INTERNATIONAL FINANCIAL MANAG

EMENT

UNIVERSITY OF MASSACHUSETTS
DARTMOUTH
Instructor: Professor Trib Puri
1

The Market for Foreign Exchange

Objectives of Study:
To understand why FX Market exist.
Continuous Trading so that Exchange rates are readily know

n.

To understand the Function & Structure of FX Market

Participants
Segments
Market activities (Arbitrage, Hedging, and Speculation)

To understand how exchange rates are determined

FX Trading
Continuous

Trading
Daily volume approximately $3.5 Trillion

Function and Structure of

the FX Market - Participants
The FX market is a two-tiered market:
a. Tier 1: Interbank Market (Wholesale)
About 200 banks worldwide stand ready to mak
e a market in foreign exchange.
Nonbank dealers account for about 40% of the
market.
There are FX brokers who match buy and sell or
ders but do not carry inventory and FX specialis
ts.
Central banks
b. Tier 2: Client Market (Retail)
4

Multinational Banks of the Interbank Market

.

Examples:

Goldman Sachs

Barclays Capital

Deutsche Bank

UBS

Credit Lyonnais

Credit Agricole (France)

Industrial and Commercial Bank of China

Credit Suisse Group

HSBC Holdings (UK)

Function and Structure of

the FX Market: Segments
Spot Market
Forward market
Futures and Options market
Swap Market
Exchange Traded Funds (ETFs)

Market Segments - The Spot Market

Spot FX Trading
Spot Rate Quotations
Two-way pricing, Bid and Ask. The Bid-ask spread.
Market microstructure
Cross Rates

Spot Market - Spot FX trading

A spot transaction of a currency is a trade that settles i

n 2 days or less in the inter bank market.

On the settlement date (the date of settlement is
referred to as value date), most dollar transaction
s in the world are settled through the computeriz
ed Cleaning House Inter bank Payments System (CHIP
S) in New York, which calculates the net balances
owned by any one bank to another and for payme
nt by 6:00 PM that same day in FED, New York fun
ds.

Spot Market - Spot Rate Quotations

Direct quotation(American Terms)
Price of a foreign currency in USD terms.
Example: $1.4425/

Indirect Quotation (European Terms)

Price of USD in terms of foreign currency
Example: 0.6932/$

Note that the direct and indirect quotes are always recipr
ocal of each other.

Two-way Pricing, BID&ASK,

The Bid-Ask Spread
Currency traders quote two prices at any time.
BID: The price of a currency at which the trader is ready t

o buy the currency. (Accumulate LONG POSITION in the

currency at BID)
ASK: The price of a currency at which the trader is ready
to sell the currency. (Accumulate SHORT POSITION in t
he currency at ASK)

10

The Bid-Ask Spread

A dealer quotes USD-EUR rate as 1.4739-44
bid price of in $ : $1.4739 per (always lower than ask)
ask price of in $ : $1.4744 per

The bid-ask spread represents the dealers expected profit.

Percent Spread =

Ask Price Bid Price

100
Ask Price

$1.4744
0.0339% $1.4739
=
$1.4744
100

x
11

BID-ASK
Trader at Barclays quotes:
BID

ASK

USD-EUR($/)

1.2350 (Buy in $)

1.2369 (Sell in $)

EUR-USD(/$)

0.8085 (Buy $ in )

0.8097 (Sell $ in )

1
1.2369

1
1.2350
12

Currency Conversion with Bid-Ask Spreads

A trader in New York wants to take a long position in pound

s in exchange for $10,000.

What is the size of long position in BP? The quotes are:
Bid
Ask
S($/)
1.9715 20
S(/$)

.5071 72

The trader can assume a long position in (Buy at

$10,000
BID of 1.9715)
=
= 5072.28
$1.9715 /
The trader can take short position in at Ask price of
$1.9720/

13

An Example
A businessman has just completed transactions in Italy and E
ngland. He is now holding 250,000 and 500,000 and wants
to convert to U.S. dollars.
His currency dealer provides this quotation:
GBP/USD
USD/EUR

0.5025 76
1.4739 44

Assuming no other fees, what are his proceeds in $ from

conversion?
14

Solution
Bid price of $1.4739/
1
Bid price of $
/
0.5076

$1.473
250,00 9
= $368,475

0x
1.00
$1.0
$985,027.5
500,00 0
=
8
.5076
0x
$1,353,502.5
8
15

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 ex

change rates.

16

Cross Rates
A Cross rate is the exchange rate between a pair of currencies, which is implie
d by a pair of exchange rates between these currencies and a common currenc
y, usually dollar.
Suppose a trader quotes the following: 134.2 /$, and $1.411/
What is the implied price of
in$.
Cross Rate / =
=

134.2
$

$1.411

x= 189.35/

17

Cross Rates- Example 2

Suppose the following quotes are observed:
DK 6.5596/Euro and NZ 1.9558/Euro
The implied exchange rate or the no-arbitrage exchange r
ate between DK and NZ (NZ/DK), which is the implied pr
ice of 1DK in NZ terms is given by:
NZ
NZ
DK
CrossRate

DK Euro Euro
NZ1.9558 / Euro

NZ 0.2982 / DK
DK 6.5596 / Euro
18

Cross rates with Bid and Ask

When currency quotes are presented without bid and ask (or
if the bid ask spread is zero), we have seen that the implied
cross rate is given by:
S(/) = S($/) x S(/$)
When bid-ask quotes are presented, then it is a bit more cum
bersome to calculate cross- Bid and cross- Ask.

19

Example
Suppose a currency trader at Goldman Sachs quotes the foll
owing quotes:
EURO-USD
($/)
1.2987-95
GBP-USD ($/)
1.5540-52
Calculate the implied Euro-GBP (/) with bid and ask.

20

Rewrite the direct and indirect rates given above with their r
espective reciprocals. You will need these for further calcula
tions.

21

The process may be represented as:

Sell $ - Buy
(Bid of in $)

Sell - Buy $
(Bid of $ in )

(/)Bid = ?
The details are:
1.Sell 0.7695 to buy $1 (Bid price of $ in = 0.7695/$)
2.Sell $1 to buy 0.6435 (Bid of in $ = $1.5540/)
Note that
0.7695 = $1 = 0.6435
or, 0.7695 = 0.6435
or, 1 = 1.1958 (Bid price of in )
22

If you have understood the above mechanism, you can readi

ly summarize the bid cross rate as follows:
S(/)bid = S(/$)bid x S($/)bid
= (0.7695/$) x ($1.5540/) = 1.1958/

23

The process may be represented as:

Sell - Buy $
(Ask of in $)

Sell $- Buy
(Ask of $ in )

(/)Ask = ?
To summarize:
1 = $1.5552 = 1.1975
1 = 1.1975 (Ask price of in )
If you have understood the above mechanism, you can readily summarize the
ask cross rate as follows:

S(/)ask = S(/$)ask x S($/)ask

= (0.7700/$) x ($1.5552/)= 1.1975/
24

25

Market Segments- The Forward Market

Forward Rate Quotations
Long and Short Forward Positions
Forward Premium

26

The Forward Market

In the forward FX market, currencies are traded for
future deliveries at prices agreed upon today.
Standard future deliveries are 30 days, 90 days, 180
days, 360 days.
Special maturities can be negotiated with the banks
as an Over the Counter (OTC) transaction.
The exchange rate for the forward transaction is est
ablished at the time the contract is agreed upon, bu
t the payment and delivery are not required until m
aturity.
27

Forward Rate Quotations

The forward market for FX involves agreements to buy a

nd sell foreign currencies in the future at prices agreed up

on today.
Bank quotes for 1, 3, 6, 9, and 12 month maturities are re
adily available for forward contracts.

28

Forward Rate Quotations

Country/currency

in US$

per US$

British Pound

1.9717

.5072

1-mos forward

1.9700

.5076

3-most forward

1.9663

.5086

6-mos forward

1.9593

.5104

Why the pound is worth less in dollars

in 6 months?
29

Spot Differential
Spot differential measures change in spot rate over

a certain period of time (Appreciation or depreciati

on of a currency against another currency over a pe
riod of time). For spot exchange rates expressed as
SF/$, it is defined as:

Appreciation of $ against SF =

30

Example:
So =SF 0.8450/$ S1 = SF 0.9525/$
Appreciation of $ against SF
=

= 0.1272 or 12.72 %

31

Depreciation of SF against dollar

=

=
= -0.1129 or -11.29%
32

Example2:
WSJ quotes are as follows:
Jan 14: Spot rate for Brazilian Real $0.7576/R$
Jan 29: Spot rate for Brazilian Real $0.4854/R$
Calculate the appreciation or depreciation, as the case may b
e, of Brazilian Real against the US $ from Jan 14 to Jan 29.

33

Let S0 be exchange rate on January 14 and St be the exchange rat

e on January 29.

=-

0.3593 or 35.93%
Percentage appreciation of dollar against Real

34

Forward Differential
(Premium or Discount)
Forward differential measures the value of a currency ver

sus another currency in the forward market with respect t

o current spot market.
The Annualized Forward Rate Differential is defined as:

Annualized Forward Differential =

Where n is the number of days to maturity of the forward co
ntract. The forward differential may be a premium or a disco
unt depending upon whether F> S0, or F< S0.
35

Example: The following quotes are published in WSJ:

Spot
$0.7021/SF SF 1.4243/$
30 days
0.7041
1.4202
90 days
0.7088
1.4108
180 days 0.7156
1.3979
Find out the forward premium or discount on SF against $ in
the 180-days forward market.
36

Annualized forward premium on SF against $

= 3.84% p.a.

Annualized forward discount on $ against SF in 180-days

= -3.70% p.a.

37

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.

38

Function and Structure of

the FX Market - Currency Futures and Options
Currency Futures
Like forward contracts, futures contracts are also maturity co

ntracts.
A futures contract represents a pure bet on the direction
of price of the underlying asset (in our case foreign curren
cy is the underlying asset and the price is the exchange rate)
Futures contracts are marked-to-market on a daily basis and
the holder of the futures contract receives or pays daily cash fl
ows depending upon the direction of movement of futures pri
ce.
39

CURRENCY OPTIONS
A unilateral contract giving the holder the right,
but not the obligation to buy (call option) or sel
l (put option) the underlying currency at any ti
me until (at) expiration.

40

Function and Structure of

the FX Market - Swaps
Currency Swaps
A swap transaction in the interbank market is t
he sale (purchase) of a currency with a simultan
eous agreement to repurchase (sell) it at a futur
e date. Thus swap is the exchange of one curre
ncy for another on one day, matched by a rever
se exchange on a later day.

41

Function and Structure of

The FX Market - ETFs
Currencies are now recognized as a distinct asset class, like stocks an

d bonds. Currency ETFs facilitate investing in these currencies

An ETF where each share represents a fixed number of FC units (e.g
. 100 Euros).
Individual shares are denominated in the U.S. dollar and trade on the
New York Stock Exchange.
The price of one share at any point in time will reflect the spot dollar
value of 100 Euros plus accumulated interest minus expenses.
Examples of Currency ETFs: Australia (FXA), Brazil (BZF), Britai
n (FXB,GBB), Canada (FXC), China (CNY,CYB), the Euro (FXE,ER
O,EU), India (INR,ICN), Japan (FXY,JYN), Mexico (FXM), New Ze
aland (BNZ), Russia (XRU), South Africa (SZR), Sweden (FXS) an
d Switzerland (FXF).

42

Market Activities- Arbitrage

Arbitrage is the process of making profit through simulta

neous buying and selling of two similar or equivalent asse

ts at two different prices, without incurring any risk. (Buy
low and sell high without any risk)
Arbitrage is an important economic force that brings price
equalization of a similar good, security, and asset across m
arkets.

43

Arbitrage (Locational) Example 1

Trader A observes that dollar is quoted as SEK7.0216 in Stockhol
m and at the same time SEK (Swedish Krone) is quoted as $0.14
22 (SEK7.0326/$) in New York. Is there any arbitrage opportunit
y? What will be the arbitrage profit on a transaction of $10m?
Compare the exchange rates in Stockholm and New York.

Stockholm
SEK/$

NY

7.0216/$
(Reciprocal)
44

The arbitrage profit on a transaction of SEK10m is

= (SEK7.0326/$ - SEK7.0216/$) x $10m
SELL

BUY

= SEK 110, 000

What will be this profit in $?
(Depends where the trader converts the arbitrage profit into $)
In NY: SEK110, 000 x $0.1422/SEK = $773, 586.00
In Stockholm: SEK 110,000 SEK7.0216/$ = $772, 376.00
45

Arbitrage (Locational)
Example 2
Given:
$/SF Exchange Rate in NY
$/BRL Exchange Rate in NY
BRL/$ Exchange Rate in Paris
BRL/SF Exchange Rate in Paris

0.6935
0. 3529
2.8336
1.9989

46

Exchange
rate

NewYork

$/SF
$/SF

0.6935
0.6935

x
= =0.7054

$/BRL
$/BRL

0.3529
0.3529

(1/2.8336)=0.3529
(1/2.8336)=0.3529

Equilibrium/
Equilibrium/
No
Arbitrage
No Arbitrage

1.9989
1.9989

Disequilibrium/
Disequilibrium/
Arbitrage
Arbitrage

BRL/SF
BRL/SF
=1.9651

Paris

Remarks

Disequilibrium/
Disequilibrium/
Arbitrage
Arbitrage

47

Arbitrage Profits
1.

$/SF Rate

Action
Buy SF in NY
Sell SF in Paris
Arbitrage Profit

Cash flow
- $ 0.6935/SF
+ $0.7054/SF
$ 0.0119/SF

2. $/Real: No arbitrage profit on $/Real rate.

3.

Real/SF Rate

Action
Buy SF in NY
Sell SF in Paris
Arbitrage Profit

Cash flow
-Real 1.9651/SF
+Real 1.9989/SF
Real 0.0338/SF

48

Market Activity - Speculation

Speculation involves betting on price movement. If

the price movement is favorable, the speculator ma

kes a profit otherwise a loss. Thus a speculators inv
estment is exposed to risk.

49

Example 1

(Speculation in the Spot Market):

Suppose a currency trader acquires a long position of 10 million at $1.4250/
. Further suppose the exchange rate moves to $1.4025/ when the trader is r
equired to net out of this long position in . What is the profit or loss in $?
First, understand that the traders long position of 10m is exposed to unexpe
cted changes in the exchange rate.
Loss on this position = (1.4025 - 1.4250) x 10m
= -$0.225 million
50

 Example 2

(Speculation in the Forward Market):

Suppose today is Feb 1, 2012. The current spot rate is $1.3350/. 90-day
forward rate is $1.3500/. The spot rate at the maturity of the forward
contract is unknown today and the forecast is to 1.270/. will depreciate
against $ in 90-days.
Calculate the speculative gains and losses on a long forward position and
also on a short forward position. Draw the contingency profit and loss graph

51

Contingency spot
rate in 90-days
S1($/)

Long
Profit/loss
(S1-F)

Short
Loss/Profit
(S1-F)

1.20

-0.15

+0.15

1.25

-0.10

+0.10

1.27

-0.08

+0.08

1.30

-0.05

+0.05

1.35

1.40

+0.05

-0.05

1.45

+0.10

-0.10

52

Contingency Profit and Loss Graph

profit
0.15

Long position

0.10
S1($/)

0
1.20 1.25 1.30

1.35

1.40 1.45

-0.10
-0.15

Short position
53

Market Activity- Hedging

Hedging involves taking measures to protect against unfa

vorable movements in price of an underlying asset or liab

ility or a cash flow, or a value of a business.

54

Example:
Suppose Best Buy places an order on SONY for Plasma TV
sets. The consignment is due in six months, when Best Buy
will be required to make a payment of 2500 million. The c
urrent spot rate is 89.90/$. The exchange rate six-months fr
om now is not known today.
a. If the exchange rate does not change, what will be the dollar pa
yment in 6 months?

55

b. What is Best Buys concern? What asset or liability is exposed to ex

change rate changes? How can Best Buy hedge its $ payment?
Best Buys accounts payable (a current liability) denominated in Yen is
exposed to the changes in exchange rate. Its concern is that yen will ap
preciate in 6 months against dollar so that the payment in dollar is likel
y to go up.
Best Buy can buy a 6-month forward contract to lock in the price of i
n $. Suppose the 6-month forward exchange rate is 89.62/$. By buyin
g a forward contract, Best Buy ensures that it can buy at the rate of
89.62/$, when the payment to SONY will be due in 6-months.
56

Best Buys portfolio contains a liability (short position in ) and a

forward contract (Long forward-long position in ).It does not have to
worry about the appreciation of against dollar.

57

Forward Market Hedge

The red line

shows the
payoff of the
$m
hedged
payable. Note
that gains on $27.89m
one position
are offset by
losses on the $ m
other position.

Unhedged
payable in $

Hedged payable

Forward
Contract
58

END