real) 0.3735 0.3791 2.6774 2.6378 The
Britain (Pound) 1.9077 1.9135 0.5242 0.5226 direct
1 Month Forward 1.9044 1.9101 0.5251 0.5235 quote for
3 Months British
Forward 1.8983 1.9038 0.5268 0.5253
6 Months pound is:
Forward 1.8904 1.8959 0.5290 0.5275
£1 =
$1.9077
 Spot Rate Quotations
USD
equiv USD equiv Currency per Currency per
Country Friday Thursday USD Friday USD Thursday

Argentina
(Peso) 0.3309 0.3292 3.0221 3.0377
The
Australia
(Dollar) 0.7830 0.7836 1.2771 1.2762 indirect
Brazil (Real) 0.3735 0.3791 2.6774 2.6378 quote for
Britain (Pound) 1.9077 1.9135 0.5242 0.5226
British
pound is:
1 Month
Forward 1.9044 1.9101 0.5251 0.5235
£.5242 =
3 Months
Forward 1.8983 1.9038 0.5268 0.5253 $1
6 Months
Forward 1.8904 1.8959 0.5290 0.5275
 Spot Rate Quotations
USD
equiv USD equiv Currency per Currency per
Country Friday Thursday USD Friday USD Thursday

Argentina
(Peso) 0.3309 0.3292 3.0221 3.0377

Australia Note that the

(Dollar) 0.7830 0.7836 1.2771 1.2762
direct quote
Brazil (Real) 0.3735 0.3791 2.6774 2.6378
is the
Britain (Pound) 1.9077 1.9135 0.5242 0.5226 reciprocal of
1 Month the indirect
Forward 1.9044 1.9101 0.5251 0.5235
quote:
3 Months

1.9077= 1
Forward 1.8983 1.9038 0.5268 0.5253

6 Months
Forward 1.8904 1.8959 0.5290 0.5275
.5242
 The Bid-Ask Spread
 The bid (buying) price is the price a dealer
is willing to pay you for something.
 The ask (selling) price is the amount the
dealer wants you to pay for the thing.
 The bid-ask spread is the difference
between the bid and ask prices.
 The Bid-Ask Spread
 A Bank could offer

bid price of $1.25/€
 ask price of $1.26/€

 While there are a variety of ways to quote

that,
$/€: 1.25/1.26 or Rs./$: 45.45/45.50 or 45.45/50

 The bid-ask spread represents the

dealer’s expected profit.
Interbank Quote vs Merchant Quote
 Merchant quote is the quote given by a
bank to its retail customers
 The Bid-Ask Spread

big small
figure figure
Bid Ask
S($/£) 1.9072 1.9077
S(£/$) .5242 .5243
 A dealer would likely quote these prices as
72-77.
 It is presumed that anyone trading $10m
already knows the “big figure”.
 Spot FX trading
 In the interbank market, the standard size
trade is about U.S. $10 million.
 A bank trading room is a noisy, active
place.
 The stakes are high.
 The “long term” is about 10 minutes.
 Cross Rates
 Suppose that S($/€) = 1.50
 i.e. $1.50 = €1.00
 and that S(¥/€) = 50
 i.e. €1.00 = ¥50
 What must the $/¥ cross rate be?

$1.50 €1.00 $1.50

× =
€1.00 ¥50 ¥50
$1.00 = ¥33.33
$0.0300 = ¥1
 Triangular Arbitrage

Suppose we
$
observe these
banks posting Barclays
Credit
these exchange S(¥/$)=120 Lyonnais
rates.
S(£/$)=1.50
Credit Agricole
First calculate any ¥ £
implied cross rate S(¥/£)=85
to see if an
arbitrage exists. £1.50 $1.00 £1.00
× =
$1.00 ¥120 ¥80
 Triangular Arbitrage

The implied S(¥/£) cross rate is

$
£1.50 $1.00 £1.00
× = Barclays
$1.00 ¥120 ¥80 Credit
S(¥/$)=120 Lyonnais
Credit Agricole has
posted a quote of S(£/$)=1.50
S(¥/£)=85 so there is ¥ Credit Agricole
£
an arbitrage S(¥/£)=85
opportunity.
So, how can we make money? Buy the £ @ ¥80; sell @ ¥85.
Then trade yen for your preferred currency.
 Triangular Arbitrage

As easy as 1 – 2 – 3:
$
1. Sell our $ for £, Barclays
Credit
2. Sell our £ for ¥, S(¥/$)=120 Lyonnais
3 1
3. Sell those ¥ for $. S(£/$)=1.50
2
¥ Credit Agricole
£
S(¥/£)=85
 Triangular Arbitrage
Sell $100,000 for £ at S(£/$) = 1.50
receive £150,000
Sell our £150,000 for ¥ at S(¥/£) = 85
receive ¥12,750,000
Sell ¥12,750,000 for $ at S(¥/$) = 120
receive $106,250
profit per round trip = $106,250 – $100,000 = $6,250
 Triangular Arbitrage

Here we have to go
“clockwise” to make $
money—but it doesn’t Barclays
Credit
matter where we start. S(¥/$)=120 Lyonnais
2 3
S(£/$)=1.50
1
¥ Credit Agricole
£
S(¥/£)=85
If we went “counter clockwise” we would be the source
of arbitrage profits, not the recipient!
 Spot Foreign Exchange
Microstructure
 Market Microstructure refers to the
mechanics of how a marketplace
operates.
 Bid-Ask spreads in the spot FX market:
 increase with FX exchange rate volatility and
 decrease with dealer competition.
 Private information is an important
determinant of spot exchange rates.
 The Forward Market
 Forward Rate Quotations
 Long and Short Forward Positions
 Forward Cross Exchange Rates
 Swap Transactions
 Forward Premium
 The Forward Market
 A forward contract is an agreement to buy
or sell an asset in the future at prices
agreed upon today.
 If you have ever had to order an out-of-
stock textbook, then you have entered into
a forward contract.
 Forward Rate Quotations
 The forward market for FX involves
agreements to buy and sell foreign
currencies in the future at prices agreed
upon today.
 Bank quotes for 1, 3, 6, 9, and 12 month
maturities are readily available for forward
contracts.
 Longer-term swaps are available.
 Forward Rate Quotations
 Consider the example from above:
for British pounds, the spot rate is
$1.9077 = £1.00
While the 180-day forward rate is
$1.8904 = £1.00
 What’s up with that?
 USD
Spot Rate Quotations
equiv USD equiv Currency per Currency per
Country Friday Thursday USD Friday USD Thursday

Argentina
(Peso) 0.3309 0.3292 3.0221 3.0377

Australia Clearly the

(Dollar) 0.7830 0.7836 1.2771 1.2762
market
Brazil (Real) 0.3735 0.3791 2.6774 2.6378
participants
Britain (Pound) 1.9077 1.9135 0.5242 0.5226 expect that
1 Month the pound
Forward 1.9044 1.9101 0.5251 0.5235
will be
3 Months
Forward 1.8983 1.9038 0.5268 0.5253
worth less
6 Months
in dollars in
Forward 1.8904 1.8959 0.5290 0.5275 six months.
Canada
(Dollar) 0.8037 0.8068 1.2442 1.2395

1 Month
 Forward Rate Quotations
 Consider the (dollar) holding period return
of a dollar-based investor who buys £1
million at the spot and sells them forward:

gain $1,890,400 – –$17,300

$HPR= = $1,907,700 =
pain $1,907,700

$HPR = –0.0091
Annualized dollar HPR = –1.81% = –0.91% × 2
 Forward Premium
 The interest ratedifferential implied by
forward premium or discount.
 For example, suppose the € is
appreciating from S($/€) = 1.25 to F180($/€)
= 1.30
 The 180-day forward premium is given by:
F180($/€) – S($/€) 360 1.30 – 1.25
f180,€v$ = × = × 2 = 0.08
S($/€) 180 1.25
Long and Short Forward Positions
 If you have agreed to sell anything (spot or
forward), you are “short”.
 If you have agreed to buy anything (forward
or spot), you are “long”.
 If you have agreed to sell FX forward, you
are short.
 If you have agreed to buy FX forward, you
are long.
 Payoff Profiles
If you agree to sell anything in the
profit
future at a set price and the spot
price later falls then you gain.

S180($/¥)
0

F180($/¥) = .009524
If you agree to sell anything in the
future at a set price and the spot
loss price later rises then you lose. Short position
 Payoff Profiles
short position
profit

Whether the payoff

profile slopes up or
down

0 depends upon
S180(¥/$) whether you use the
F180(¥/$) = 105 direct or indirect
quote:
F180(¥/$) = 105 or
-F180(¥/$) F180($/¥) = .009524.
loss
 Payoff Profiles
profit
short position

S180(¥/$)
0

F180(¥/$) = 105
When the short entered into this forward contract,
he agreed to sell ¥ in 180 days at F180(¥/$) = 105
-F180(¥/$)
loss
 Payoff Profiles
profit
short position

15¥

S180(¥/$)
0
120
F180(¥/$) = 105
If, in 180 days, S180(¥/$) = 120, the short will
-F180(¥/$) make a profit by buying ¥ at S180(¥/$) = 120 and
loss delivering ¥ at F180(¥/$) = 105.
 Payoff Profiles
profit
F180(¥/$)
Since this is a zero-sum game, short position
the long position payoff is the
opposite of the short.

S180(¥/$)
0

F180(¥/$) = 105

-F180(¥/$) Long position

loss
 Payoff Profiles
profit
The long in this forward contract agreed to BUY
-F180(¥/$)
¥ in 180 days at F180(¥/$) = 105
If, in 180 days, S180(¥/$) = 120, the long will
lose by having to buy ¥ at S180(¥/$) = 120
and delivering ¥ at F180(¥/$) = 105.
S180(¥/$)
0
120
F180(¥/$) = 105
–15¥
Long position
loss
Forward Cross Exchange Rates
 It’s just an “delayed” example of the spot
cross rate discussed above.
 In generic terms

FN ($ / k )
FN ( j / k ) =
FN ($ / j )
Notice that the “$”s cancel.
and
FN ($ / j )
FN (k / j ) =
FN ($ / k )
 Forward Cross Exchange Rates

USD
equiv USD equiv The forward
Currency per
Country Friday Thursday USD Friday
Argentina
pound-Canadian dollar
(Peso) 0.3309 0.3292 3.0221 cross rate
Australia
(Dollar) 0.7830 0.7836 1.2771
Brazil (Real) 0.3735 0.3791 2.6774
GBP1.00 USD1.00
×
USD1.8904 CAD1.2412
Britain (Pound) 1.9077 1.9135 0.5242
1 Month
Forward 1.9044 1.9101 0.5251
3 Months GBP1.00
Forward 1.8983 1.9038 0.5268 =
6 Months CAD2.3464
Forward 1.8904 1.8959 0.5290

Canada (Dollar) 0.8037 0.8068 1.2442

 Currency Symbols
 In addition to the familiar currency
symbols (e.g. £, ¥, €, $) there are three-
letter codes for all currencies.
It is a long list, but selected codes include:
CHF Swiss francs
GBP British pound
ZAR South African rand
CAD Canadian dollar
JPY Japanese yen
 SWAPS
A swap is an agreement to provide a
counterparty with something he wants in
exchange for something that you want.
 Often on a recurring basis—e.g. every six
months for five years.
 Swap transactions account for
approximately 56 percent of interbank FX
trading, whereas outright trades are 11
percent.
 Swaps are covered fully in chapter 14.
 Summary
 Spot rate quotations
 Direct and indirect quotes
 Bid and ask prices
 Cross Rates
 Triangular arbitrage
 Forward Rate Quotations
 Forward premium (discount)
 Forward points
 Practice Problem
The current spot exchange rate is $1.55/£ and
the three-month forward rate is $1.50/£. Based
on your analysis of the exchange rate, you are
confident that the spot exchange rate will be
$1.52/£ in three months. Assume that you would
like to buy or sell £1,000,000.
a. What actions do you need to take to speculate
in the forward market? What is the expected
dollar profit from speculation?
b. What would be your speculative profit in dollar
terms if the spot exchange rate actually turns out
to be $1.46/£?
c. Graph your results.
 Solution

a. If you believe the spot exchange rate will be

$1.52/£ in three months, you should buy
£1,000,000 forward for $1.50/£. Your expected
profit will be:
$20,000 = £1,000,000 × ($1.52 – $1.50)

b. If the spot exchange rate actually turns out to be

$1.46/£ in three months, your loss from the long
position will be:
–$40,000 = £1,000,000 × ($1.46 – $1.50)
 Solution
profit

$20k

0 S180(£/$)
1.46 1.52
F180(£/$) = 1.50

–$40k
loss
End Chapter Five
International Financial Management
P G Apte
 CURRENCY MARKETS
•The foreign exchange market is the market in which
currencies are bought and sold against each other.
•The interbank foreign exchange market is an over-
the-counter (OTC) market. Daily turnover about $1.5
trillion. Average transaction is about USD 4 million
•The participants in the wholesale market are
commercial banks, investment institutions,
corporations and central banks. Currency brokers act
as middlemen between dealers
•A small number of currencies account for bulk of
turnover: USD, GBP, EUR, CHF, CAD, JPY, DEM,
AUD
 CURRENCY MARKETS
•Among the participants, primary price makers or
professional dealers make a two-way market to each other
and to their clients
•Foreign currency brokers act as middlemen between two
market makers. Their main function is to provide
information to market-making banks
•Corporations usually are price takers. However, some non-
bank, non-financial companies do act as market makers.
•Large money centre banks deal in a large number of
currencies. Smaller banks have a restricted range.
CURRENCY MARKETS
Geographically, the markets span all the time zones from New
Zealand to the West coast of the United States. When it is 3.00
p.m. in Tokyo it is 2.00 p.m. in Hong Kong. When it is 3.00 p.m.
in Hong Kong it is 1.00 p.m. in Singapore. At 3.00 p.m. in
Singapore it is 12.00 noon in Bahrain. When it is 3.00 p.m. in
Bahrain it is noon in Frankfurt and Zurich and 11.00 a.m. in
London. 3.00 p.m. in London is 10.00 a.m. in New York. By the
time New York is starting to wind down at 3.00 p.m., it is noon in
Los Angeles. By the time it is 3.00 p.m. in Los Angeles it is 9.00
a.m. of the next day in Sydney. The gap between New York
closing and Tokyo opening is about 21/2 hours. Thus the market
functions 24 hours. Of all these centres, London, Tokyo and New
York are the big ones accounting for about 50% volume.
Foreign Exchange Interbank (I/B) Desk of
Bank A
Corporate Desk
of Bank A or
I/B Desk of
Bank B
I/B
Desk
of
Bank A

I/B Desk
of Bank C
Corporate Foreign Exchange (CorpFx)
Desk of Bank A
Corporate
Client
of Bank A
CorpFx
Desk
of
Bank A

I/B Desk
of Bank A
Dealings of Corporate Foreign Exchange
(CorpFx) Desk of Bank A

CorpFx Desk of Bank A

Export / Import
Desk of Bank A
Client of Outward / Inward
Bank A Remittance
Desk of Bank A
 CURRENCY MARKETS
• Spot Markets : Value date 2 business days from
transaction date. If bank holiday in either settlement
centre, push to next business day.
•Outright Forwards : Value date 3 days and beyond.
•Standard forward dates : 1,2,3,6,9,12 months. Spot value
date plus required calendar months.
•Swaps : A spot plus a forward or two forwards. Buy
USD spot vs. EUR, sell USD 3 month forward vs.EUR.
Sell USD 1 month forward, buy USD 3 month forward vs.
GBP.
 CURRENCY MARKETS
• A spot GBP/USD deal on Friday Dec 8 : Value date
Tuesday Dec 11
•If Dec 11 holiday in NY/London, value date 12 Dec.
•A 2-month forward deal USD/CHF on Monday Dec 11:
Value date Feb 13 2001. If holiday in NY/Zurich, Feb 14.
•A 2-month forward USD/JPY on Dec 26. Value date Feb 28.
If holiday Tokyo/NY, push forward? NO. Pushing forward
must not carry to next calendar month. Push back to Feb 27.
• Spot deals in some currency pairs such as US dollar-
Canadian dollar settled in one business day
 CURRENCY MARKETS
ACI QUOTATION CONVENTIONS
SPOT RATE QUOTATIONS:
• Base Currency/Quoted Currency Bid Rate/Offer Rate
•USD/CHF : USD base, CHF quoted
•GBP/USD : GBP base, USD quoted
•Most currencies quoted with USD as base. Exceptions are
EUR, GBP, AUD, NZD
•Quotation given as no. of units of quoted currency per unit
of base currency, bid rate/offer rate.
•Bid rate applies to market maker buying base currency.
Offer rate applies to market maker selling base currency.
 CURRENCY MARKETS
• Currency Codes : All currencies have a 3-letter code used
by SWIFT for all interbank transactions.

DEM : Deutsche Mark CHF : Swiss Franc

NLG : Dutch Guilder BEF : Belgian Franc
FRF : French Franc DKK : Danish Kroner
ESP : Spanish Peseta ITL : Italian Lira
USD : US Dollar AUD : Australian
Dollar
CAD : Canadian Dollar JPY : Japanese Yen
GBP : British Pound IEP : Irish Pound (punt)
INR : Indian Rupee SAR : Saudi Riyal
EUR : Euro
 CURRENCY MARKETS
SPOT QUOTES : EXAMPLES
USD/CHF SPOT: 1.4575/1.4580

Bid Offer

Bank will buy 1 USD and give CHF 1.4575

Bank will sell 1 USD and want to be paid CHF
1.4580.
Shortened to 1.4575/80 or even 75/80 between
dealers. “1.45” is the “big figure”
 CURRENCY MARKETS
SPOT QUOTES : EXAMPLES
Interpret these quotes :
GBP/USD : 1.5665/70 USD/DEM : 1.9995/05
GBP/EUR : 1.2545/50 USD/INR : 46.7585/46.7685
USD/JPY : 110.25/35
•Most currencies quoted up to six significant figures. Last
two figures known as “points” or “pips”. GBP/USD the
bid-offer spread is 10 pips. Smaller currencies quoted to 2
decimals.
 CURRENCY MARKETS
• Quotations in European Terms: Units of a currency per
US dollar. Example : USD/INR : 46.7560/7675
• Quotations in American Terms : US dollars per unit of a
currency. Example : GBP/USD : 1.5060/65
• Direct Quotations: Units of “home” currency per unit of
“foreign” currency. Example : USD/INR above, a direct
quote in India.
• Reciprocal or Indirect Quotations: Units of “foreign”
currency per unit of “home currency”. Example:
USD/GBP : 0.6638/0.6640, an indirect quote in UK.
 CURRENCY MARKETS
Interbank Arbitrage : Suppose banks A and B are quoting :
A B
GBP/USD : 1.4550/1.4560 1.4538/1.4548

--------- Bank A
bid ask
---------- Bank B
bid ask
Buy GBP from bank B, sell to bank A. Prices will move.
A B
GBP/USD : 1.4550/1.4560 1.4548/1.4558
--------- Bank A
---------- Bank B

No arbitrage. Quotes must “overlap”.

INVERSE QUOTES AND 2-POINT ARBITRAGE
USD/CHF : 1.4955/1.4962 A bank in Zurich
CHF/USD : 0.6695/0.6699 A bank in NY
Arbitrage Opportunity? Buy Swiss francs 1 million in Zurich
sell in New York.
$(1,000,000/1.4955) i.e. $6,68,700 needed to acquire the Swiss
francs.
$(0.6695 × 1000000) i.e. $6,69,500, obtained on selling, a
riskless profit of $800. Zurich USD/CHF quotes imply certain
CHF/USD quotes:
Implied (CHF/USD)bid = 1/(USD/CHF)ask
Implied (CHF/USD)ask = 1/(USD/CHF)bid
INVERSE QUOTES AND 2-POINT ARBITRAGE

To prevent arbitrage, the New York bank's (CHF/USD) quotes

must overlap the (CHF/USD) quotes implied by the Swiss bank's
quotes. The latter work out to 0.6684/0.6687. A quote such as
0.6686/0.6689 will not lead to arbitrage though it may lead to a
one-way market for the banks. The rates actually found in the
markets will obey the above relations to a very close
approximation.

GBP/USD: 1.5465/70 USD/GBP ?

USD/INR: 46.7550/46.7650 (100)INR/USD ?
GBP/EUR: 1.3035/45 EUR/GBP?
Cross-Rates and Three-Point Arbitrage
A New York bank is currently offering these quotes :

USD/JPY : 110.25/111.10
USD/AUD : 1.6520/1.6530

At the same time, a bank in Sydney is quoting :

AUD/JPY : 68.30/69.00

Is there an arbitrage opportunity?

Consider this sequence of transactions: Sell yen against US

dollars and the US dollars against Australian dollars both in
New York and finally sell the AUD for yen in Sydney.
This is known as 3-point arbitrage : Sell A, buy B; Sell B buy C;
Finally sell C buy A.
Cross-Rates and Three-Point Arbitrage
The calculations are :(N: NY S: Sydney)

1 JPY in NY gets USD [1/(USD/JPY)ask(N)] = USD (1/111.10)

Sell USD [1/(USD/JPY)ask(N)] in NY to get AUD

{[1/(USD/JPY)ask(N)](USD/AUD)bid(N) } = AUD (1/111.10)(1.6520)

Sell AUD {[1/(USD/JPY)ask(N)](USD/AUD)bid(N) } in Sydney to get

JPY{[1/(USD/JPY)ask(N)](USD/AUD)bid(N)(AUD/JPY bid(S) }
= JPY (1/111.10)(1.6520)(68.30) = JPY 1.0156
 EUR Locking Rates
EUR Locking Rates
EUR/ATS= 13.760300
EUR/BEF= 40.339900
EUR/DEM= 1.955830
EUR/ESP= 166.386000
EUR/FIM= 5.945730
EUR/FRF= 6.559570
EUR/IEP= 0.787564
EUR/ITL= 1936.270000
EUR/LUF= 40.339900
EUR/NLG= 2.203710
EUR/PTE= 200.482000
 INTERBANK SPOT DEALING
•Monday September 21 10.45 am
BANK A: "Bank A calling. DLR-FRF 25 please.
•BANK B: "Forty -Fiftytwo”
(Bank B is specifying a two-way price. Knowing that the
caller is also a forex dealer, the dealer in Bank B quotes
only the last two decimals of the full quotation. For
instance the full quotation might be 4.1540/4.1552.)
•BANK A: “Mine”
(Bank A dealer finds bank B’s price acceptable and wishes to
buy USD 25 million. She conveys this by saying “mine”)
 SPOT DEALING (Contd.)
•BANK B: OK. I sell you USD 25 million against FRF at
4.1552 value 23 September. BNP Paris for my FRF.
•BANK A: CITIBANK NYK for my dollars. Thanks & Bye.

• Deal is consummated. Back office staff will retrieve details,

exchange confirmatory faxes/telexes and arrange settlement.

•Spot deals account for about 60 % of total turnover.

•Dealers work within limits assigned by management

•Counterparty must be acceptable credit.

 FORWARD AND SWAP QUOTES
• Forward outrights can be given like spot quotes.
• USD/CHF 3-months 1.5655/65 bid/ask
•More commonly given as a spot quote plus a pair of swap
points
USD/CHF Spot : 1.6525/35
1 month : 15/10 2 months : 25/18 3 months : 35/25
GBP/USD Spot : 1.4925/35
1 month : 12/15 2 months : 20/25 3 months : 28/35
 FORWARD AND SWAP QUOTES
• To find outrights : Spot quote ± Swap Points
• Each swap point is 0.0001 ( or 0.01)
•When to add, when to subtract?
•Take USD/CHF Spot : 1.6525/35 1 month : 15/10
•If you add : 1 month outright : 1.6540/45
• If you subtract 1 month outrights : 1.6510/1.6525
•Which is correct?

•Two “rules” : 1 Ask > Bid 2 Bid-Ask spread must

widen as you go farther into future
 FORWARD AND SWAP QUOTES

• Using rule 2, 1.6540/1.6545 is wrong. 1.6510/25 is correct.

• Now take GBP/USD Spot 1.4925/35 2 months : 20/25
• If add, 2 month outrights 1.4945/1.4960, if subtract
1.4905/1.4910. The latter is correct.
•Mechanical rule : If swap points are Big/Small, subtract,
base currency at forward discount, quoted currency at
premium. If swap points Small/Big, add. Quoted currency at
discount, base currency at premium.
 FORWARD AND SWAP QUOTES

• A quote like : USD/SEK Spot 8.4565/70 3 month : 10/20

•Bank will do either swap:
(1) Buy USD spot, sell USD 3 months forward agnst SEK. The
forward rate would be 20 points above the spot rate.
(2) Sell USD spot, buy 3 months forward, forward rate 10 points
above spot.
In a swap, amount of one currency - usually the base currency-
kept same in the spot and the forward leg. Buy USD 1m spot, sell
USD 1m forward. Amount of SEK will be different.
INTERBANK FORWARD DEALING
DEC 4 2000
BANK A : "Bank A calling. Three-month yen-dollar
please.”

BANK B : "Thirty two; twenty five."

BANK A : "Fifteen dollars yours at thirty two".

BANK B : "OK. Let's use a spot of 120.50 which is for

value December 6; I buy at 120.18 for value March 6."
 OPTION FORWARDS
•Delivery date to be chosen by the contract buyer within a
specified interval.
•A 3 month forward with delivery option over 3rd month
•A 6 month forward with delivery option over last three
months.
•Banks extract maximum premium or give least discount
•GBP/USD spot : 1.4565/70 2 Mth. 15/10 3 Mth 22/17
•Customer wants to buy USD, 3 mths forward, option over
3rd month. USD at premium at 2 mths, greater premium
at 3 mths. Bank will charge 3 mths premium.
 OPTION FORWARDS
•If customer wanted to sell USD, bank would give only 2
months premium.
•USD/CHF Spot 1.6570/75 3 Mths 15/20
(1) Customer wants to buy USD 3 mths forward option
period from spot to 3 months. Rates?
(2) Customer wants to buy CHF. Rates?
•In the Indian market, length of option period cannot
exceed one month.
FORWARD QUOTES
INR1F=
Bid Ask
INR= 46.4425 46.4625
INRON= 0.25 0.50
INRTN= 0.75 1.00
INRDECM= 5.00 6.00
INRJANM= 20.75 21.75
INRFEBM= 34.50 35.50
INRMARM= 51.00 52.00
INRAPRM= 67.25 68.25
INRMAYM= 83.50 84.50
INRJUNM= 98.50 99.50
INRJULM= 116.50 117.50
INRAUGM= 133.50 134.50
INRSEPM= 150.50 152.00
INROCTM= 167.50 169.00
INRNOVM= 184.00 185.50
 BROKEN DATES
• Standard forward are whole months. Banks will do any
number of days forward - 63 days, 135 days etc. These are
“broken date” or “odd date” forwards.
•Interpolate between two whole month dates. OK if the gap
between the two dates is not too long and no special
technical factors are at work.
•USD/INR spot 46.95/96 1 month 10/12 2 mths 20/27
•Customer wants to buy USD 43 days forward.
•15 paise premium from 1 mth to 2 mths. Suppose 30 days in
2nd month. 0.5 paisa per day, 6 paise for 12 days. Rate
would be 46.96+0.12+0.06 = 47.14
 SHORT DATES
• Delivery same day- cash
•Delivery next day - Tomorrow or “Tom”.
•Markets quote overnight O/N, tomorrow/next T/N and
Spot/Next S/N swaps. These are used to compute rates for
short date transactions.
•Reverse swap points and follow add/subtract rule.
•USD/DEM Spot 1.9545/50 T/N : 5/3 3/5
•Outright for tom : 1.9548/50
 FOREX AND MONEY MARKETS
• Annualised %Premium/Discount, T-year forward
= [(Forward-Spot)/(Spot)] × (1/T) × 100
•Use mid rates for quick calculations.
•Annualised forward margin = Interest rate differential
True for fully convertible currencies with no capital controls.
• Currency with higher interest rate will be at discount.
•3-month Euro LIBOR : 8% p.a. 3-month USD LIBOR : 6%
•USD will be at a 3-month forward premium of 2% p.a.
 FOREX AND MONEY MARKETS

This relation between interest rate differential and spot-forward

margin is known as Covered Interest Parity.
It holds for freely convertible currencies with no capital controls.
It is a result of investors arbitraging between money markets in
different currencies in search of highest return.
Holds with Euromarket interest rates.
It is not a causal relation but an equilibrium relationship.
It will be analysed in detail in the next chapter
 FORWARD-FORWARDS AND
RELATED PRODUCTS
• Buy USD 1 month sell 3 months vs.GBP. A 1-3 swap.
•Related products are FSAs, ERAs and FXAs
•Third currency forwards in the Indian market.
•Forward contracts can be cancelled. Settlement payments
depend upon current forward rates.
•Forward contracts tie up credit limits and attract capital
adequacy norms. FSAs, ERAs and FXAs are innovations to
get around these problems. Analysed in next chapter