Finance 508 Notes 18Jul2011 Foreign Exchange: Bank A Bank B Bid $1.4838/ $1.4842/ Ask $1.4841/ $1.

4845/ Bid/Ask Spread

Can trade (have credit) of $10million How to make a profit (remember this is done simultaneously): Buy from Bank A at the Ask price: ($10 mil)x(/$1.4841) = 6,738,090.425 Sell to Bank B at the Bid price:

Arbitrage: Risk free profit being made due to inconsistencies in the trading rates. The above example is called Locational Arbitrage (or two point arbitrage). Speculation: The buying and holding of securities long term looking for a profit. Arbitrage is looking for these differentials and making a profit quickly.

As the buy orders for Euros to Bank A starts rolling in, their inventory of Euros will do down and their inventory of dollars will go up. They will see this and begin to increase their Ask price. The reverse is happening to Bank B, their inventory of Euros is going up and their inventory of dollars is going down. They will lower their Bid price to level out their inventories.

Finance 508 Notes 18Jul2011

If currency pairs are inactively traded, use a widely traded third currency to determine that exchange rate. This is known as the Cross-Rate.

Example: We want to see the exchange rate between Korean Yuan and the Swiss Franc. We will look at the KYuan/$ and the SwF/$

Bank 1: Bank 2: Bank 3:

SwF 1.9025/$ C$ 1.2646/$ SwF 1.5214/C$

If you look, we can take the values between Bank 1 and Bank 2, we can get SwF/C$ (actually, you will need to go both ways to determine the best way to go) If this cross rate is different, triangular arbitrage is possible

Rules for Triangular Arbitrage: 1. Check if arbitrage is possible a. Multiply all of the exchange rates to see if they equal 1 b. Ensure the currency symbols cancel c. Go to paper. 2. If R1 x R2 x R3 = 1, then no arbitrage is possible 3. If R1 x R2 x R3 <1 , buy the currency in the denominator with the currency in the numerator for each spot rate. a. Start with $1,000,000 bank credit standing i. Buy C$ ii. Perform the equation setup and the answer will be C$1,264,600 iii. Now buy SwF iv. Perform the equation setup and the answer will be SwF1,923,962.44 v. Now buy $ vi. Answer is $1,011,211 1. Risk free profit is $11,211

Finance 508 Notes 18Jul2011 4. If R1 x R2 x R3 > 1, buy the currency in the numerator with the currency in the denominator for each spot rate a. Repeat the above; remember to use the numerator/denominator setup that you used to make the conversions. Fixed vs. flexible (floating) rates 1. Fixed rates provide stability in international prices. This decreases business risk and promotes trade. 2. When you have a fixed rate of currency, a drop in its value is called devaluation. A rise in this currency is called a revaluation (Germany/England). 3. Fixed rates make it difficult to control your countrys own monetary and fiscal policy (Mexican Peso Crisis). 4. Fixed rates require central banks to maintain large inventories of international reserves to defend their own currency. If they run out of international reserves, they may have to devalue their currency (Mexican Peso Crisis). 5. Fixed rates, once in place, may be kept at levels that are not consistent with economic fundamentals. Floating rates allow smoother transitions rather than significant changes. International Parity Conditions Law of one price (purchasing power parity): states that in the absence of market frictions (transaction costs, shipping, etc.), two identical assets must sell for the same price whenever they are bought or sold. If this does not hold, then arbitrage occurs. Absolute purchasing power parity looks at not just one product across markets, but a basket of goods and then determines the exchange rate. Relative PPP: states the relative prices (inflation) between countries over a period of time determine the change in exchange rates of that period. This assumes an equal but opposite effect. If there were 4% higher inflation in U.S. than in Japan, the Dollar should depreciate by 4% against the Yen. Relative PPP tends to hold over the long term (> 1 yr) and is more affected in high inflation countries Formula Where S is the spot rate and IP is the inflation premium (both numbers must be entered in decimal format)

Finance 508 Notes 18Jul2011 Given a spot rate of $1.30/, 4% inflation in the U.S., 2% in Europe. Expected spot rate is Answer is 1.3255/

Germany wanted to slow their economy down due to overheating. They did this by having their central bank increase interest rates. Meanwhile, England was lowering their interest rates in order to spur growth. So, England took their s and bought German marks. They were then making money on the German interest rates. However, their deposits were going down. So, in order to attract more people, they increased their interest rates. This was the exact opposite of what they wanted to do. This is the reason they left the European Monetary Unit agreement. In the late 1960s, the inflation in the United States caused inflation in the U.K. due to people buying things in the U.K. because they were cheaper. As demand started to go up, prices would start to go up. Therefore, they had more inflation.

The Mexican Peso Crisis.

Timeline on the paper:

Project #3 Notes 18Jul2011 Hedging: Taking of a position, which will rise (lower) in value to offset the decline (rise) in value of an existing position.

Example: A U.S. company has 1,000,000 pounds coming in on accounts receivable. Lets say the spot rate is $1.60/pound. However, the accounts receivable is due in six months (graph on paper). Lets say there is a forward contract available for $1.60/pound. Lets say there is a Put option. The Strike is $1.55/pound and the premium is $0.05 per pound.

Finance 508 Arbitrage Handout 18Jul2011 Finance 508: Arbitrage Practice Problems 1) Locational Arbitrage Given the following quotes, is locational arbitrage possible across the two banks, and if so, how much profit could be made and what are the proper steps if an arbitrager in the U.S. is authorized to trade $15,000,000? United Bank Manchester Bank Bid $1.5967/ $1.5958/ Ask $1.5970/ $1.5961/

2) Triangular Arbitrage An arbitrager based in the U.S. is authorized to trade $1,000,000. The following quotes are available: Bank 1: $0.0096/ Bank 2: 61/A$ Bank 3: A$1.7125/$ Is arbitrage possible, and if so, what are the steps and risk free profit?

3) Covered Interest Arbitrage A Canadian banker is able to borrow C$2,000,000 or its U.S. dollar equivalent. The following quotes are available: Spot Rate Forward6mos C$1.49/$ C$1.51/$ C$ i-rate is 7.50% p.a. U.S. $ i-rate is 4.00% p.a.

Is arbitrage possible, and if so, what are the steps and risk free profit?