Foreign Exchange

Markets and Foreign

Exchange Rates
Chapter

objective:
examines the functions, actual operation of
the FOREX markets including exchange
rate and international financial markets.

Outline
1.Foreign

Exchange Market
2.Foreign Exchange Rates
3.Spot and Forward Rates, Currency Swaps,
Futures and Options
4.Foreign Exchange Risks, Hedging, and
Speculation
5.Interest Arbitrage
6.Offshore Financial Markets

1. FOREX Market

(1)concept
(2)Function and Structure

(1) concept
FOREX

market is the market in which

individuals ,firms,and banks buy and sell foreign
currencies or foreign exchange.
Broadly define:
FOREX market encompasses
the conversion of purchasing power from the
currency into another, bank deposits of foreign
currency, the extension of credit denominated in a
foreign currency, foreign trade financing, and
trading in foreign currency options and futures
contracts.

 the

largest financial market, open 365 days

a year, 24 hours a day
central marketplace
over the counter(OTC)
Reuters, Telerate, Bloomberg
three major market segments:
Australasia, Europe, North America

(2)Function and Structure of the FOREX

Market
1)Function
2)Structure
1)Function:
the

transfer of funds or purchasing power from one

nation and currency to another
operate as clearinghouses for the foreign exchange
demanded and supplied
the credit function
the facilities for hedging and speculation

(2)Function and Structure of the

FOREX Market
2)Structure

Wholesale or interbank market

Retail or client market
Participants: Four levels
central bank
FX brokers
commercial banks
customers
(tourists,importers,
exporters, investors)

3.Foreign Exchange Rates

(1)Equilibrium

exchange rates
(2)Foreign exchange rate quotations
(3) Exchange rates categories
(4)Arbitrage

(1) Equilibrium exchange rates

Million /day
Appreciation and Depreciation

(2)FX rate quotations

(Direct

quotations) the price of one unit of the

foreign currency priced in domestic currency. See
case study FX quotations:p.463 Wednesday
The dollar price of the euro:$1.0551/1
(Indirect

quotations) The price of one

domestic currency in the foreign currency.
Case study p.463:
The euro price of the dollar: 0.9478/$

(3) Exchange Rates Categories

Cross exchange rate
Ignore the transaction costs
A cross

exchange rate is an exchange rate between a

currency pair where neither currency is the U.S. dollar.
If

S($/)=1.5683
S($/ )= 0.5235
then /
S( /)= S($/)/S($/ )
= 1.5683 / 0.5235=2.9958

Effective exchange rate

Nominal exchange rate
Real exchange rate

(4)Arbitrage
Make

a profit
Two-point arbitrage:The exchange rate between any two
currencies is kept the same in different monetary centers.
example: in the same time
in Hong Kong $100=HKD778.07
in New York $100=HKD775.07
one Hong Kong bank sold 1million dollars in Hong Kong,
and in New York sold 7.7507million Hong Kong dollars,
gained 1 million dollars. Profit:30 thousand HKD

(4)Arbitrage
Triangular

arbitrage: three currencies and three

monetary centers are involved.
example: in the same time
=$2 in London $0.4= SF1in New York The
corresponding cross rate is /SF=($/SF)/($/ )
=0.4/2=0.2. If we observe the market where one of
the three exchange rates is not out of line with the
other two, arbitrage opportunity.

(4)Arbitrage
Suppose

in Zurich /SF=0.2,while in New York

$/SF=0.4,but in London $/ =1.9.one trade could
buy 1million in London for $1.9million.using
pounds to buy francs at /SF=0.2,so
1million=SF5million, then in New York using
SF5million to buy dollars,so that
SF5million=$2million.
The initial $1.9million could be turned into
$2million.earning $0.1million.

(4)Arbitrage
Remember:
The

different financial centers operate in

different time zones. Therefore, it only
makes senses to compare quotations at a
time when the markets overlap. Could not
compare $/ quotes in New York with those
in Tokyo because there is no overlap
between the trading time.

3.Spot and Forward Rates, Currency

Swaps, Futures and Options
(1)spot

and forward rates

1)Spot transaction and spot rate
2)forward transaction and forward rate
(2)currency swaps
(3)foreign exchange futures and options
1) foreign exchange futures
2) foreign exchange options

3.Spot and Forward Rates

1)spot

transaction and spot rate

Be quoted at specific time,based on large trades
Example :the U.S importer
Spot transaction:FX transaction involves the
payment and receipt of FX within two business
days after the day the transaction is agree upon.
Spot rate:The exchange rate at which the spot
transaction take place .

3.Spot and Forward Rates

2)forward

transaction and forward rate

Forward transaction: contracting today for the
specified future purchase or sale of foreign exchange
at a rate agreed upon today.(the forward rate)
The forward price :
At premium : it is higher than the spot price.
At discount: it is lower than the spot price.
Maturities: 1,3,6,9,12 months, beyond one year,for
good bank customers, extending 5

(2)Currency Swap
An

agreement to trade currencies at one date and

reverse the trade at later date.
Forward trades, is the simultaneous sale or
purchase of spot foreign exchange against a
forward purchase or sale of a approximately an
equal amount of the foreign currency.
outright 11% swap transactions 55% spot 34%
Swap rate: is the difference between the spot and
forward rates in the currency swap.

(2)Currency Swap
Be

quoted in basis points

a basis point 0.0001
Not care about the actual spot and forward
rate, but the difference between them
Meet a banks needs ,combine two separate
transactions into one deal
The names of the banks making bids and
offers are not known until a deal is reached.

(3)Foreign exchange futures and

options
1)Futures
The

futures market is a market where foreign currencies

may be bought and sold for delivery at a future day.
Futures contract is a forward contract for standardized
currency amounts and selected calendar dates traded on
an organized market. (contract size and maturity date)
Standard features:
Contract size, maturity date, delivery months see p.469
The futures market differs from a forward market

Futures

Organized exchange
Standardized amount
Daily settlement done by
the clearinghouse through
the participants margin
account
Standardized delivery date
Delivery seldom made,
reversing trade is transacted
to exit the market
For small firms

Forward

OTC
Tailor-made
Buy or sell at maturity at the
forward price
Meets the needs of investor
Commonly made
For large financial institutions,
business firms and wholesale
banking activities

1)Futures:Daily Resettlement
Suppose

you want to speculate on a rise in

the $/ exchange rate (specifically you
think that the dollar will appreciate).

Japan (yen)
1-month forward
3-months forward
6-months forward

U.S. $ equivalent
Wed
Tue
0.007142857 0.007194245
0.006993007 0.007042254
0.006666667 0.006711409
0.00625 0.006289308

Currency per
U.S. $
Wed
Tue
140
139
143
142
150
149
160
159

Currently $1 = 140. The 3-month forward price is $1=150.

1)Futures: Daily Resettlement

Currently

$1 = 140 and it appears that the dollar is

strengthening.
If you enter into a 3-month futures contract to sell
at the rate of $1 = 150 you will make money if the
yen depreciates. The contract size is 12,500,000
To trade futures market, a trader must deposit
money with a broker(margin).Your initial margin is
4% of the contract value:
$1
$3,333.33 .04 12,500,000
150

1)Futures: Daily Resettlement

If tomorrow, the futures rate closes at $1 =
149, then your positions value drops.
Your original agreement was to sell
12,500,000 and receive $83,333.33
But now 12,500,000 is worth $83,892.62
$1
$83,892.62 12,500,000
149

You have lost $559.28 overnight.

1)Futures: Daily Resettlement

The

$559.28 comes out of your $3,333.33 margin

account, leaving $2,774.05
This is short of the $3,355.70 required for a new
position.

$1
$3,355.70 .04 12,500,000
Your broker will let you slide until you
149
run through
your maintenance margin. Then you must post
additional funds or your position will be closed out.
This is usually done with a reversing trade.

1)Futures: Daily Resettlement

Suppose

the March pound contract requires

an initial margin of $2,000.if the price fell
$0.0175 on one day, then the fall in the
settlement price of $0.0175 represents a loss
of $1,093.75=0.0175 62,500, and
deducting this daily loss from the margin
deposit. So in a single day the margin
account reduces to $906.25

1)Futures:reversing trade
If

in March the pound will sell for $1.45,and

March futures contract is currently priced at $1.5 ,
we would sell a March contract.then at maturity
,we will receive $1.5 per pound,or $93,750. If the
actual price of the pound falls below $1.5, we
realize a profit. Suppose the actual price in March
is $1.45, we could then buy pound for $90,625.
The difference of $93,750-$90,625=$3,125,will be
the profit.

2)Foreign Exchange Options

A foreign

currency option is a contract that

provides the right, but not the obligation, to buy
(Call options )or sell (put options )a given amount
of an asset at a specified price at some time in the
future.
American options can be exercised at any time
during their life, European options can only be
exercised at maturity.
Exercised price or striking price:the price at which
currency can be bought or sold.

2)Foreign Exchange Options

Exchange-traded

options with standardized

features are traded on two exchanges. Options on
the spot foreign exchange are traded at the
Philadelphia Stock Exchange, option on currency
futures at the Chicago Mercantile Exchange.
OTC volume is much bigger than exchange
volume.
Trading is in seven major currencies plus the euro
against the U.S. dollar.

2)Foreign Exchange Options

Profit

Long call
E

loss

St

E
Short call

2)Foreign Exchange Options

Profit
Long put
E

Loss

E
Short put

2)Foreign Exchange Options

Suppose

a U.S importer is buying equipment from

a German manufacturer with a 1 million due in
three months. The importer can hedge against a
euro appreciation by buying a call option that
confers the right to purchase euros over the next
three months at a specified price. The current $1.2/
, if $1.25/ over the next three months. The
importer exercises the option.
Basic option-pricing relationships at expiration
(see case study14-4 p.470-471)

2)options: example1
Example1:

expiration value of an American call option

Consider the PHLX 75 Mar. CD American call option,
the exercise price 75 cents per CD, current premium
Ca=0.84 cents per CD. Suppose at expiration the spot
rate is $0.7564/CD
The call option, exercise value: 75.64-75=0.64 cents
per each of the CD50,000 of the contract, or $320. That
is, the call owner can buy CD50,000, worth
$37,820=CD50,000$0.7564 in the spot market, for
$37,500=CD50,000$0.7500.

2)options: example1
Call

option
Exercise price:
$0.7500/CD
Current premium: c0.84/CD
Spot rate:
$0.7564/CD
CD50,000
Exercise value:
$320

2)options: example1
profit

E=75

ST

-0.84
ST=E+Ca =75+0.84
=75.84

Call option :
Buyers perspective

2)options: example1
Call

option: Writers perspective

profit
0.84
ST=E+Ca

ST

2)options: example1
At

ST=E+Ca both the call buyer and writer break

even . The speculative possibilities of a long
position in a call: Anytime the speculator believes
ST will be in excess of the breakeven point, establish
a long position in the call. If correct ,profit. If
incorrect, the loss limited to the premium paid.
If the speculator believes ST will be less than the
breakeven point, a short position in the call will
yield a profit, the largest amount being the call
premium. If incorrect, very large losses.

Example 2
expiration

value of an American put option

Consider the 104 Sep EUR American put, a current
premium pa, of 2.47 cents per EUR. If
ST=$1.0307/EUR, the put contracts exercise value:
104-103.07=0.93 cents per EUR for each of the
EUR62,500, worth$64,618.75=EUR62,500$1.0307
in the spot market, for $65,000=EUR62,500 $1.04.
If $1.0425/EUR,the exercise value is 104-104.25=0.25 cents per EUR.the put buyer will not exercise.

2)options: example2
Put

option
Exercise price:
Current premium:
Spot rate:
EUR62,500
Exercise
If spot rate:
Not exercise:

$1.04/EUR
c2.47/EUR
$1.0307/EUR
1.04-1.0307= 0.93
$1.0425/EUR
1.04-1.0425=-0.0025

2)options: example2

Put option: buyerperspective

Profit

E-Pa=104- 2.47
=101.53
E=104

Put

option: writers
perspective
Profit
ST

-2.47
104-2.47=101.53

2.47

4.Foreign Exchange Risks ,Hedging,

and Speculation
(1)Foreign

exchange risks
(2)Hedging
(3)Speculation

(1)Foreign exchange risks

Exchange

rate changes can systematically

affect the value of the firm by influencing
the firms operating cash flows as well as
the domestic currency values of its assets
and liabilities. Open position. exposure
classify foreign currency exposure into
three classes:

(1)Foreign exchange risks

1)Economic

Exposure
Exchange rate risk as applied to the firms
competitive position.
2)Transaction Exposure
Exchange rate risk as applied to the firms
home currency cash flows.
3)Translation Exposure
Exchange rate risk as applied to the firms
consolidated financial statements.

Balance sheet of one-Saudi Arabia May 31

Cash
SAR1,000,000
Accounts receivable
3,000,000
Plant and equipment
5,000,000
Inventory
2,000,000
SAR11,000,000
Dollar translation on May 31, SAR4=$1
Cash
$250,000
Accounts receivable
750,000
Plant and equipment
1,250,000
Inventory
500,000
$2,750,000
Dollar translation on June 31, SAR5=$1
Cash
$200,000
Accounts receivable
600,000
Plant and equipment
1,000,000
Inventory
400,000
$2,200,000

Debit
Equity

SAR5,000,000
6,000,000

SAR11,000,000
Debt
Equity

$1,250,000
1,500,000

$2,750,000
Debt
Equity

$1,000,000
1,200,000

$2,200,000

(2)Hedging
Hedging

refers to the avoidance of a foreign

exchange risk,or the covering of an open position.
An activity to offset risk.

Money

Market Hedge
Forward Market Hedge
Options Market Hedge
Futures Market Hedge
Cross-Hedging Minor Currency Exposure
Hedging Contingent Exposure
Hedging Recurrent Exposure with Swap Contracts

(2)Hedging
Hedging

Through Invoice Currency

Hedging via Lead and Lag
Exposure Netting
Should the Firm Hedge?
What Risk Management Products do Firms
Use?

Money Market Hedge

This is the same idea as covered interest arbitrage
Example: The importer of British woolens can hedge his
100 million payable with a money market hedge:
Lend $112.05 million in the U.S.
Translate $112.05 million into pounds at the spot rate S($/) =
$1.25/
Invest 89.64 million in the UK at i = 11.56% for one year.
In one year your investment will have grown to 100 million.

Spot exchange rate

360-day forward rate

S($/) = $1.25/
F360($/) = $1.20/

U.S. discount rate

i$ = 7.10%

British discount rate

i =

11.56%

Money Market Hedge

Where do the numbers come from?
We owe our supplier 100 million in one yearso we know
that we need to have an investment with a future value of
100 million. Since i = 11.56% we need to invest 89.64
million at the start of the year.

100
89.64
1.1156
How many dollars will it take to acquire 89.64 million
at the start of the year if the spot rate S($/) = $1.25/?

$1.00
$112.05 89.64
1.25

Forward Market Hedge

The

most direct and popular way of hedging

If you are going to owe foreign currency in the
future, agree to buy the foreign currency now by
entering into long position in a forward contract.
(Long position:buying currency for future delivery.)
If you are going to receive foreign currency in the
future, agree to sell the foreign currency now by
entering into short position in a forward contract.
(Short position: selling currency for future delivery)

Options Market Hedge

Options

provide a flexible hedge against the downside,

while preserving the upside potential.
To hedge a foreign currency payable buy calls on the
currency.
If the currency appreciates, your call option lets you
buy the currency at the exercise price of the call.
To hedge a foreign currency receivable buy puts on the
currency.
If the currency depreciates, your put option lets you
sell the currency for the exercise price.

Example

Suppose that Boeing Corporation exported a Boeing 747 to

British Airways and billed 10million payable in one year.
the money market interest rates and foreign exchange rates
are given as follows:
The U.S. interest rate:6.10%
The U.K. interest rate:9.00%
The spot exchange rate:$1.50/
The forward exchange rate:$1.46/
Give the various techniques for managing this transaction
exposure

Example
Forward

market hedge
Gain=(F-ST)10 million
Money

market hedge
The firm may borrow (lend) in foreign
currency to hedge its foreign currency
receivables (payables), thereby matching its
assets and liabilities in the same currency.

Example
Money

market hedge
Borrow 9,174,312= 10/1.09 in the U.K.
Convert 9,174,312 into $13,761,468 at the spot
rate of $1.5/
Invest $13,761,468 in the U.S.
Collect 10million receivable and use it to repay
the pound loan
Receive the maturity value of dollar investment,
$14,800,918= $13,761,468 1.061

Example
Option

market hedge
buy a put option with an exercise price of $1.46
Assume premium was $0.02 per pound, $200,000
Under the options hedge, the net dollar proceeds
from the British sale become:
$14,387,800=$14,600,000-$200,0001.061

Cross-Hedging
Minor Currency Exposure
The

major currencies are the: U.S. dollar, Canadian

dollar, British pound, French franc, Swiss franc,
Japanese yen, and now the euro. Easy to use
forward ,money market, or options to hedge.
In contrast, if minor currencies, such as Korean
won, Czech koruna.
It is difficult, expensive, or impossible to use
financial contracts to hedge exposure to minor
currencies.

Cross-Hedging
Minor Currency Exposure
Cross-Hedging

involves hedging a position in one asset

by taking a position in another asset.
The effectiveness of cross-hedging depends upon how
well the assets are correlated.
An example would be a U.S. importer with liabilities
in Czech koruna hedging with long or short forward
contracts on the euro. If the koruna is expensive
when the euro is expensive, or even if the koruna is
cheap when the euro is cheap it can be a good hedge.
But they need to co-vary in a predictable way.

Hedging Contingent Exposure

Contingent

exposure refers to a situation in which

the firm may or may not be subject to exchange
exposure.
If only certain contingencies give rise to exposure,
then options can be effective insurance.
For example, if your firm is bidding on a
hydroelectric dam project in Canada, you will need
to hedge the Canadian-U.S. dollar exchange rate
only if your bid wins the contract. Your firm can
hedge this contingent risk with options.

Hedging Recurrent Exposure

with Swaps
Recurrent

exposure: Recurrent cash flows in a

foreign currency, hedged using a currency swap
contract which can be viewed as a portfolio of
forward contracts. It is an arrangement to
exchange one currency for another at a
predetermined exchange rate, the swap rate , on
a sequence of future dates. Swaps are very
flexible in terms of amount and maturity which
can range from a few months to 20 years.

Hedging Recurrent Exposure

with Swaps
Firms

that have recurrent exposure can very

likely hedge their exchange risk at a lower
cost with swaps than with a program of
hedging each exposure as it comes along.
It is also the case that swaps are available in
longer-terms than futures and forwards.

(2)Hedging : Operation techniques

Hedging

Through Invoice Currency

Hedging via Lead and Lag
Exposure Netting

Hedging Through Invoice Currency

The

firm can shift, share, or diversify:

shift exchange rate risk
by invoicing foreign sales in home currency
share exchange rate risk
by pro-rating the currency of the invoice
between foreign and home currencies
diversify exchange rate risk
by using a market basket index

Hedging via Leads and Lags

If

a currency is appreciating, pay those bills

denominated in that currency early; let
customers in that country pay late as long as
they are paying in that currency.
If a currency is depreciating, give incentives
to customers who owe you in that currency to
pay early; pay your obligations denominated
in that currency as late as your contracts will
allow.

Exposure Netting
A multinational

firm should not consider deals in

isolation, but should focus on hedging the firm as
a portfolio of currency positions.
As an example, consider a U.S.-based
multinational with Korean won receivables and
Japanese yen payables. Since the won and the
yen tend to move in similar directions against
the U.S. dollar, the firm can just wait until these
accounts come due and just buy yen with won.

Exposure Netting
Even if its not a perfect hedge, it may be too

expensive or impractical to hedge each

currency separately.
Many multinational firms use a reinvoice center.
Which is a financial subsidiary that nets out the
intrafirm transactions.
Once the residual exposure is determined, then the
firm implements hedging.

Exposure Netting: an Example

Consider a U.S. MNC with three subsidiaries and the
following foreign exchange transactions:
$20
$30
$30
$40
$10 $35

$60
$25
$10
$20
$30

$30

$40

Exposure Netting: an Example

Clearly, multilateral netting can simplify things greatly.

$15
$40

Should the Firm Hedge?

Not

everyone agrees that a firm should hedge:

Hedging by the firm may not add to
shareholder wealth if the shareholders can
manage exposure themselves.
Hedging may not reduce the nondiversifiable risk of the firm. Therefore
shareholders who hold a diversified portfolio
are not helped when management hedges.

Should the Firm Hedge?

In

the presence of market imperfections, the firm should

hedge.
Information Asymmetry
The managers may have better information than the
shareholders.
Differential Transactions Costs
The firm may be able to hedge at better prices than the
shareholders.
Default Costs
Hedging may reduce the firms cost of capital if it
reduces the probability of default.

Should the Firm Hedge?

Taxes

can be a large market imperfection.

Corporations that face progressive tax
rates may find that they pay less in taxes
if they can manage earnings by hedging
than if they have boom and bust cycles
in their earnings stream.

What Risk Management Products do

Firms Use?
Most

U.S. firms meet their exchange risk

management needs with forward, swap, and
options contracts.
The greater the degree of international
involvement, the greater the firms use of
foreign exchange risk management.

A survey of knowledge and use of foreign

exchange risk management products

Type of product
Forward
Foreign currency swaps
Foreign currency futures
Exchange-trade currency options
Exchange-trade futures options
OTC currency options

Columbia Journal of World Business(1995)

heard of
100%
98.8
98.8
96.4
95.8
93.5

used
93%
52.6
20.1
17.3
8.9
48.8

(3)Speculation
The

opposite of hedging. A speculator accepts and

seeks out a foreign exchange risk, or an open
position, to make a profit.
In general, speculation believed to be stabilizing.
Long and short position

long position: buying currency for future

delivery.

short position: selling currency for future

delivery.

(3)Speculation
Speculative

forward position
It is July 6,1999. Suppose the $/SF trader has
heard the dollar will likely appreciate in value
against Swiss franc to level less than the forecast
rate over the next three months. He will short the
90-day $/SF contract. If the trader sells
SF5,000,000 forward, suppose the forward has
proven correct, on Oct.6, 1999, spot $/SF is trade
at $0.6400.

(3)Speculation
And

the trader can buy Swiss franc at $0.6400 and

deliver it under the forward contract at $0.6453.
Speculative profit: $0.6453- $0.6400= $0.0053 per
unit,
total:SF5000000 $0.0053= $26500
If the dollar depreciated at $0.6500
loss: $0.6453- $0.6500= -$0.0047, per unit
Total loss:
SF5000000 - $0.0047 =-$23500

(3)Speculation
P/L(profit/loss)

long position

0.6453

0.0053

S90 ($/SF)

0.6400

0.6500

-0.0047
Short position
short position

5.Interest Arbitrage
1)uncovered

interest arbitrage
2)covered interest arbitrage
3)covered interest arbitrage parity
4)covered interest arbitrage margin
5)efficiency of FOREX market

5.Interest Arbitrage
Arbitrage:

the act of simultaneously buying

and selling the same or equivalent assets or
commodities for making certain profits.
Interest arbitrage: refers to the international
flow of short-term liquid capital to earn
higher returns abroad.

1)Uncovered Interest arbitrage

To earn

higher return abroad, a foreign exchange

risk involved due to the possible depreciation of
the foreign currency during the period of the
investment. If such risk uncovered, then
uncovered interest arbitrage.
Consider the following set of foreign and domestic
interest rates and spot and forward exchange rates.
Spot exchange rate
360-day forward rate

S($/) = $1.25/
F360($/) = $1.20/

U.S. discount rate

i$ = 7.10%

British discount rate

i =

11.56%

1)Uncovered Interest arbitrage

A trader with $1,000 to invest could invest in the
U.S., in one year his investment will be worth
$1,071 = $1,000(1+ i$) = $1,000(1.071)
Alternatively, this trader could exchange $1,000 for
800 at the prevailing spot rate, (note that 800 =
$1,000$1.25/) invest 800 at i = 11.56% for
one year to achieve 892.48. Translate 892.48
back into dollars at F360($/) = $1.20/, the
892.48 will be exactly $1,071.

2)Covered Interest Arbitrage

Refers

to the spot purchase of the foreign

currency to make the investment and the
offsetting simultaneous forward sale of the
foreign currency to cover the foreign
exchange risk.
F360($/) $1.20/, an astute trader could
make money with a forward contract.

If

The

result of covered interest arbitrage

3)Covered Interest Arbitrage Parity

The net return from covered interest arbitrage
is usually equal to the interest differential in
favor of the foreign monetary center minus
the forward discount on the foreign
currency.as covered interest arbitrage
continues the net gain is reduced and finally
eliminated.when the net gain is zero,the
currency is said to be at interest parity.

4)Covered Interest Arbitrage Margin

Suppose you have $1 to invest for one year. You can either
1.
invest in the U.S. at i$. Future value = $1 (1 + i$)
2.
trade your dollars for GBP at the spot rate, invest in
London at i and hedge your exchange rate risk by
selling the future value of the Britain investment
forward. The future value = $1 (F/S)(1 + i )
Since both of these investments have the same risk, they
must have the same future valueotherwise an arbitrage
would exist.
(F/S)(1 + i ) = (1 + i$)

4)Covered Interest Arbitrage Margin

Formally,

(F/S)(1 + i ) = (1 + i$)

or if you prefer,

1 i$ F

1 i S

IRP is sometimes approximated as

(F- S)
(i$ -i )
S

4)Covered Interest Arbitrage Margin

F S
d
F / S 1
S

d>0,GBP premium, if d<0,GBP discount

i$ ( F / S )(1 i ) 1
i$ (d 1)(1 i ) 1
i$ d i di

i$ d i

4)Covered Interest Arbitrage Margin

Transactions Costs
The interest rate available to an arbitrageur for

borrowing, ib,may exceed the rate he can lend at, il.

There may be bid-ask spreads to overcome, Fb/Sa < F/S
Thus

(Fb/Sa)(1 + il) (1 + i b) 0
Capital

Controls

Governments sometimes restrict import and export of

money through taxes or outright bans.

4)Covered Interest Arbitrage Margin

i-i*
IRP line
D
B
(F-S)/S
A

5)Efficiency of FOREX Markets

Financial Markets are efficient if prices reflect all available

and relevant information.
If this is so, exchange rates will only change when new
information arrives, thus:
St = E[St+1]
and
Ft = E[St+1| It]
Predicting exchange rates using the efficient markets approach
is affordable and is hard to beat.
If forward rates accurately predict future spot rates

6.Offshore Financial Markets

1)Eurocurrency

Market
Whats the Eurocurrency?
Offshore market
2)Reasons for its Development
Political
Credit and deposit rate
3)Eurobonds and Euronotes

6.Offshore Financial Markets

Products
Eurobonds
FRNs
Euronotes
among
CP
EMTNs
NIFs
Syndicated Euro-loans

82 88
94
71.7 225.5 422.1
12.6
23.1 92.7
2.3
76.4 193.3
0
58.25 36.4
0
19.196 157
2.3
3.7
0.5
100.5 102
248.6

Foreign exchange market

Exchange rate
Spot rate
Forward rate
Cross exchange rate
Swap
Appreciation
Depreciation
Devaluation
Arbitrage
Currency swap
Futures and options
Hedging
Position
Long and short position
Foreign exchange risk
Covered and uncovered interest arbitrage
Eurocurrency

Key Words

1.Assume you are a trader with Deutsche

Bank.from the quote screen on your
computer terminal, you notice Dresdner
Bank is quoting 1.6230/$1.00 and Credit Discussion
Suisse is offering SF1.4260/$1.00. You
and Problems
learn that UBS is making a direct market
between the Swiss franc and the euro, with
a current /SF quote of 1.1250. Show how
you can make a triangular arbitrage profit
by trading at these prices.(ignore bid-ask
spreads for this problem.) Assume you
have $5,000,000 with which to conduct
the arbitrage. What happens if you initially
sell dollars for Swiss francs? What /SF
price will eliminate triangular arbitrage?