CHAPTER 7 THE FOREIGN EXCHANGE MARKET

Chapter 7 is basically institutional in nature although it opens by discussing the rationale for a foreign exchange market, namely to facilitate the transfer of purchasing power denominated in one currency to purchasing power denominated in another currency. Like other financial markets, the foreign exchange market facilitates trading in financial assets by lowering transaction costs. The balance of the chapter provides the institutional framework of the foreign exchange market, both spot and forward transactions. It discusses pricing conventions, costs, si e, and participants, and goes through some of the mechanics of foreign exchange trading. I always illustrate this sub!ect matter with "uotes found in The Wall Street Journal. #very issue of the Journal $%ection C& contains a story on the foreign exchange market, providing spot "uotations for the Canadian dollar, pound sterling, %wiss francs, euros, and 'apanese yen. The financial section also carries a more extensive listing of spot and forward prices for about forty currencies.

SUGGESTED ANSWERS TO ARBITRAGING CURRENCY CROSS RATES

(. )o any triangular arbitrage opportunities exist among these currencies* +ssume that any deviations from the theoretical cross rates of , points or less are due to transaction costs.

ANSWER. -nfortunately, there are no shortcuts here. It is necessary to try out each possibility. .ere are the / arbitrage opportunities that I found. If anyone finds any additional ones, please contact me at my email address0 ashapiro1marshall.usc.edu. (. <. 7. /. <. Convert dollars to %2r, %2r to )3r, and )3r back to dollars. The profit per dollar e"uals 4( x (.,756 x 7.75(58,.7677 9 4( : 46.66;7. Convert dollars to )3r, )3r to pounds, and pounds back to dollars. The profit per dollar e"uals 4( x ,.76<( x .(<75(8.;,(6 9 ( : 46.665/. Convert dollars to pounds, pounds to )3r, and )3r back to dollars. The profit per dollar e"uals 4( x . ;,6< x 5.<67(8,.7677 9 ( : 46.66,7. Convert dollars to yen, yen to )3r, and )3r back to dollars. The profit per dollar e"uals 4( x (<7.,;= x . 6/7(,8,.7677 9 ( : 46.66,/.

.ow much profit could be made from a 4, million transaction associated with each arbitrage opportunity*

ANSWER. +ll the answers are based on rounding the arbitrage profit per dollar to the fourth decimal place. (. <. 7. /. The profit for the 48%2r8)3r84 arbitrage will be 4,,666,666 x 6.66;7 : 47(,,66. The profit from the 48)3r8>84 arbitrage will be 4,,666,666 x 6.665/ : 4/<,666. The profit from the 48>8)3r84 arbitrage will be 4,,666,666 x 6.66,7 : 4<5,,66. The profit from the 48?8)3r84 arbitrage will be 4,,666,666 x 6.66,/ : 4<7,666.

<

IE%TF-CTGF% H+E-+L0 MULTINATIONAL FINANCIAL MANAGEMENT, 7T. #).

SUGGESTED ANSWERS TO CHAPTER 7 QUESTIONS

(. a. +nswer the following "uestions based on data in #xhibit 7.,. .ow many %wiss francs can you get for one dollar*

ANSWER. The indirect "uote is 4( : %2r (.<,,<. b. .ow many dollars can you get for one %wiss franc*

ANSWER. The direct "uote is %2r( : 46.7=;7. c. @hat is the three9month forward rate for the %wiss franc*

ANSWER. The three9month forward rate is %2r( : 46.7=5/. d. Is the %wiss franc selling at a forward premium or discount*

ANSWER. +t a forward premium. e. @hat is the =69day forward discount or premium on the %wiss franc*

ANSWER. The =69day forward premium is (7 points $pips&, which translates into an annuali ed forward premium of 6.5,A $/ x $6.7=5/ B 6.7=;7&86.7=;7&. <. @hat risks confront dealers in the foreign exchange market* .ow can they cope with these risks*

ANSWER. 2oreign exchange dealers must cope with exchange risk, because of the foreign currency positions they take. They also bear credit risks since the counterparties to the trades they enter into may not honor their obligations. They can cope with currency risk by using forward contracts and currency options $see Chapter (6&, widening their bid9ask "uotes, and limiting the position they are willing to take in any one currency. They can limit credit risk by restricting the position they are willing to take with any one customer and by setting margin re"uirements that vary with the riskiness of their customers $banks will generally not do this&. 7. %uppose a currency increases in volatility. @hat is likely to happen to its bid9ask spread* @hy*

ANSWER. +s a currencyCs volatility increases, it becomes riskier for traders to take positions in that currency. To compensate for the added risks, traders "uote wider bid9ask spreads. /. @ho are the principal users of the forward market* @hat are their motives*

ANSWER. The principal users of the forward market are currency arbitrageurs, hedgers, importers and exporters, and speculators. +rbitrageurs wish to earn risk9free profitsD hedgers, importers and exporters want to protect the home currency values of various foreign currency9denominated assets and liabilitiesD and speculators actively expose themselves to exchange risk to benefit from expected movements in exchange rates. ,. .ow does a company pay for the foreign exchange services of a commercial bank*

ANSWER. Companies compensate banks for foreign exchange services through the bid9ask spread. The bank will buy foreign exchange at the bid rate $low& and sell at the ask rate $high&.

7 ADDITIONAL CHAPTER 7 QUESTION AND ANSWER

(. .ow have forward premiums and discounts relative to the dollar changed over annual intervals during the past five years for the 'apanese yen, Iritish pound, euro, %wiss franc, and Canadian dollar* -se beginning of year data.

ANSWER. This "uestion can only be answered by reference to the data.

SUGGESTED SOLUTIONS TO CHAPTER 7 PROBLEMS

(. The 40 J exchange rate is J( : 46.=,, and the J8%2r exchange rate is %2r ( : J6.7(. @hat is the %2r84 exchange rate*

ANSWER. %2r( : J6.7( x 6.=, : 46.;7/,. <. %uppose the direct "uote for sterling in Eew Kork is (.(((69,. @hat is the direct "uote for dollars in London*

ANSWER. The direct "uote for the dollar in London is !ust the reciprocal of the direct "uote for the pound in Eew Kork or (8(.(((, 9 (8(.(((6 : 6.5==796.=66(. 7. -sing the data in #xhibit 7.,, calculate the 769day, =69day, and (569day forward discounts for the Canadian dollar.

ANSWER. .ere are the relevant rates for the Canadian dollar0 %pot0 C4( : 46.7,/, 769day forward0 C4( : 46.7,7; =69day forward0 C4( : 46.7,<6 (569day forward0 C4( : 46.7,6( The 769day forward discount is0 The =69day forward discount is0 The (569day forward discount is0 L$46.7,7; 9 46.7,/,&846.7,/,M x (< : (./7A L$46.7,<6 9 46.7,/,&846.7,/,M x / : (.77A L$46.7,6( 9 46.7,/,&846.7,/,M x < : (.(7A

In this case, the forward discounts at these maturities are relatively small, indicating that Canadian and -.%. interest rates are close to each other. /. a. +n investor wishes to buy euros spot $at 46.=656& and sell euros forward for (56 days $at 46.=(/;&. @hat is the swap rate on euros*

ANSWER. + premium of ;; points. b. @hat is the premium on (569day euros*

ANSWER. The (569day premium is $6.=(/; 9 6.=656&86.=656 x < : (./,A. ,. a. %uppose Credit %uisse "uotes spot and =69day forward rates of 46.7=,79;6, 59(7. @hat are the outright =69day forward rates that Credit %uisse is "uoting*

IE%TF-CTGF% H+E-+L0 MULTINATIONAL FINANCIAL MANAGEMENT, 7T. #).

ANSWER. The outright forwards are0 bid rate : 46.7=;, $6.7=,7 N 6.6665& and ask rate : 46.7=77 $6.7=;6 N 6.66(7&. b. @hat is the forward discount or premium associated with buying =69day %wiss francs*

ANSWER. The annuali ed forward premium : L$6.7=77 9 6.7=;6&86.7=;6Mx / : 6.;,A. c. Compute the percentage bid9ask spreads on spot and forward %wiss francs.

ANSWER. The bid9ask spread is calculated as follows0

&ercent prea# %

A ! price $ "i# price x 100 A ! price

%ubstituting in the numbers yields a spot bid9ask spread of $6.7=;6 9 6.7=,7&86.7=;6 : 6.6/A. The corresponding forward bid9ask spread is $6.7=77 9 6.7=;,&86.7=77 : 6.(6A. ;. a. %uppose )ow Chemical receives "uotes of 46.66=7;=97( for the yen and 46.67;7,9; for the Taiwan dollar $ET4&. .ow many -.%. dollars will )ow Chemical receive from the sale of ?,6 million*

ANSWER. )ow must sell yen at the bid rate, meaning it will receive from this sale 4/;5,/,6 $,6,666,666 x 6.66=7;=&. b. @hat is the -.%. dollar cost to )ow Chemical of buying ?( billion*

ANSWER. )ow must buy at the ask rate, meaning it will cost )ow 4=,77(,666 $(,666,666,666 x 6.66=77(& to buy ?( billion. c. .ow many ET4 will )ow Chemical receive for -.%.4,66,666*

ANSWER. )ow must sell at the bid rate for -.%. dollars $which is the reciprocal of the ask rate for ET4, or (86.67;7;&, meaning it will receive from this sale of -.%. dollars ET4(7,;6(,7/( $,66,66686.67;7;&. d. .ow many yen will )ow Chemical receive for ET4<66 million*

ANSWER. To buy yen, )ow must first sell the ET4<66 million for -.%. dollars at the bid rate and then use these dollars to buy yen at the ask rate. The net result from these transactions is ?75/,77/,;/=./, $<66,666,666 x 6.67;7,86.66=77(&. e. @hat is the yen cost to )ow Chemical of buying ET456 million*

ANSWER. )ow must sell the yen for dollars at the bid rate and then buy ET4 at the ask rate with the -.%. dollars. The net yen cost to )ow from carrying out these transactions is ?7(7,55;,<<6.,( $56,666,666 x 6.67;7;86.66=7;=& 7. a. %uppose the euro is "uoted at 6.76;/956 in London, and the pound sterling is "uoted at (.;<//9,= in 2rankfurt. Is there a profitable arbitrage situation* )escribe it.

,
ANSWER. %ell euros for >6.76568J in London. -se the pounds to buy euros for J(.;<//8> in 2rankfurt. This is e"uivalent to buying pounds for >6.;(,;. There is a net profit of >6.6=</ per pound bought and soldBa percentage yield of (7.6,A $6.6=</86.7656&. b. Compute the percentage bid9ask spreads on the pound and euro.

ANSWER. The percentage bid9ask spreads on the pound and euro are calculated as follows0 > bid9ask spread : $(.;<,= 9 (.;<//&8(.;<,= : 6.6=A euro bid9ask spread : $6.7656 9 6.76;/&86.7656 : 6.<7A 5. +s a foreign exchange trader at %umitomo Iank, one of your customers would like a yen "uote on +ustralian dollars. Current market rates are0 %pot ?(6(.7795,8-.%.4( +4(.<=</9//8-.%.4( a. 769day (,9(7 <69<;

@hat bid and ask yen cross rates would you "uote on spot +ustralian dollars*

ANSWER. Iy means of triangular arbitrage, we can calculate the market "uotes for the +ustralian dollar in terms of yen as ?75.7(95(8+4( These prices can be found as follows. 2or the yen bid price for the +ustralian dollar, we need to first sell +ustralian dollars for -.%. dollars and then sell the -.%. dollars for yen. It costs +4(.<=// to buy -.%.4(. @ith -.%.4( we can buy ?(6(.77. .ence, +4(.<=// : ?(6(.77, or +4( : ?75.7(. This is the yen bid price for the +ustralian dollar. The yen ask price for the +ustralian dollar can be found by first selling yen for -.%. dollars and then using the -.%. dollars to buy +ustralian dollars. Oiven the "uotes above, it costs ?(6(.5, to buy -.%.4(, which can be sold for +4(.<=</. .ence, +4(.<=</ : ?(6(.5,, or +4( : ?75.5(. This is the yen ask price for the +ustralian dollar. +s a foreign exchange trader, you would try to buy +ustralian dollars at slightly less than ?75.7( and sell them at slightly more than ?75.5(. Iuying and selling +ustralian dollars at the market price will leave you with no profit. .ow much better than the market prices you can do depends on the degree of competition you face from other traders and the extent to which your customers are willing to shop around to get better "uotes. b. @hat outright yen cross rates would you "uote on 769day forward +ustralian dollars*

ANSWER. Oiven the swap rates, we can compute the outright forward direct "uotes for the yen and +ustralian dollar by adding or subtracting the forward points as follows %pot ?(6(.7795,8-.%.4( +4(.<=</9//8-.%.4( 769day (,9(7 <69<; 769day outright forward rates ?(6(.<<97<8-.%.4( +4(.<=//9768-.%.4(

Iy means of triangular arbitrage, we can then calculate the market "uotes for the 769day forward +ustralian dollar in terms of yen as ?75.6/9,58+4(

IE%TF-CTGF% H+E-+L0 MULTINATIONAL FINANCIAL MANAGEMENT, 7T. #).

These prices can be found as follows. 2or the yen bid price for the forward +ustralian dollar, we need to first sell +ustralian dollars forward for -.%. dollars and then sell the -.%. dollars forward for yen. It costs +4(.<=76 to buy -.%.4( forward. @ith -.%.4( we can buy ?(6(.<<. .ence, +4(.<=76 : ?(6(.<<, or +4( : ?75.6/. This is the yen bid price for the forward +ustralian dollar. The yen ask price for the +ustralian dollar can be found by first selling yen forward for -.%. dollars and then using the -.%. dollars to buy forward +ustralian dollars. Oiven the "uotes above, it costs ?(6(.7< to buy -.%.4(, which can be sold for +4(.<=//. .ence, +4(.<=// : ?(6(.7(, or +4( : ?75.,5. This is the yen ask price for the forward +ustralian dollar. c. @hat is the forward premium or discount on buying 769day +ustralian dollars against yen delivery*

ANSWER. +s shown in parts a and b, the ask rate for 769day forward +ustralian dollars is ?75.,5 and the spot ask rate is ?75.5(. Thus, the +ustralian dollar is selling at a forward discount to the yen. The annuali ed discount e"uals 97./7A, computed as follows0

For3ar# pre1iu1 or #i count

For3ar# rate Spot rate '+0 ,-(.- $ ,-(-1 '+0 x % x % $ '()'* For3ar# contract Spot rate ,-(-1 '0 nu12er o0 #a/

=.

%uppose +ir 2rance receives the following indirect "uotes in Eew Kork0 J6.=< 9 7 and >6.;7 9 /. Oiven these "uotes, what range of >8 J bid and ask "uotes in Paris will permit arbitrage*

ANSWER. Triangular arbitrage can take place in either of two ways0 $(& Convert from euros to dollars $at the ask rate&, then from dollars to pounds $at the bid rate&, or $<& convert from pounds to dollars $at the ask rate&, then from dollars to euros $at the bid rate&. The first "uote will give us the bid price for the euro in terms of the pound and the second "uote will yield the ask price. -sing the given rates, +ir 2rance would end up with the following amounts0 $(& #uros to pounds : : : : : J84 $ask& x 6.=7 x J (./7;<8> or >6.;77/8 J >84 $ask& x 6.;/ x >6.;=,78J or J(./77,8> 48> $bid& (86.;7 48 J $bid& (86.=<

$<& Pounds to euros

The import of the figures in method $(& is that +ir 2rance can buy pounds in Eew Kork for J(./7;<8>, which is the e"uivalent of selling euros at a rate of >6.;77/8 J. %o, if +ir 2rance can buy euros in Paris for less than >6.;77/8 J $which is the e"uivalent of selling pounds for more than J6.;77/8>&, it can earn an arbitrage profit. %imilarly, the figures in method $<& tell us that +ir 2rance can buy euros in Eew Kork at a cost of >6.;=,78 J. Oiven this exchange rate, +ir 2rance can earn an arbitrage profit if it can sell these euros for more than >6.;=,7822 in Paris. Thus, +ir 2rance can profitably arbitrage between Eew Kork and Paris if the bid rate for the euro in Paris is greater than >6.;=,78 J or the ask rate is less than >6.;77/8 J.

7
(6. Gn checking the Telerate screen, you see the following exchange rate and interest rate "uotes0 Curre !" )ollar %wiss franc a. #$%&'" ( )ere*) r')e* ' /.==A 9 ,.67A 7.(/A 9 7.(=A 46.7(( 9 << 46.7<; 9 7< u'+(,e& S-.) r')e* #$%&'" /.r0'r& r')e*

Can you find an arbitrage opportunity*

ANSWER. Kes. There are two possibilities0 Iorrow dollars and lend in %wiss francs or borrow %wiss francs and lend in dollars. The profitable arbitrage opportunity lies in the former0 Lend %wiss francs financed by borrowing -.%. dollars. b. @hat steps must you take to capitali e on it*

ANSWER. Iorrow dollars at (.<,7,A for =6 days $,.67A8/&, convert these dollars into francs at the ask rate of 46.7<<, lend the francs at 6.75,A for =6 days $7.(/A8/&, and immediately sell the francs forward for dollars at the buy rate of 46.7<;. c. @hat is the profit per 4(,666,666 arbitraged*

ANSWER. The profit is 4(,666,666 x L$(.6675,86.7<<& x 6.7<; 9 (.6(<,7,M : 45,5.;;.

ADDITIONAL CHAPTER 7 PROBLEMS AND SOLUTIONS

(. a. %uppose the "uote on pounds is 4(.;</97(. If you converted 4(6,666 to pounds and then back to dollars, how many dollars would you end up with*

ANSWER. 2or 4(6,666, you would buy pounds at the price of 4(.;7(, giving you >;,(7(.<( $4(6,6668(.;7(& and resell them at the bid price of 4(.;</. The latter transaction would yield 4=,=,7.65, resulting in a round9trip cost of 4/<.=<. b. %uppose you could buy pounds at the bid rate and sell them at the ask rate. .ow many dollars would you have to transact in order to earn 4(,666 on a round9trip transaction $buying pounds for dollars and then selling the pounds for dollars&*

ANSWER. 2or every pound you could buy at the bid and sell at the ask, you would earn the spread of 46.667. To earn 4(,666, you would have to transact >(/<,5,7.(/ $4(,666846.6667&. +t the current bid rate of 4(.;</,this is e"uivalent to 4<7<,666 $(/<,5,7.(/ x 4(.;</&. <. -sing the following data, calculate the 769day, =69day, and (569day forward premiums for the Iritish pound. %pot0 769day forward0 =69day forward0 (569day forward0 >( : 4(.//57 >( : 4(.//=5 >( : 4(./,(( >( : 4(./,<=

ANSWER. .ere are the relevant calculations for the pound0 The 769day forward premium is0 L$4(.//=5 9 4(.//57&84(.//57M x (< : 6.=(A

IE%TF-CTGF% H+E-+L0 MULTINATIONAL FINANCIAL MANAGEMENT, 7T. #).

The =69day forward premium is0

L$4(./,(( 9 4(.//57&84(.//57M x / : 6.;;A

The (569day forward premium is0 L$4(./,<= 9 4(.//57&84(.//57M x < : 6.,5A The small forward premiums at these maturities indicate that Iritish and -.%. interest rates are very close. 7. The spot and =69day forward rates for the pound are 4(.(77; and 4(.(7,6, respectively. @hat is the forward premium or discount on the pound*

ANSWER. The forward premium $discount& on the Iritish pound is L$f( 9 e6&8e6M x $7;68n& : L$(.(7,6 9 (.(77;&8(.(77;M x / : 9.=(A which is a forward discount of .=(A. /. a. %uppose the spot "uote on the euro is 46.=76<9(5, and the spot "uote on the %wiss franc is 46.;(569=6. Compute the percentage bid9ask spreads on the euro and franc.

ANSWER. The percentage bid9ask spreads on the euro and franc are calculated as follows0 #uro bid9ask spread : $6.=7(5 9 6.=76<&86.=7(5 : 6.(7A %2r bid9ask spread : $6.;(=6 9 6.;(56&86.;(=6 : 6.(;A b. @hat is the direct spot "uote for the franc in 2rankfurt*

ANSWER. In order to sell one franc for euros, first sell the franc for 46.;(56 and then convert 46.;(56 into euros at the ask rate of 46.=7(5. Thus the bid rate for the franc is 6.;(5686.=7(5 : J6.;;7<. %imilarly, to ac"uire one franc, sell euros for dollars and then sell dollars for francs. %pecifically, it costs 46.;(=6 to buy J(. Iecause J( can be converted into 46.=76<, it takes J6.;(=686.=76< : J6.;;,/ to buy 46.;(=6. Thus the ask rate for francs is J6.;;,/. The bid9ask "uote on the franc in 2rankfurt is therefore J6.;;7<9,/. ,. %uppose you observe the following direct spot "uotations in Eew Kork and Toronto, respectively0 6.56669,6 and (.<,669;6. @hat are the arbitrage profits per 4( million*

ANSWER. Converting the direct "uotes in Toronto into indirect "uotes yields bid9ask rates for the Canadian dollar in terms of the -.%. dollar of -.%.4.7=;<9.5666. .ence, there is no arbitrage opportunity. ;. +ssuming no transaction costs, suppose >( : 4<./((6 in Eew Kork, 4( : 22 7.==7 in Paris, and 22 ( : >6.(655 in London. .ow could you take profitable advantage of these rates*

ANSWER. %ell pounds in Eew Kork for 4<./((6 apiece. %ell the dollars in Paris for 22 7.==7, and sell the francs in London for >.(655. This se"uence of transactions yields <./((6 x 7.==7 x .(655 pounds or >(.6/5, per pound initially traded. 7. %uppose the euro is "uoted at 46.575<9=<, while the yen is "uoted at 46.66(7;69;=. a. Oiven these "uotes for the euro and yen, what is the maximum bid9ask spread in the ?8)H rate for which there is no arbitrage*

=
ANSWER. The ?8 J bid rate based on triangular arbitrage is ?/=;.//8J( $6.575<86.66(7;=&. %imilarly, the ?8J ask rate based on triangular arbitrage is ?/==.,,8J( $6.57=<86.66(7;6&. .ence, the bid9ask spread based on triangular arbitrage is ?/==.,, 9 ?/=;.// : ?7.((. This spread is the maximum one would expect. Ieyond this spread, it would be profitable to engage in triangular arbitrage. b. @hat is the maximum bid9ask spread in percentage terms*

ANSWER. The maximum bid9ask spread in percentage terms e"uals the maximum spread divided by the bid price or 7.((8/=;.// : 6.;7A. Felative to the ask price, this percentage is 6.;<A $8/==.,,&. 5. a. +ssume that back in (==, the pound sterling is worth 22 =.56 in Paris and %2r ,./6 in Qurich. %how how Iritish arbitrageurs can make profits given that the %wiss franc is worth two 2rench francs. @hat would be the profit per pound transacted*

ANSWER. %ell pounds in Qurich for %2r ,./6. %ell %wiss francs in Qurich for 22<. Then buy pounds in Paris for 22=.56. This yields $,./6 x <&8=.5 : >(.(6< or a profit of >.(6< per pound transacted. b. @hat would be the eventual outcome on exchange rates in Paris and Qurich given these arbitrage activities*

ANSWER. The %wiss franc price of the pound would decline in Qurich. The %wiss franc would depreciate relative to the 2rench franc. The pound would appreciate relative to the 2rench franc in Paris. c. Fework Part a, assuming that transaction costs amount to 6.;A of the amount transacted. @hat would be the profit per pound transacted*

ANSWER. #ach transaction costs 6.;A. Thus, at each stage the arbitrageur receives ==./A of what he previously received. Thus after the three transactions undertaken in part a, the arbitrageur receives (.(6< x $.==/& 7 : >(.65<7 for a profit per pound sold e"ual to >.65<7. d. %uppose the %wiss franc is "uoted at 22 < in Qurich. Oiven a transaction cost of 6.;A of the amount transacted, what are the minimum8maximum 2rench franc prices for the %wiss franc that you would expect to see "uoted in Paris*

ANSWER. @ith a transaction cost of .;A, an arbitrageur will receive ==./A of what she would receive absent these costs. To find the maximum and minimum 2rench franc prices for the %wiss franc that would be "uoted in Paris, it is sufficient to invoke the following no9arbitrage conditions0 (. <. Converting 22( into %wiss francs in Qurich and then converting the %wiss francs back into 2rench francs in Paris should yield no more than one 22(. Converting %2r ( into 2rench francs in Qurich and then converting the 2rench francs back into %wiss francs in Paris should yield no more than %2r(.

If e is the direct "uote for the %wiss franc in Paris, the first no9arbitrage condition says that 6., x 6.==/ x e x 6.==/ R ( or e R <.6</< +ccording to the second no9arbitrage condition, < x 6.==/ x $(8e& x 6.==/ R ( or e S (.=7;(

(6

IE%TF-CTGF% H+E-+L0 MULTINATIONAL FINANCIAL MANAGEMENT, 7T. #).

Combining these two ine"ualities yields the minimum and maximum exchange rates or (.=7;( R e R <.6</<. =. Gn checking the Feuters screen, you see the following exchange rate and interest rate "uotes0

Curre !" Pound Ken a.

#$%&'" ( )ere*) r')e* 7 78(; 9 ,8(;A < 785 9 (8/A

S-.) r')e* ?(,=.=;=;9==(<8>

#$%&'" /.r0'r& r')e* ?(/,.,77(95;=<8>

Can you find an arbitrage opportunity*

ANSWER. There are two alternatives0 $(& Iorrow yen at < 785A8/, convert the yen into pounds at the spot ask rate of ?(,=.==(<8>, invest the pounds at 7 ,8(;A8/. and sell the expected proceeds forward for yen at the forward bid rate of ?(/,.,77(8>, or $<& borrow pounds at 7 78(;A8/, convert the pounds into yen at the spot bid rate of ?(,=.=;=;8>, invest the yen at < (8/A8/, and sell the proceeds forward for pounds at the forward ask rate of ?(/,.5;=<8>. The first alternative will yield a loss of 9?7.=/ per ?(66 borrowed, indicating that this is not a profitable arbitrage opportunity0 $(668(,=.==(<& x $(.6(57& x (/,.,77( 9 (66 x (.66,= : 97.=/ %witching to alternative <, the return per >(66 borrowed is >5./<, indicating that this is a very profitable arbitrage opportunity0 (66 x (,=.=;=; x (.66,;8(/,.5;=< 9 (66 x (.6(5; : 5./< b. @hat steps must you take to capitali e on it*

ANSWER. The steps to be taken have already been outlined in the answer to part a. c. @hat is the profit per >(,666,666 arbitraged*

ANSWER. Iased on the answer to part a, the profit is >5/,<66 $5./< x (6,666&.

NOTES ON FOREIGN EXCHANGE QUOTES

(. Spot rate 9 rate at which foreign exchange can be bought or sold for immediate delivery. J( : 46.=(67 %2r( : 46.;7/6 a& +ctual rates are given in pairs0 a bid $buy& rate and ask $sell& rate J( : 46.=(679(6 %2r( : 46.;7/69/< b& Cross rates0 J( : %2r (./7;/ $6.=(6786.;7/6& J( : %2r (./7;69= $6.=(6786.;7/< 9 6.=((686.;7/6& c& Heasuring currency changes Kear <0 J( : 46.=(67 or 4( : J(.6=5( Kear (0 J( : 46.5(;7 or 4( : J(.<<,6 The euro is said to have appreciated against the dollar by $6.=(67 9 6.5(;7&86.5(;7 : ((.,;A. +lternatively, the dollar is said to have depreciated against the euro by $(.6=5( 9 (.<<,6&8(.<<,6 : 9 (6.77A. Thursday, 'anuary =, (=5;0 Cr4( : 46.6666=;(, or 4( : Cr4(6/66 Thursday, 'anuary 7(, (=5,0 Cr4( : 46.666<5== or 4( : Cr47//=.,6 The Ira ilian cru eiro has depreciated against the dollar by $.6666=;(, 9 .666<5==&8.666<5== : 9 ;;.57A.. +lternatively, the dollar has appreciated against the cru eiro by $(6/66 9 7//=.,&87//=., : <6(./=A. Eote0 The new Ira ilian currency is now the real. This example dates back to a time when the Ira ilian currency was running a very high rate of inflation and so was continually devaluing <. a& For3ar# rate 9 rate at which foreign exchange can be bought or sold today for delivery at a fixed future date, typically in multiples of 76 days, e.g., 76, ;6, =6, or (56 days. 2orward "uotations 76 day forward rates J( : 46.=(<6 %2r( : 46.;775 b& 2orward premium $N& or discount $9& $annuali ed& : L$forward rate 9 spot rate&8spot rateM x $7;68n&

where n is the number of days in the forward contract. Thus, the euro is selling at an annuali ed forward premium of (.7(A against the dollar0 L$6.=(<6 9 6.=(67&86.=(67M x (< : (.7(A. The %wiss franc is selling at an annuali ed forward discount of 6.75A against the dollar0 L$6.;775 9 6.;7/6&86.(7/6M x (< : 9 6.75A. c& %wap rates %pot rates0 J( : 46.=(679(6 %2r( : 46.;7/69/< 769day forward rates0 J( : 46.=(<69<, %2r( : 46.;7759/( #xpressed as0 J( : 46.=(679(6 (79(, %2r( : 46.;7/69/< <9(

d& Cross rates on a 769day forward contract0 J( : %2r(./7579=7 $6.=(<686.;7/( 9 6.=(<,86.;775&