THE FOREIGN EXCHANGE MARKET The foreign exchange market operates 24 hours a day through a network of foreign exchange

brokers, local and multi-national banks, and other participants. The exhibit below shows the volume of trade that takes place each hour. Typical daily market activity is $ .2!. Exhibit 4.1 Foreign Exchange Activit
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Green*ich Mean Ti+e

1 $ % 4 " & ' ( ) 1! 11 1$ 1% 1 4 1" 1& 1 ' 1 ( 1) $! $1 $$ $ % $4

1! AM 14nch E4ro-e In To, o In To, o o-ening

A.ia c/o.ing

A+erica. 1on2on o-en c/o.ing

A0ternoon in A+erica

& -+ To, o In N3 o-en.

5o4rce6 Fe2era/ Re.erve 7an, o0 Ne* 3or,# 8The Foreign Exchange Mar,et in the 9nite2 5tate.#: $!!1# ***.n .0rb.org.

Q: According to your book, who are the main participants in the foreign exchange market? "# $ bank and nonblank foreign exchange dealers 2$ individuals and firms %$ speculators and arbitragers 4$ central banks and treasuries &$ foreign exchange brokers

Q: What makes central banks and treasuries different from other market participants? "# Their goal is '(T profit) it is to support economic policies or political commitments.

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Two basic markets exist. $ the spot currency exchange market and 2$ the forward currency exchange market. The 5-ot Mar,et -urrencies trade for .immediate/ delivery in the spot market 0but settle 2 days after the trade date$. Q: If the spot rate for Mexican pesos is s!"#$%%&' and your company buys s(%%,%%% spot from your bank on Monday, how much must your company pay and on what day? "# The company will pay The For*ar2 Mar,et -urrencies trade for future delivery. 5tandard forward contracts are for %1, 21, and 61 days after the trade date. )ote .buying forward/ and .selling forward/ can be used to describe the same transaction. *or example, %&+ $ represents the six-month forward rate to buy 8aitian gourde forward for 7.5. dollars or the six month forward rate to sell 7.5. dollars forward for 8aitian gourde. " contract to deliver 7.5. dollars for 8aitian gourde in 9-months at * 61 = ,e-iew ;irect <4otation = is the home currency price of a unit of foreign currency. *or example, $1.&13 !ds$ is a direct :uote for the 7.5. dollar 0as the home currency$ and the !arbados dollar 0as the foreign currency$. This is also known as .A+erican ter+../ .he Wall /treet 0ournal uses this format for listing :uotes under the heading .7.5.$ e:uivalent./ In2irect <4otation ; the foreign currency price of a unit of home currency. *or example, .22!d$3$ is an indirect :uote for the !arbados dollar 0as the foreign currency$ and the 7.5. dollar 0as the home currency$. This is also known as .E4ro-ean ter+../ The 4all 5treet <ournal uses this format for listing :uotes under the heading .-urrency per 7.5.$./ s 11, 111 = $ 1,&14.21 on 4ednesday. s2.&2 3 $

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" 7ro,er is an agent that facilitates trading between market participants. " broker charges a commission. " ;ea/er keeps an inventory of securities and stands willing to buy or sell at a given spread. " dealer makes money on the spread between the bid and the ask. 05ee below$ 7i2>A., <4ote. The bid is the price a 2ea/er will buy a security. The ask is the price a 2ea/er will sell a security.

Bid = $22
" dealer=s profit comes from the spread between the bid and the ask. " c4.to+er will buy at the ask and sell at the bid.

Ask = $22.5

" dealer=s spread is calculated as follows# ask bid spread = x 11 ask Q: Assume an in-estor wants to in-est '$%,%%% in /wiss securities" .he exchange rates posted by four 1"/" banks are as follows: 5fr3$ 5fr3$ 5fr3$ 5fr3$ !ank " !ank ! !ank !ank ? .9%&> ; >2 .9 9 ; %% .929 ; 61 .9&% ; 42

At which of these banks should the in-estor make the currency exchange? a. b. c. d. !ank " !ank ! !ank !ank ?

"# -hoice .d/ is correct. +xchange rates are generally :uoted with the lower price the bank pays 0the bid$ on the left and the higher price at which they will sell 0the ask$ on the right. @n this example !ank " will buy dollars for .9%&> 5wiss francs but will sell dollars at 5fr .9%>23$. The investor will be selling dollars, so the bank with the highest bid will be the target. @n this example, !ank ? has the highest bid for dollars at 5fr .9&% 3$.

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Q: Assume that an in-estor has 2ust recei-ed /fr $#,%%% and wants to obtain dollars for *rancs" .he exchange rates posted by four 1"/" banks are as follows: 5fr3$ 5fr3$ 5fr3$ 5fr3$ !ank " !ank ! !ank !ank ? .9%&> ; >2 .9 9 ; %% .929 ; 61 .9&% ; 42

With which of the four banks should the in-estor deal? e. f. g. h. !ank " !ank ! !ank !ank ?

"# -hoice .b/ is correct. +xchange rates are generally :uoted with the lower price the bank pays 0the bid$ on the left and the higher price at which they will sell 0the ask$ on the right. @n this example, !ank " will buy dollars for .9%&> 5wiss francs but will sell dollars at 5fr .9%>23$. The investor will be buying dollars, so the bank with the lowest ask will be the target. @n this example, !ank ! has the lowest asking price for dollars at 5fr .9 %%3$. Q: .he exchange rates posted by four 1"/" banks are as follows: 5fr3$ 5fr3$ 5fr3$ 5fr3$ !ank " !ank ! !ank !ank ? .9%&> ; >2 .9 9 ; %% .929 ; 61 .9&% ; 42 ask bid x 11 ask

Aemember the formula for a dealer=s spread is# spread = Q: 3ompute the bid4asked spread for the following bond" ?ealer @ @@ @@@ a. b. c. d. 1.1% 2& 1.192& 1. 2& 1. &92& !id 11 3%2 11 43%2 11 23%2 "sk 11 &3%2 11 93%2 11 &3%2

"# The correct answer is .a./ 5ubtract the highest bid that you can sell from the lowest offer where you can buy. 0 11 &3%2$ ; 0 11 43%2$ B 3%2 B 1.1% 2&

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For*ar2 Tran.action. ; " forward transaction re:uires delivery at a future value date of a specified amount of one currency for a specified amount of another currency. *orward rates are usually :uoted for value dates of one, two, three, six, and twelve months. )ote# The exchange rate is established at the time of the agreement, but payment and delivery are not re:uired until maturity. )ote: F4t4re. are exchange-traded agreements that call for future delivery of a standard amount of a currency 0or other security or even commodity$ at a fixed time, place, and price. Q: What are the three functions of the foreign exchange market? "# . To transfer purchasing power 2. To provide credit %. To minimiCe foreign exchange risk 5-ot again.t a 0or*ar2 - buy currency in the spot market and sell the same amount back to the same bank in the forward market. 5xample: !ank " buys 1,111,111 'icaraguan naira at today=s spot rate 0D &.&nira3$$ from !ank ! 7an, A E 1,111,111 nira - 94&, 9 dollars 7an, 7 - 1,111,111 nira E 94&, 9 dollars and simultaneously sells 1,111,111 back to !ank ! for dollars for delivery in % months 0at the %-month forward rate D &.4nira3$$. 7an, A - 1,111,111 nira E 942,%& dollars 7an, 7 E 1,111,111 nira - 942,%& dollars 7an, A 1 nira - 4, 62 dollars 7an, 7 1 nira E 4, 62 dollars !ank " has in effect borrowed at the forward percent per year interest rate of 2.&2>F. ?epending on the actual interest rates in % months, one party will .win/ on this transaction. ff = &.&nira 3 $ &.4nira 3 $ %91 x x 11 = 2.&2>F &.4nira 3 $ 21

)ote# the above formula is explained in detail later in these notes.

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&

For*ar2>0or*ar2 .*a-. ; The simultaneous purchase and sale of two forward contracts. !ecause of interest rate parity, the difference between the prices should be the interest rate differential. 5xample# " dealer sells G21,111,111 forward for dollars for delivery in 2 months at $ .96>13G and simultaneously buys G21,111,111 forward for delivery in three months at $ .96213G. T B 2 months T B % months ;ea/er -G 21,111,111 E G21,111,111 1 ;ea/er E $%%,>41,111 - $ %%,941,111 $ 11,111 To check the parity condition you can use the formula for the forward premium. ff = H1.&2263$ H1.&24&3$ %91 x x 11 = %.&&>F H1.&24&3$ %1

+ssentially the dealer borrowed $%%,>41,111 and paid back $%%,941,111) so for a onemonth loan the dealer paid 1.229F interest, which is %.&&>F on an annual basis. $%%,941,111 $%%,>41,111 x 11 = 1.229F x 2 = %.&&>F $%%,>41,111 Cro.. rate. = " .cross rate/ is the exchange rate between two currencies implied by their value with respect to a third currency. 5xample: Iiven the following :uotations# ?ominican Aepublic pesos per 7.5. dollar# A?$4&.&3$ -olombian pesos per 7.5. dollar# -ol$2> %.23$ *ind the exchange rate between the ?ominican Aepublic peso and the -olombian peso. ,6$ 3ol $ ,6$ = $ $ 3ol $ 4&.& ,6$ 2> %.23ol $ 1.1 9>99 ,6$ &2.9493ol $ = or $ $ 3ol $ ,6$ )ote: @f the rates are given in different terms 0i.e. indirect and direct :uotes$, then you can multiply the two exchange rates to get the third. ,6$ $ ,6$ x = $ 3ol $ 3ol $

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Q: Assume the following exchange rates for Mexican pesos and )etherlands guilders -ersus the 1"/" dollar: Jesos3$ Iuilders3$ 2.6>11 2.%119

7ased on this information, which of the following is the cross exchange rate between the pesos and the guilder, measured in pesos per guilder? a. b. c. d. J4.22123I J1.2%% 3I J22.>1923I J4.%1%23I

"# -hoice .a/ is correct. The cross-exchange rate cancels out the common currency against which they were originally :uoted. pesos pesos pesos dollar pesos $ = x or = guilders guilder dollar guilder guilder $

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>

Cro.. Exchange Rate. *ith 7i2?A., 2ea/er .-rea2. 4hen calculating exchange rates with bid3ask spreads, use the relatively lowest rate for the currency you want to calculate the bid and the relatively highest exchange rate that you are looking for to calculate the ask. *or example, if given the following :uotes# K3$ 1; 2 L3$ .1& ; .19 @f you want the bid3ask for the K3L. 5te- 1 7se the lowest :uote for the yen which is K 13$ and multiply that by the lowest :uote for the dollar which is .19L3$ which gives you the bid K 1%.>>%93L. 5te- $ 7se the highest :uote for the yen which is K 23$ and multiply that by the highest :uote for the dollar which is .1&L3$ which gives you the ask K 19.999>3L.
K 1 3$ K 2 3$

L .1& 3$

L .19 3$

Q: 3an wants to sell, by means of a 8%4day forward contract, euros for 0apanese yen to be deli-ered in 7oston" .he 7oston dealers are 9uoting the following exchange rates of euros and yen against 1"/" deli-ery" 5pot# *orward 091 days$ L3$ 1.21%9 ; %6 L3$ 1.214& ; 42 K3$ 11.9 ; 2 K3$ 11.22 ; 44 What is the yen&euro cross4rate in the spot market? a. b. c. d. 1.>&29 ; .% 62 ; .%4%& ; 1.>&29 ; 1.22&> .9>&& .9&16 .1446 K 11.9 3$ =K 1.21%6euros3$ .% 623euro and the

"# -hoice .b/ is correct. The bid calculation is ask calculation is

K 11.2 3$ =K .9>&&3euro . 'ote# 5ince the bid is the lower 1.21%9euros3$ exchange rate and the ask is the higher exchange rate, the implied bid3ask spread is choice .b./
L1.21%9 3$ L1.21%6 3$

K 11.9 3$

K 11.2 3$

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Triang4/ar Arbitrage = "rbitrage among three currencies. 5xample: !ank " :uote# $1.214&3L 0or . 1&9L3$$ !ank ! :uote# $ .444%3G 0or 1.9224G3$$ !ank - :uote# L .92113G 0or 1.9 >6G3L$ )ote: these are :bid; 9uotes ,emember: the :bid; is lower than the :ask;

!ased on the cross rate relationship, the exchange rate for the L3G should be# . 1&9euros 1.9224H .&296euros = $ $ H /ince 7ank 3 9uotes the exchange rate as <("8$%%&=, an arbitrage opportunity exists" The following three steps illustrate how to profit from this disparity. 5te- 1 ; 5ell @1#!!!#!!! to !ank ! at $ .444%3G 0Aeceive G922,%>>$ H1.922%>> $ , 111, 111 x = H922,%>> $ 5te- $ ; 5ell G922,%>> to !ank - at L .92113G 0Aeceive L , 2 ,9& $ .921euros H922,%>> x = , 2 ,9& euros H 5te- % ; 5ell L , 2 ,9& to !ank " at $1.214&3L 0Aeceive @1#!14#"%%$ $1.214& , 2 ,9& euros x = $ , 1 4,&%% euros "lternatively, 5te- 1 ; 5ell A1#!!!#!!! to !ank " at $1.214&3L 0Aeceive $214,&11$ $1.214& ,111,111euros x = $214,&11 euros 5te- $ ; 5ell $214,&11 to !ank ! at $ .444%3G 0Aeceive G929,2&&$ H1.922%>> $214,&11 x = H929,2&& $ 5te- % ; 5ell G929,2&& to !ank - at L .92113G 0Aeceive A1#!14#"%%$ H1.9 >6 ,49&,221euros x = H214,&11 euros

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For*ar2 -ercent -er ear -re+i4+?2i.co4nt 0or+4/a BIn2irect <4otation.C6 ,emember# an indirect :uote is foreign3domestic. ff = /pot *orward %91 x x 11 *orward n

5xample: 5uppose the spot rate for the !raCilian real is 2.2%2A$3$ and the %-month forward rate is 2.2A$3$. 4hat is the percent per year premium 0or discount$ for the realM ff = 2.2%2 ,$ 3 $ 2.2 ,$ 3 $ %91 x x 11 = 4.4 F 2.2 ,$ 3 $ 21

The forward real is selling at a 4.4 F per year premium to the dollar. Q: .he nine4month forward exchange rate between the 1"/" dollar and the euro is '%"!8&<" .he spot exchange rate is '%"!>&<" What is the forward premium on the euro? "# The forward premium for the euro is# ff = .19euro 3 $ .14euro 3 $ %91 x x 11 = 2.64F .14euro 3 $ 2>1

5-ot exchange rate change. 0or+4/a BIn2irect <4otation.C6 F = 7eginning rate 5nding rate x 11 5nding rate

5xample: 5uppose the spot rate for the !raCilian real is 2.2%2A$3$ on ,onday and increases to %A$3$ on *riday. 4hat is the percent change in the spot rate for the realM F = 2.2%2 ,$ 3 $ %,$ 3 $ x 11 = 2.29>F %, $ 3 $

The !raCilian real depreciated by 2.29>F from ,onday to *riday.

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Final Project 5ession The 4orld *actbook# http#33www.cia.gov3cia3publications3factbook3index.html Jotential value drivers 0destroyers$ -hapter 5ession 2 The 4orld !ank# http#33www.worldbank.org3data3countrydata3countrydata.html Resources for Finance Courses 5ession www.investopedia.com Resources for your Career 5ession N@*" +xam# www.the-ira.org -*" +xam# www.cfainstitute.org 5ession 2 www.Oobsinthemoney.com Practice Homework Problems -hapter ; Puestion Q 2 -hapter 2 ; Jroblems Q 6 -hapter % ; Puestions 2-& Q 1 a, b, e, s, t and Jroblems -4 -hapter 4 ; Jroblems 2-& -hapter & ; Jroblems 2 Q -hapter 9 ; Jroblems 2 Q % -hapter > ; Jroblems ; 1 -hapter 4 ; Jroblems Q 2 .he midterm on /eptember ($th will co-er these chapters"

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JroOect Jroposals are due next weekR DroEect Dro-o.a/. Sour proOect proposals are due by the date noted in the syllabus 0before 4#%1pm$. Sou will loose & points for turning it in after 4#%1pm and 1 points for turning it in after >pm. 0Sou will loose &1 points for turning it in after the date noted in the syllabus, and your team will be re:uired to meet with me outside of class.$ Sour proOect proposal is worth 1F of your final proOect grade. ?f course I will happily accept your pro2ect proposals early@ 4hat it should include# Team members= names 0each team should have 4-& members$, e-mails, and phone numbers. 0This is a good way to make sure each of you can get in contact throughout the semester.$ "lso, let me know who your designated team leader is, your chosen country 0or countries$, and the two different industries or companies you want to invest in. @ want my copy to be signed by all team members. Sou will be graded on professionalism 0no typos$, overall appearance, completeness 0all contact info, signatures, and re:uired information$, timeliness, and preparation 0your reasons for choosing your country and industries3companies$. *inally, your proOect proposals should be no more than page.

I ha-e already heard some exciting ideas, and I am already looking forward to your final pro2ects@

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