CHAPTER 6: THE FOREIGN EXCHANGE MARKET 1

CHAPTER 6
THE FOREIGN EXCHANGE MARKET

Please do not spend much time in Section 6.1

SUGGESTED ANSWERS TO CHAPTER 6 QUESTIONS

1. Answer the following questions based on data in Exhibit 6.5.

1.a. How many Swiss francs can you get for one dollar?

ANSWER. The indirect quote is $1 = SFr 1.2297.

1.b. How many dollars can you get for one Swiss franc?

ANSWER. The direct quote is SFr1 = $0.8132.

1.c. What is the three-month forward rate for the Swiss franc?

ANSWER. The three-month forward rate is SFr1 = $0.8192.

1.d. Is the Swiss franc selling at a forward premium or discount?

ANSWER. At a forward premium.

1.e. What is the 90-day forward discount or premium on the Swiss franc?

ANSWER. The 90-day forward premium is 60 points (pips), which translates into an annualized forward
premium of 2.95% (4 * (0.8192 0.8132)/0.8132).

2. What risks confront dealers in the foreign exchange market? How can they cope with these
risks?

ANSWER. Foreign exchange dealers must cope with exchange risk, because of the foreign currency
positions they take. They also bear credit risk 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, widening their bid-ask
quotes, 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 requirements
that vary with the riskiness of their customers (banks will generally not do this).

3. Suppose a currency increases in volatility. What is likely to happen to its bid-ask spread? Why?

ANSWER. As a currencys volatility increases, it becomes riskier for traders to take positions in that
currency. To compensate for the added risks, traders quote wider bid-ask spreads.

4. Who are the principal users of the forward market? What are their motives?
2 INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

ANSWER. The principal users of the forward market are currency arbitrageurs, hedgers, importers and
exporters, and speculators. Arbitrageurs wish to earn risk-free profits; hedgers, importers and exporters
want to protect the home currency values of various foreign currency-denominated assets and liabilities;
and speculators actively expose themselves to exchange risk to benefit from expected movements in
exchange rates.
CHAPTER 6: THE FOREIGN EXCHANGE MARKET 3

5. How does a company pay for the foreign exchange services of a commercial bank?

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

SUGGESTED SOLUTIONS TO CHAPTER 6 PROBLEMS

1. The $: exchange rate is 1 = $1.35, and the /SFr exchange rate is SFr 1 = 0.61. What is the
SFr/$ exchange rate?

ANSWER. SFr1 = 0.61 * 1.35 = $0.8235.

2. Suppose the direct quote for sterling in New York is 1.9880-5.

2.a. How much would 500,000 cost in New York?

ANSWER. To buy 500,000 would cost 500,000 * 1.9885 = $99,425.

2.b. What is the direct quote for dollars in London?

ANSWER. The direct quote for the dollar in London is just the reciprocal of the direct quote for the pound
in New York or 1/1.9880 - 1/1.9885 = 0.5029-0.5030.

3. Using the data in Exhibit 6.5, calculate the 30-day, 90-day, and 180-day forward discounts for
the Canadian dollar.

ANSWER. Here are the relevant rates for the Canadian dollar:

Spot: C$1 = $0.9207

30-day forward:
90-day forward:
180-day forward:
The 30-day forward discount is:
The 90-day forward discount is:
The 180-day forward discount is:
C$1 = $0.9216
C$1 = $0.9231
C$1 = $0.9250
[($0.9216 - $0.9207)/$0.9207] * 12 = 1.17%
[($0.9231 - $0.9207)/$0.9207] * 4 = 1.04%
[($0.9250 - $0.9207)/$0.9207] * 2 = 0.86%

In this case, the forward discounts at these maturities are relatively small, indicating that Canadian and
U.S. interest rates are close to each other.

4. An investor wishes to buy euros spot (at $1.3480) and sell euros forward for 180 days (at
$1.3526).

4.a. What is the swap rate on euros?

ANSWER. A premium of 46 points.

4.b. What is the premium on 180-day euros?

ANSWER. The 180-day premium is (1.3526 - 1.3480)/1.3480 * 2 = 0.68%.

4 INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

5. Suppose Credit Suisse quotes spot and 90-day forward rates of $0.7957-60 and 8-13, respectively.

5.a. What are the outright 90-day forward rates that Credit Suisse is quoting?

ANSWER. The outright forwards are: bid rate = $0.7965 (0.7957 + 0.0008) and ask rate = $0.7973
(0.7960)

5.b. What is the forward discount or premium associated with buying 90-day Swiss francs?

ANSWER. The annualized forward premium = [(0.7973 - 0.7960)/0.7960] * 4 = 0.65%.

5.c. Compute the percentage bid-ask spreads on spot and forward Swiss francs.

ANSWER. The bid-ask spread is calculated as follows:

Ask price - Bid price

Percent spread = x 100
Ask price

Substituting in the numbers yields a spot bid-ask spread of (0.7960 - 0.7957)/0.7960 = 0.04%. The
corresponding forward bid-ask spread is (0.7973 - 0.7965)/0.7973 = 0.10%.

6. Suppose Dow Chemical receives quotes of $0.008242-45 for the yen and $0.03023-27 for the
Taiwan dollar (NT$).

6.a. How many U.S. dollars will Dow Chemical receive from the sale of 50 million?

ANSWER. Dow must sell yen at the bid rate, meaning it will receive $412,100 (50,000,000 * 0.008242).

6.b. What is the U.S. dollar cost to Dow Chemical of buying 1 billion?

ANSWER. Dow must buy at the ask rate, meaning it will cost Dow $8,245,000 (1,000,000,000 *
0.008245) to buy 1 billion.

6.c. How many NT$ will Dow Chemical receive for U.S.$500,000?

ANSWER. Dow must sell at the bid rate for U.S. dollars (which is the reciprocal of the ask rate for NT$, or
1/0.03027), meaning it will receive from this sale of U.S. dollars NT$16,518,005 (500,000/0.03027).

6.d. How many yen will Dow Chemical receive for NT$200 million?

ANSWER. To buy yen, Dow must first sell the NT$200 million for U.S. dollars at the bid rate and then use
these dollars to buy yen at the ask rate. The net result from these transactions is 733,292,905
(200,000,000 * 0.03023/0.008245).

6.e. What is the yen cost to Dow Chemical of buying NT$80 million?

ANSWER. Dow must sell the yen for dollars at the bid rate and then buy NT$ at the ask rate with the U.S.
dollars. The net yen cost to Dow from carrying out these transactions is 293,812,182 (80,000,000 *
0.03027/0.008242)
CHAPTER 6: THE FOREIGN EXCHANGE MARKET 5

7. Suppose the euro is quoted at 0.6786-98 in London, and the pound sterling is quoted at 1.4724-
70 in Frankfurt.

7.a. Is there a profitable arbitrage situation? Describe it.

ANSWER. Buy euros for 0.6798/ in London. Use the pounds to buy euros for 1.4770/ in Frankfurt.
This is equivalent to buying pounds for 0.6770. There is a net profit of 0.0028 per pound bought and
sold a percentage yield of 0.41% (0.0028/0.6798).

7.b. Compute the percentage bid-ask spreads on the pound and euro.

ANSWER. The percentage bid-ask spreads on the pound and euro are calculated as follows:

bid-ask spread = (1.4770 - 1.4724)/1.4770 = 0.31%

bid-ask spread = (0.6798 - 0.6786)/0.6798 = 0.18%

8. As a foreign exchange trader at Sumitomo Bank, one of your customers would like a yen quote
on Australian dollars. Current market rates are:

Spot 30-day

121.37-85/U.S.$1 15-13
A$1.1878-98/U.S.$1 20-26

8.a. What bid and ask yen cross rates would you quote on spot Australian dollars?

ANSWER. By means of triangular arbitrage, we can calculate the market quotes for the Australian dollar in
terms of yen as
102.00-58/A$1

These prices can be found as follows. For the yen bid price for the Australian dollar, we need to first sell
Australian dollars for U.S. dollars and then sell the U.S. dollars for yen. It costs A$1.1898 to buy U.S.$1.
With U.S.$1 we can buy 121.37. Hence, A$1.1898 = 121.37, or A$1 = 102.00. This is the yen bid
price for the Australian dollar.

The yen ask price for the Australian dollar can be found by first selling yen for U.S. dollars and then
using the U.S. dollars to buy Australian dollars. Given the quotes above, it costs 121.85 to buy U.S.$1,
which can be sold for A$1.1878. Hence, A$1.1878 = 121.85, or A$1 = 102.58. This is the yen ask price
for the Australian dollar.

8.b. What outright yen cross rates would you quote on 30-day forward Australian dollars?

ANSWER. Given the swap rates, we can compute the outright forward direct quotes for the yen and
Australian dollar by adding or subtracting the forward points as follows

Spot 30-day 30-day outright forward rates

121.37-85/U.S.$1 15-13 121.22-72/U.S.$1

A$1.1878-98/U.S.$1 20-26 A$1.1898-1.1924/U.S.$1
6 INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.

By means of triangular arbitrage, we can then calculate the market quotes for the 30-day forward
Australian dollar in terms of yen as
101.66-102.30/A$1

These prices can be found as follows. For the yen bid price for the forward Australian dollar, we need to
first sell Australian dollars forward for U.S. dollars and then sell the U.S. dollars forward for yen. It costs
A$1.1924 to buy U.S.$1 forward. With U.S.$1 we can buy 121.22. Hence, A$1.1924 = 121.22, or A$1
= 100.82. This is the yen bid price for the forward Australian dollar.

The yen ask price for the Australian dollar can be found by first selling yen forward for U.S. dollars and
then using the U.S. dollars to buy forward Australian dollars. Given the quotes above, it costs 121.72 to
buy U.S.$1, which can be sold for A$1.1898. Hence, A$1.1898 = 121.72, or A$1 = 102.30. This is the
yen ask price for the forward Australian dollar.

8.c. What is the forward premium or discount on buying 30-day Australian dollars against yen
delivery?

ANSWER. As shown in 8.a and 8.b, the ask rate for 30-day forward Australian dollars is 102.30 and the
spot ask rate is 102.58. Thus, the Australian dollar is selling at a forward discount to the yen. The
annualized discount equals -0.27%, computed as follows:

9. Suppose Air France receives the following indirect quotes in New York: 0.92-3 and 0.63-4.
Given these quotes, what range of / bid and ask quotes in Paris will permit arbitrage?

ANSWER. Triangular arbitrage can take place in either of two ways: (1) Convert from euros to dollars (at
the ask rate), then from dollars to pounds (at the bid rate), or (2) convert from pounds to dollars (at the ask
rate), then from dollars to euros (at the bid rate). The first quote will give us the bid price for the euro in
terms of the pound and the second quote will yield the ask price. Using the given rates, Air France would
end up with the following amounts:

i) Euros to pounds = /$ (ask) * $/ (bid)

= 0.93 * 1/0.63
= 1.4762/ or 0.6774/

ii) Pounds to euros = /$ (ask) * $/ (bid)

= 0.64 * 1/0.92
= 0.6957/ or 1.4375/

The significance of the figures in method (i) is that Air France can buy pounds in New York for
1.4762/, which is the equivalent of selling euros at a rate of 0.6774/ . So, if Air France can buy euros
in Paris for less than 0.6774/ (which is the equivalent of selling pounds for more than 0.6774/), it can
earn an arbitrage profit.

Similarly, the figures in method (ii) tell us that Air France can buy euros in New York at a cost of
0.6957/. Given this exchange rate, Air France can earn an arbitrage profit if it can sell these euros for
more than 0.6957/FF in Paris. Thus, Air France can profitably arbitrage between New York and Paris if
the bid rate for the euro in Paris is greater than 0.6957/ or the ask rate is less than 0.6774/.
CHAPTER 6: THE FOREIGN EXCHANGE MARKET 7

10. On checking the Telerate screen, you see the following exchange rate and interest rate quotes:

90-Day Interest 90-Day

Currency Rates Annualized Spot Rates Forward Rates
Dollar 4.99% - 5.03%
Swiss franc 3.14% - 3.19% $0.711-22 $0.726-32

10.a. Can you find an arbitrage opportunity?

ANSWER. Yes. There are two possibilities: Borrow dollars and lend in Swiss francs or borrow Swiss
francs and lend in dollars. The profitable arbitrage opportunity lies in the former: Lend Swiss francs
financed by borrowing U.S. dollars.

10.b. What steps must you take to capitalize on it?

ANSWER. Borrow dollars at 1.2575% for 90 days (5.03%/4), convert these dollars into francs at the ask
rate of $0.722, lend the francs at 0.785% for 90 days (3.14%/4), and immediately sell the francs forward
for dollars at the buy rate of $0.726.

10.c. What is the profit per $1,000,000 arbitraged?

ANSWER. The profit is $1,000,000 * [(1.00785/0.722) * 0.726 - 1.012575] = $858.66.