CHAPTER 5 THE MARKET FOR FOREIGN EXCHANGE

SUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTER

QUESTIONS AND PROBLEMS
QUESTIONS
1. Give a full definition of the market for foreign exchange.
An!er" #roadl$ defined% the foreign exchange (FX) market encom&ae the converion of
&urchaing &o!er from one currenc$ into another% 'ank de&oit of foreign currenc$% the extenion of
credit denominated in a foreign currenc$% foreign trade financing% and trading in foreign currenc$
o&tion and future contract.
(. )hat i the difference 'et!een the retail or client market and the !holeale or inter'ank
market for foreign exchange*
An!er" The market for foreign exchange can 'e vie!ed a a t!o+tier market. One tier i the
wholesale or interbank market and the other tier i the retail or client market. International 'ank
&rovide the core of the ,- market. The$ tand !illing to 'u$ or ell foreign currenc$ for their
o!n account. Thee international 'ank erve their retail client% cor&oration or individual% in
conducting foreign commerce or making international invetment in financial aet that re.uire
foreign exchange. /etail tranaction account for onl$ a'out 10 &ercent of ,- trade. The other
12 &ercent i inter'ank trade 'et!een international 'ank% or non+'ank dealer large enough to
tranact in the inter'ank market.
3. )ho are the market &artici&ant in the foreign exchange market*
An!er" The market &artici&ant that com&rie the ,- market can 'e categori4ed into five
grou&" international 'ank% 'ank cutomer% non+'ank dealer% ,- 'roker% and central 'ank.
International banks &rovide the core of the ,- market. A&&roximatel$ 155 to (55 'ank
!orld!ide make a market in foreign exchange% i.e.% the$ tand !illing to 'u$ or ell foreign
currenc$ for their o!n account. Thee international 'ank erve their retail client% the bank
customers% in conducting foreign commerce or making international invetment in financial aet
that re.uire foreign exchange. Non-bank dealers are large non+'ank financial intitution% uch
a invetment 'ank% mutual fund% &enion fund% and hedge fund% !hoe i4e and fre.uenc$ of
trade make it cot+ effective to eta'lih their o!n dealing room to trade directl$ in the
inter'ank market for their foreign exchange need.
6ot inter'ank trade are speculative or arbitrage tranaction !here market &artici&ant
attem&t to correctl$ 7udge the future direction of &rice movement in one currenc$ veru another
or attem&t to &rofit from tem&orar$ &rice dicre&ancie in currencie 'et!een com&eting dealer.
FX brokers match dealer order to 'u$ and ell currencie for a fee% 'ut do not take a
&oition themelve. Inter'ank trader ue a 'roker &rimaril$ to dieminate a .uickl$ a
&oi'le a currenc$ .uote to man$ other dealer.
Central banks ometime intervene in the foreign exchange market in an attem&t to
influence the &rice of it currenc$ againt that of a ma7or trading &artner% or a countr$ that it
8fixe9 or 8&eg9 it currenc$ againt. Intervention i the &roce of uing foreign currenc$
reerve to 'u$ one: o!n currenc$ in order to decreae it u&&l$ and thu increae it value in
the foreign exchange market% or alternativel$% elling one: o!n currenc$ for foreign currenc$ in
order to increae it u&&l$ and lo!er it &rice.
0. ;o! are foreign exchange tranaction 'et!een international 'ank ettled*
An!er" The inter'ank market i a net!ork of correspondent banking relationships% !ith large
commercial 'ank maintaining demand de&oit account !ith one another% called corre&ondent
'ank account. The corre&ondent 'ank account net!ork allo! for the efficient functioning of
the foreign exchange market. A an exam&le of ho! the net!ork of corre&ondent 'ank account
facilitie international foreign exchange tranaction% conider a U.S. im&orter deiring to
&urchae merchandie invoiced in guilder from a <utch ex&orter. The U.S. im&orter !ill contact
hi 'ank and in.uire a'out the exchange rate. If the U.S. im&orter acce&t the offered exchange
rate% the 'ank !ill de'it the U.S. im&orter: account for the &urchae of the <utch guilder. The
'ank !ill intruct it corre&ondent 'ank in the Netherland to de'it it corre&ondent 'ank
account the a&&ro&riate amount of guilder and to credit the <utch ex&orter: 'ank account. The
im&orter: 'ank !ill then de'it it 'ook to offet the de'it of U.S. im&orter: account% reflecting
the decreae in it corre&ondent 'ank account 'alance.
=. )hat i meant '$ a currenc$ trading at a dicount or at a &remium in the for!ard market*
An!er" The for!ard market involve contracting toda$ for the future &urchae or ale of foreign
exchange. The for!ard &rice ma$ 'e the ame a the &ot &rice% 'ut uuall$ it i higher >at a
&remium? or lo!er >at a dicount? than the &ot &rice.
2. )h$ doe mot inter'ank currenc$ trading !orld!ide involve the U.S. dollar*
An!er" Trading in currencie !orld!ide i againt a common currenc$ that ha international
a&&eal. That currenc$ ha 'een the U.S. dollar ince the end of )orld )ar II. ;o!ever% the euro
and @a&anee $en have tarted to 'e ued much more a international currencie in recent $ear.
6ore im&ortantl$% trading !ould 'e exceedingl$ cum'erome and difficult to manage if each
trader made a market againt all other currencie.
A. #ank find it necear$ to accommodate their client: need to 'u$ or ell ,- for!ard% in
man$ intance for hedging &ur&oe. ;o! can the 'ank eliminate the currenc$ ex&oure it ha
created for itelf '$ accommodating a client: for!ard tranaction*
An!er" S!a& tranaction &rovide a mean for the 'ank to mitigate the currenc$ ex&oure in a
for!ard trade. A swap trasa!t"# i the imultaneou ale >or &urchae? of &ot foreign
exchange againt a for!ard &urchae >or ale? of an a&&roximatel$ e.ual amount of the foreign
currenc$. To illutrate% u&&oe a 'ank cutomer !ant to 'u$ dollar three month for!ard
againt #ritih &ound terling. The 'ank can handle thi trade for it cutomer and
imultaneoul$ neutrali4e the exchange rate rik in the trade '$ elling >'orro!ed? #ritih &ound
terling &ot againt dollar. The 'ank !ill lend the dollar for three month until the$ are needed
to deliver againt the dollar it ha old for!ard. The #ritih &ound received !ill 'e ued to
li.uidate the terling loan.
1. A B<CD 'ank trader i currentl$ .uoting a small figure 'id+ak of 3=+05% !hen the ret of the
market i trading at B<1.3032+B<1.3001. )hat i im&lied a'out the trader: 'elief '$ hi
&rice*
An!er" The trader mut think the Banadian dollar i going to a&&reciate againt the U.S. dollar
and therefore he i tr$ing to increae hi inventor$ of Banadian dollar '$ dicouraging &urchae
of U.S. dollar '$ tanding !illing to 'u$ D at onl$ B<1.303=CD1.55 and offering to ell from
inventor$ at the lightl$ lo!er than market &rice of B<1.3005CD1.55.
E. )hat i triangular ar'itrage* )hat i a condition that !ill give rie to a triangular ar'itrage
o&&ortunit$*
An!er" riangular arbitrage i the &roce of trading out of the U.S. dollar into a econd
currenc$% then trading it for a third currenc$% !hich i in turn traded for U.S. dollar. The &ur&oe
i to earn an ar'itrage
&rofit via trading from the econd to the third currenc$ !hen the direct exchange 'et!een the t!o
i not in alignment !ith the cro exchange rate.
6ot% 'ut not all% currenc$ tranaction go through the dollar. Bertain 'ank &eciali4e in
making a direct market 'et!een non+dollar currencie% &ricing at a narro!er 'id+ak &read than
the cro+rate &read. Neverthele% the im&lied cro+rate 'id+ak .uotation im&oe a dici&line
on the non+dollar market maker. If their direct .uote are not conitent !ith the cro exchange
rate% a triangular ar'itrage &rofit i &oi'le.
15. Over the &at ix $ear% the exchange rate 'et!een S!i franc and U.S. dollar% S,rCD% ha
changed from a'out 1.35 to a'out 1.25. )ould $ou agree that over thi ix+$ear &eriod% the S!i
good have 'ecome chea&er for 'u$er in the United State*

B,A Guideline An!er"
The value of the dollar in S!i franc ha gone u& from a'out 1.35 to a'out 1.25. Therefore% the
dollar ha a&&reciated relative to the S!i franc% and the dollar needed '$ American to
&urchae S!i good have decreaed. Thu% the tatement i correct.
F/O#GE6S
1. A 'ank i .uoting the follo!ing exchange rate againt the dollar for the S!i franc and the
Autralian dollar"

S,rCD H 1.=E25+1.=EA5
ADCD H 1.A((=+1.A(3=
An Autralian firm ak the 'ank for an ADCS,r .uote. )hat cro+rate !ould the 'ank
.uote*
'id ADCS, H >'id ADCD?C>ak S,CD? H 1.A((=C1.=EA5H1.5A12
ak ADCS, H >ak ADCD?C>'id S,CD? H 1.A(3=C1.=E25 H 1.5AEE
E. Given the follo!ing information% !hat are the NI<CSG< currenc$ againt currenc$ 'id+ak
.uotation*
!merican erms "uropean erms
#ank $uotations #id Ak #id Ak
Ne! Iealand dollar .A(2= .A(A( 1.3A=1 1.3A2=
Singa&ore dollar .213= .2105 1.2(1A 1.2355
Solution" E.uation =.1( from the text im&lie %
b
(N&'(%)') H %
b
(*(%)') x %
b
(N&'(*) H .213= x
1.3A=1 H .1032. The reci&rocal% +(%
b
(N&'(%)') H %
a
(%)'(N&') H 1.11=0. Analogoul$% it i
im&lied that %
a
(N&'(%)') H %
a
(*(%)') x %
a
(N&'(*) H .2105 x 1.3A2= H .10=(. The reci&rocal%
+(%
a
(N&'(%)') H %
b
(%)'(N&') H 1.113(. Thu% the NI<CSG< 'id+ak &read i NI<5.1032+
NI<5.10=( and the SG<CNI< &read i SG<1.113(+SG<1.11=0.
15. <oug #ernard &eciali4e in cro+rate ar'itrage. ;e notice the follo!ing .uote"
S!i francCdollar H S,r1.=EA1D
Autralian dollarCU.S. dollar H AD1.1(1=CD
Autralian dollarCS!i franc H AD1.1005CS,r
Ignoring tranaction cot% doe <oug #ernard have an ar'itrage o&&ortunit$ 'aed on thee
.uote* If there i an ar'itrage o&&ortunit$% !hat te& !ould he take to make an ar'itrage &rofit%
and ho! !ould he &rofit if he ha D1%555%555 availa'le for thi &ur&oe.
B,A Guideline An!er"
A. The im&licit cro+rate 'et!een Autralian dollar and S!i franc i ADCS,r H ADCD x DCS,r
H >ADCD?C>S,rCD? H 1.1(1=C1.=EA1 H 1.105=. ;o!ever% the .uoted cro+rate i higher at
AD1.1.1005CS,r. So% triangular ar'itrage i &oi'le.
#. In the .uoted cro+rate of AD1.1005CS,r% one S!i franc i !orth AD1.1005% !herea the
cro+rate 'aed on the direct rate im&lie that one S!i franc i !orth AD1.105=. Thu% the
S!i franc i overvalued relative to the AD in the .uoted cro+rate% and <oug #ernard: trateg$
for triangular ar'itrage hould 'e 'aed on elling S!i franc to 'u$ AD a &er the .uoted cro+
rate. Accordingl$% the te& <oug #ernard !ould take for an ar'itrage &rofit i a follo!"
i. Sell dollar to get S!ifranc" Sell D1%555%555 to get D1%555%555 x S,r1.=EA1CD H
S,r1%=EA%155.
ii. Sell S!i franc to 'u$ Autralian dollar" Sell S,r1%=EA%155 to 'u$ S,r1%=EA%155
x AD1.1005CS,r H AD1%1(A%51(.05.
iii. Sell Autralian dollar for dollar" Sell AD1%1(A%51(.05 for
AD1%1(A%51(.05CAD1.1(1=CD H D1%553%520.A3.
Thu% $our ar'itrage &rofit i D1%553%520.A3 + D1%555%555 H D3%520.A3.
11. Aume $ou are a trader !ith <eutche #ank. ,rom the .uote creen on $our com&uter
terminal% $ou notice that <redner #ank i .uoting J5.A2(ACD1.55 and Bredit Suie i offering
S,1.1152CD1.55. Kou learn that U#S i making a direct market 'et!een the S!i franc and the
euro% !ith a current JCS, .uote of .23E=. Sho! ho! $ou can make a triangular ar'itrage &rofit '$
trading at thee &rice. >Ignore 'id+ak &read for thi &ro'lem.? Aume $ou have D=%555%555
!ith !hich to conduct the ar'itrage. )hat ha&&en if $ou initiall$ ell dollar for S!i franc*
)hat JCS, &rice !ill eliminate triangular ar'itrage*
Solution" To make a triangular ar'itrage &rofit the <eutche #ank trader !ould ell D=%555%555 to
<redner #ank at J5.A2(ACD1.55. Thi trade !ould $ield J3%113%=55H D=%555%555 x .A2(A. The
<eutche #ank trader !ould then ell the euro for S!i franc to Union #ank of S!it4erland at
a &rice of J5.23E=CS,1.55% $ielding S,=%E23%(=3 H J3%113%=55C.23E=. The <eutche #ank trader
!ill reell the S!i franc to Bredit Suie for D=%5=1%532 H S,=%E23%(=3C1.1152% $ielding a
triangular ar'itrage &rofit of D=1%532.
If the <eutche #ank trader initiall$ old D=%555%555 for S!i franc% intead of euro% the
trade !ould $ield S,=%E53%555 H D=%555%555 x 1.1152. The S!i franc !ould in turn 'e traded
for euro to U#S for J3%AA0%E2EH S,=%E53%555 x .23E=. The euro !ould 'e reold to <redner
#ank for D0%E0E%011 H J3%AA0%E2EC.A2(A% or a lo of D=5%=1E. Thu% it i necear$ to conduct
the triangular ar'itrage in the correct order.
The %(J(%F) cro exchange rate hould 'e .A2(AC1.1152 H .2025. Thi i an e.uili'rium rate
at !hich a triangular ar'itrage &rofit !ill not exit. >The tudent can determine thi for himelf.?
A &rofit reult from the triangular ar'itrage !hen dollar are firt old for euro 'ecaue S!i
franc are &urchaed for euro at too lo! a rate in com&arion to the e.uili'rium cro+rate% i.e.%
S!i franc are &urchaed for onl$ J5.23E=CS,1.55 intead of the no+ar'itrage rate of
J5.2025CS,1.55. Similarl$% !hen dollar are firt old for S!i franc% an ar'itrage lo reult
'ecaue S!i franc are old for euro at too lo! a rate% reulting in too fe! euro. That i% each
S!i franc i old for J5.23E=CS,1.55 intead of the higher no+ar'itrage rate of J5.2025CS,1.55.
1(. The current &ot exchange rate i D1.E=CL and the three+month for!ard rate i D1.E5CL. #aed
on $our anal$i of the exchange rate% $ou are &rett$ confident that the &ot exchange rate !ill 'e
D1.E(CL in three month. Aume that $ou !ould like to 'u$ or ell L1%555%555.
a. )hat action do $ou need to take to &eculate in the for!ard market* )hat i the ex&ected
dollar &rofit from &eculation*
'. )hat !ould 'e $our &eculative &rofit in dollar term if the &ot exchange rate actuall$ turn
out to 'e D1.12CL.
Solution"
a. If $ou 'elieve the &ot exchange rate !ill 'e D1.E(CL in three month% $ou hould 'u$
L1%555%555 for!ard for D1.E5CL. Kour ex&ected &rofit !ill 'e"
D(5%555 H L1%555%555 x >D1.E( +D1.E5?.
'. If the &ot exchange rate actuall$ turn out to 'e D1.12CL in three month% $our lo from the
long &oition !ill 'e"
+D05%555 H L1%555%555 x >D1.12 +D1.E5?.