Foreign Exchange

Sainatth Wagh

Eurocurrency Market

The Eurocurrency market in Asia is sometimes referred to separately as the Asian dollar market. The primary function of banks in the Asian dollar market is to channel funds from depositors to borrowers. Another function is interbank lending and borrowing USD,CND,EURO

Eurocredit Market

LOANS

Loans of one year or longer are extended by Eurobanks to MNCs or government agencies in the Eurocredit market. These loans are known as Eurocredit loans. Floating rates are commonly used, since the banks asset and liability maturities may not match - Eurobanks accept short-term deposits but sometimes provide longer term loans.

Eurobond Market

BONDS

There are two types of international bonds. Bonds denominated in the currency of the country where they are placed but issued by borrowers foreign to the country are called foreign bonds or parallel bonds. Bonds that are sold in countries other than the country represented by the currency denominating them are called Eurobonds.

Eurobond Market

BONDS

Interest rates for each currency and credit conditions in the Eurobond market change constantly, causing the popularity of the market to vary among currencies. About 70% of the Eurobonds are denominated in the U.S. dollar. In the secondary market, the market makers are often the same underwriters who sell the primary issues.

International Stock Markets

Stock issued in the U.S. by non-U.S. firms or governments are called Yankee stock offerings. Many of such recent stock offerings resulted from privatization programs in Latin America and Europe. Non-U.S. firms may also issue American depository receipts (ADRs), which are certificates representing bundles of stock. ADRs are less strictly regulated.

Foreign Exchange Market

The foreign exchange market is predominantly an over the counter market. There is no single physical or electronic market place or organized exchange with a central trade clearing mechanism. The market functions virtually the whole day. The wholesale market is called the inter bank market and consists of commercial banks, investment institutions and Central Banks.

Foreign Exchange Market

The Primary price makers or Professional dealers make a two way market to each other and their clients. On request they will quote a two-way quote and be prepared to take either the buying or the selling side. The difference between the buying and the selling prices is the bid-ask spread.

Spot and Forward transactions

Settlement of transactions takes place by transfers of deposits between two parties. The day on which these transfers are affected is called the settlement date or value date. Depending on the time elapsed between the transaction date and the settlement date, foreign exchange transactions are categorized into spot (within forty eight hours) and forward transactions.

Exchange rate quotations

Direct Quotes are those that give units of the currency of that country per unit of foreign currency. Thus USD/INR 43.20-43.50 is a Direct Quote in India. Indirect Quotes are stated as a number of units of foreign currency per unit of home currency. Eg. INR/USD 2.560 2.552 is an indirect quotation in India per rupees one hundred.

Conventions
Inter Bank markets generally use quotation conventions adopted by ACI (Association Cambiste Internationale) 1. A currency quote is denoted by a three letter code for two currencies separated by an oblique or a hyphen. Eg: USD/INR 2. The first currency in the pair is the base currency and the second the quoted currency.

Currency quotation conventions

3. The exchange rate quotation is given as number of units of quoted currency per unit of base currency. Thus USD/INR quotation will be giving number of rupees per dollar. 4. The quotation consists of two prices. The rate shown on the left of the hyphen or oblique is the bid price and the one on the right is the ask or offer price.

Forex Quotes
The bid price is the price at which the dealer is willing to buy and is bidding for one unit of base currency against the quoted currency. The bidder will give that amount of quoted currency in return for one unit of base currency. The ask or offer rate is the price at which the dealer is willing to sell / is offering one unit of base currency.

Forex Quotes
When a dealer is buying a currency, he will want as much of it as he can possibly get for the currency he offers, but when he is selling, he will only give away as little of it as he is forced to. The dealer will quote a rate at which he will sell and rate at which he will buy. The dealer is the master of the situation and whoever does business with that dealer he must do so on terms laid down by dealer.

Spread
The difference between the offer rate and the bid rate is called the bid offer spread or bid ask spread. The offer rate must always exceed the bid rate. The bank giving the quote will always want to make a profit on its currency dealing.

Arbitrage
Arbitrage is an activity which results in riskless profits . Locational arbitrage takes advantage of imperfections in markets to make profits. Bank , though having day light and overnight exposures would generally square off position at the end of the exercise.

Arbitrage
Quotations should overlap to prevent arbitrage. The rule for dealing is buy high, sell low. This can be directly applied to indirect quotes since the rule refers to the quantity sold and bought. In the case of indirect quotations, the rate shown on the left is the selling price and the one on the right the buying price.

Locational Arbitrage - Illustration

The following rates are available to an MNC Bank. Zurich (Spot rates) USD/CHF 1.4955/1.4962 New York CHF/USD 0.6695/0.6699

Locational Arbitrage
Bank buys One million Swiss Francs in the market where it is cheap and sells in the market where it is costlier. Calculate the profit from arbitrage.

Local Arbitrage - Solution

Zurich rates USD/CHF 1.4955/1.4962 (Converting to indirect quotation we get CHF/USD 0.668673/ 0.66836.) This quote refers to Buying and Selling of One unit of base currency i.e USD. New York rates CHF/USD 0.6695/0.6699 MNC Bank buys One million Swiss Francs in Zurich i.e Sells equivalent USD. The dealer buys USD from MNC Bank.

Locational Arbitrage
So buying rate has to be applied. For buying One million Swiss Francs 1000000/1.4955 USD have to be paid. = 6686726.85 In New York. This is a direct quotation. Sell One million Swiss Francs. That is, the dealer buys CHF from MNC Bank. So buying rate has to be applied.

Locational Arbitrage -Solution

1000000 *0.6695 = 669500. Profit in the transaction 669500 668672.69= $827.31. The quotations do not overlap, i.e the highest rate in Zurich (0.66867269 )is lower than the lowest rate in New York(0.6695).

Triangular Arbitrage
Bank quote in New York USD/JPY - 110.25/111.10 USD/AUD - 1.6520/1.6530 Bank Quote in Sydney AUD/JPY 68.30/69.00 US MNC Bank initiates a triangular arbitrage by selling One million JPY against US Dollars. Calculate profit/loss in JPY.

Triangular Arbitrage -Solution

Both are indirect quotations since home currency is the base currency. The principle Buy High, sell low should be applied. The dealer should be able to buy higher quantity of foreign currency and sell lower quantity of foreign currency for one unit of base currency which is the domestic currency.

Triangular Arbitrage
The dealer should take higher amount of JPY for one unit of USD. So the rate to be applied for conversion of JPY to USD is 111.10 per USD. So sale of 1m JPY will be 1000000/111.10 = USD9000.90 Convert USD to AUD i.e Purchase of AUD It is a sale of AUD for the dealer. So less quantity of AUD will be sold 9000.90 * 1.6520 = 14869.486

Triangular Arbitrage -Solution

In Sydney Sell AUD for JPY. It is a purchase of AUD for the dealer. It is thus a sale of JPY against AUD. So the dealer sells lower quantity of JPY for every unit of AUD. 14869.486 * 68.30 = JPY 1015585.80. Profit = JPY15585.80