Dr.

Jian Wang

Office: 211 Wharfe Building

Email: J.Wang@hull.ac.uk
Office hours: Tuesday 4 5pm
Wednesday 1-2pm
 Teaching and learning methods
Lectures
> Every week(except week 16), 2 hours per week

Tutorials Finance part

> 1 hour every fortnight
> Week 12 and 14
> Preparation is essential

Workshop
> 1 hour in week 16
 Canvas
Lecture slides, tutorial questions and answers will
be available on Canvas
https://canvas.hull.ac.uk/

Also, the main means for communication with you

please check regularly

3
 Course Textbooks
There are a number of excellent text books covering our topic.
Core text:
Keith Pilbeam (2013), International Finance, 4th. Palgrave Macmillan.

Other texts that you might consider as alternatives are

Wang, Peijie Economics of Foreign Exchange and Global Finance 2nd edition,
Springer, 2009.
Bekaert, Geert and Hodrick, Robert International Financial Management.
Pearson 2012.
Eun, Cheol, and Resnick, Bruce, International Financial Management, 3rd ed,
McGraw-Hill, 2012.
 Assessment Finance part

Unseen examination (2 hours) - (50%)

 International Accounting and Finance

Lecture 6

Foreign Exchange Fundamentals

Dr.Jian Wang
 Learning Objectives
Gain knowledge of foreign exchange markets, exchange
rates, and use of terminology
Understand how arbitrage may arise in these multi-faceted
markets and how transaction costs reduce arbitrage
opportunities
Calculate a forward premium and forward discount
Be familiar with exchange rate regimes, regime changes and
the effect on and implications of exchange rates in practice

Reading: Keith Pilbeam, Ch 1 and 10

Foreign Exchange Markets
and Exchange Rates
A foreign exchange market is a market where a
convertible currency is traded for other convertible
currencies.

An exchange rate is the price of one currency in

terms of another currency; it is the relative price of
the two currencies.
eg, 100/$1 or 100/$ (the number one is implied)
 Foreign Exchange Quotations
Direct quotation: expressed as the number of units of the
home/ domestic currency per foreign currency unit.

Eg, from the UK perspective, 0.90/ is a direct quotation.

Indirect quotation: foreign currency units per home currency

unit.

Eg, from the UK perspective, 1.11/ is an indirect quotation.

Foreign Exchange Quotations

Direct and indirect are inverse: Direct = 1 / Indirect

We use direct quotations in our discussions, i.e., Sh/f

So an increase in the exchange rate

indicates depreciation of the home currency
or appreciation of the foreign currency.
Foreign Exchange Quotations
Exchange rates dollar versus foreign currencies
European quote the foreign currency price of a dollar,
eg, 0.90/$

American quote the dollar price of a foreign currency,

eg, $1.11/.
 Stop & Think ??
Are the exchange rates in the table quoted in Direct and Indirect,
European and American quotes?

In the US In the UK

$ per Direct Indirect

$ per American American

per $ Direct / Indirect?? Direct / Indirect??

per $ European / American?? European / American??

In China In the European Union

Chinese Yuan per Direct / Indirect?? Direct / Indirect??

 Answers
Are the exchange rates in the table quoted in Direct and Indirect,
European and American quotes?

In the US In the UK

$ per Direct Indirect

$ per American American

per $ Indirect Direct

per $ European European

In China In the European Union

Chinese Yuan per Direct Indirect

 Foreign Exchange Quotations

Matrix illustration of direct and indirect quotes

Market Data
The Demand for Pounds
The Supply for Pounds
Determination of the dollar-pound
Exchange Rate
 Currency Cross -rates
Cross-rates - the exchange rate between two currencies,
both of which are not the official currencies of the country
in which the exchange rate quote is given in.

E.g., the / exchange rate quoted in the New York

market where both currencies are not expressed in U.S.
dollars.
Cross Rates
Suppose in New York the exchange rate between the euro and $ is 0.76388 /
$ and in London the exchange rate between $ and is $1.5386/
What must the / cross rate be?

/ = /$ * $/

0.76388 $1.5386 1.1753

=
$1 1 1
Thus, the cross rate should be 1.1753/

4-19
 Cross Rates and Arbitrage
Now if in Frankfurt the exchange rate between and is
quoted as 1.1555/, which means 1.1555/ < 1.1753/.
An arbitrage opportunity arises arbitrage profit can be
generated. How?

What is arbitrage?
Arbitrage in the foreign exchange market is the simultaneous buying of
currency in a market where the price is low and selling in an other market
where the price is high, with the purpose of obtaining a sure profit from the
differential between the buying and selling price. Arbitrage makes the
exchange rates to tend to be equal worldwide.
 Triangular (three-point) arbitrage

An arbitrage process involving three currencies

Occurs when one can trade three currencies and make a

profit (versus two)
eg, / < /$ * $/ Or / > /$ * $/
Example A Triangular Arbitrage
In New York the exchange rate between the euro and $ is 0.76388 / $

In London the exchange rate between $ and is $1.5386/

In Frankfurt the exchange rate between the euro and is 1.1555/

Determine the arbitrage profit (suppose a trader holds 1million).

Example A Triangular Arbitrage
Answer:
The implied cross-rate of / = /$ * $/ = 0.76388 * 1.5386
= 1.1753/
As 1.1555/ < 1.1753/, is undervalued
Suppose starting 1m
Step 1: sell , buy at 1.1555/
1m / 1.1555/ = 0.86543m
Step 2: sell , buy $ at $1.5386/
0.86543m * $1.5386/ = $1.33155m
Step 3: sell $, buy at 0.76388/$
$1.33155m * 0.76388/$ = 1.017m
In this way an arbitrageur can make a profit of 0.017 million ( =1.017m -1m)
Or a rate of return 1.7% (= 0.017m/1m)
 Cross Rates and Arbitrage
If the market is efficient, then the quoted cross-rate should be
the same as the cross rate implied by two dollar quotes.
/ = /$ * $/
If the quoted / < /$ * $/ (1.1555 < 1.1753), is undervalued.

Demand for ( ); supply of ()

The / rate will be pushed up to settle at 1.1753/

Spot and Forward Exchange Rates
A spot exchange rate, S
quoted for immediate delivery of the purchased currency, or
the currency is delivered on the spot (usually within two
working days).

A forward exchange rate, F

The rate agreed today for delivery of the currency at a
future date.
Typically the future date is 30, 90, 180 days and one year
ahead.
 Forward Rate Quotations

Consider the exchange rates Country/currency in US$ per US$

shown to the right. For British UK pound 1.9717 .5072
pounds, the spot exchange rate
1-mos forward 1.9700 .5076
is
3-mos forward 1.9663 .5086
$1.9717 = 1.00 while the 180-
6-mos forward 1.9593 .5104
day forward rate is $1.9593 =
1.00
Whats up with that? Clearly market participants expect
that the pound will be worth less in
dollars in six months.

4-26
 Forward Premiums and Discounts
Forward premium - occurs when the price of the
currency contract is higher than the spot rate
F$/ > S$/ (the price of a is higher for Forward)
Forward discount - occurs when the price of the
currency contract is lower than the spot rate
F$/ < S$/ (the price of a is lower for Forward)

forward spot 360

AnnualizedPercent
spot Ndays
 Long and Short Forward Positions

If you have agreed to sell anything (spot or forward),

you are short. /you take a short position.

If you have agreed to buy anything (forward or spot),

you are long. /you take a long position.

4-28
Foreign Exchange Transactions

Banks provide foreign exchange services for a fee:

The banks bid (buy) quote for a foreign currency
Will be less than its ask (sell) quote.
This is the bid-ask spread

Bid-ask spread in percentage =

(ask rate bid rate)/ask rate
 The Bid-Ask Spread
A dealer could offer:
> A bid price of $1.4739 per .
> An ask price of $1.4744 per .
While there are a variety of ways to quote the above, the bid-ask
spread represents the dealers expected profit.
Ask Price Bid Price
Percent Spread = 100
Ask Price

$1.4744 $1.4739
0.0339% = x 100
$1.4744
Transaction Costs and Arbitrage
If the cross exchange rates are substantially different
Traders will be able to make profit through arbitrage
trading

Recall the previous example (a return of 1.7%), if the

bid-ask spread is 2%, does the arbitrage opportunity still
exist?
Answer: No
Exchange Rate Regimes

The floating/ flexible, exchange rate regime

A flexible, or floating exchange rate

Level is determined exclusively by supply and demand
for the currencies involved
Without government intervention
Determined by general economic factors, inflation, gdp etc
The UK operates a floating exchange rate
Floating Exchange Rate Regimes
Exchange Rate Regimes

The fixed exchange rate regime

A fixed exchange rate

Level is fixed by the government
Through imposing legal restrictions
Or intervention in the foreign exchange market.
The government maintains target rates.
Central banks buy/sell currency if target rates are
threatened.
Fixed Exchange Rate Regimes
Exchange Rate Regimes

Managed float or dirty float

Market forces set exchange rates under normal
circumstances.
Central banks intervene when markets are
excessively volatile
Exchange Rate Regimes

Target zones
Upper and Lower levels are set for the exchange rate

Member states of the regime adjust their economic

policies to maintain the target zone.

This was the process for the European Monetary System

Before the creation of the Euro

Brief History of the International Monetary Systems
single currencies: past to present

1989: The European Council approved the vision of the

Delors committee, which proposed a three-stage transition in
Europe to an Economic and Monetary Union (EMU) with a
single European currency
1992: Signing of the Maastricht Treaty which committed
Europe to a single European currency. All countries ratified
the treaty in 1993
Brief History of the International Monetary
Systems
single currencies: past to present

1999: Twelve European countries implement the euro by

using the currencies as a measure, but not yet issuing coins
and notes. It was assigned an initial value of $1.15
2002: The new Euro currency starts circulation on 1 January
2002. Continued use of the old currencies was permitted for
another two months and thereafter it could be exchanged for
euros only in banks
 Thank you!

Next week
International Parity Conditions