FINANCIAL INSTITUTIONS AND MARKETS( LW-2316)

MODULE V: FOREIGN EXCHANGE MARKET AND THE INTERNATIONAL

FINANCIAL SYSTEM

5.1 Meaning and concept of Exchange Rates ,Exchange Rates in the Long Run and Short Run
5.2 Hedging: Definition and Types
5.3 Arbitrage: Definition, Two Point Arbitrage, Three Point Arbitrage.
5.4 International Financial System
5.5 FERA and FEMA

Forex

Foreign exchange, or forex, is the conversion of one country's currency into another. In a free
economy, a country's currency is valued according to the laws of supply and demand. In other
words, a currency's value can be pegged to another country's currency, such as the U.S. dollar,
or even to a basket of currencies. A country's currency value may also be set by the country's
government.

However, most countries float their currencies freely against those of other countries, which
keeps them in constant fluctuation.

The value of any particular currency is determined by market forces based on trade,
investment, tourism, and geo-political risk. Every time a tourist visits a country, for example,
they must pay for goods and services using the currency of the host country. Therefore, a
tourist must exchange the currency of his or her home country for the local
currency. Currency exchange of this kind is one of the demand factors for a particular
currency.

Another important factor of demand occurs when a foreign company seeks to do business
with another in a specific country. Usually, the foreign company will have to pay in the local
company's currency. At other times, it may be desirable for an investor from one country to
invest in another, and that investment would have to be made in the local currency as well.
All of these requirements produce a need for foreign exchange and contribute to the vast size
of foreign exchange markets.

Foreign Exchange Market

The foreign exchange market is a global online network where traders buy and sell currencies.
It has no physical location and operates 24 hours a day from 5 p.m. EST on Sunday until 4
p.m. EST on Friday because currencies are in high demand. It sets the exchange rates for
currencies with floating rates.

The Forex market has an estimated turnover of $6.6 trillion a day. It is the largest and most
liquid financial market in the world. Demand and supply determine the differences in
exchange rates, which in turn, determine traders’ profits.

This global market has two tiers. The first is the interbank market. It's where the biggest
banks exchange currencies with each other. Even though it only has a few members, the
trades are enormous. As a result, it dictates currency values.

The second tier is the over-the-counter market. That's where companies and individuals trade.
OTC has become very popular since there are now many companies that offer online trading
platforms. New traders, starting with limited capital, need to know more about forex trading.
It’s risky because the forex industry is not highly regulated and provides substantial leverage.

The biggest geographic OTC trading center is in the United Kingdom. London dominates the
market. A currency’s quoted price is usually London’s market price. As of April 2019, U.K.’s
forex trading amounted to 43.1% of total global trading. This makes London the most
important forex trading center1 in the world. 

Foreign exchange trading is a contract between two parties. There are three types of trades.
The spot market is for the currency price at the time of the trade. The forward market is an
agreement to exchange currencies at an agreed-upon price on a future date. 

A swap trade involves both. Dealers buy a currency at today's price on the spot market and
sell the same amount in the forward market. This way, they have just limited their risk in the
future. No matter how much the currency falls, they will not lose more than the forward price.
Meanwhile, they can invest the currency they bought on the spot market.

What is the Bid Price

In any given market, the bid price is the highest price the market is willing to pay for that
trading instrument. If there are several buyers, all willing to pay a different price, the highest
of those prices will show as the bid. 

The bid price is the highest price at which a seller can sell a trading instrument at any given
time.

What is the Ask Price

The ask price is the lowest price at which the market is willing to sell a given trading
instrument. The ask price is also known as the offer price. If there are several sellers with
limit orders in the market, the order with the lowest price will show as the market’s ask price. 

The ask price is the lowest price at which a buyer can buy a trading instrument at any given
time.

What's the difference between the bid and ask price?

The following is an example of a Forex quote:

GBPUSD: 1.27256/1.27272

In this example, the first price mentioned is the bid price, which will always be the lower of
the two prices in a quote. As a seller, this will be the price at which you will be able to sell
GBP for USD.

The second price in the example is the ask price, which is also the higher of the two prices. If
you are a buyer, this is the lowest price at which you can buy GBP for USD.
Bid and ask prices both show limit orders in the market. A market order would be
immediately executed at the best bid or ask price.

Bid-Ask Spreads in the Retail Forex Market

The bid price is what the dealer is willing to pay for a currency, while the ask price is the rate
at which a dealer will sell the same currency.

For example, Ellen is an American traveler visiting Europe. The cost of purchasing euros at
the airport is as follows:

EUR 1 = USD 1.30 / USD 1.40

The higher price (USD 1.40) is the cost to buy each euro. Ellen wants to buy EUR 5,000, so
she would have to pay the dealer USD 7,000.

Suppose also that the next traveler in line has just returned from her European vacation and
wants to sell the euros that she has left over. Katelyn has EUR 5,000 to sell. She can sell the
euros at the bid price of USD 1.30 (the lower price) and would receive USD 6,500 in
exchange for her euros.

Because of the bid-ask spread, the kiosk dealer is able to make a profit of USD 500 from this
transaction (the difference between USD 7,000 and USD 6,500).

When faced with a standard bid and ask price for a currency, the higher price is what you
would pay to buy the currency and the lower price is what you would receive if you were to
sell the currency.

The Bid-Ask Spread

The Bid-Ask spread is simply the difference between the ask price and the bid price. In order
driven markets, the spread is determined by a market maker or broker, whereas the spread for
an order driven market is determined by supply and demand.

Liquidity and the Bid-Ask Spread

A tighter spread signifies a more liquid market. Higher liquidity means more buyers and
sellers and more market makers. As buyers compete with one another, the bid price rises and
as sellers compete, the ask price falls. The result is a tighter spread between the bid and ask
price.

The bid-ask spread amounts to a trading cost for traders. In other words, a market with a
lower spread is cheaper to trade. Liquidity often leads to more liquidity, as traders are
attracted to markets with lower bid-ask spreads.

Example : Currency Bid-Ask Spread

Forexica sells Euro at 1.3093€/$ and purchases it at 1.3089€/$. Find the bid-ask spread.

1.3093 is the sale price, so it is the ask. 1.3089 is the purchase price, and hence the bid. This
gives us a bid-ask spread of 0.0004 [= 1.3093 − 1.3089] or 4 pips. In foreign currency
markets this 4th decimal is called one pip.
What is a Cross Rate & How To Derive One

The US dollar (USD) is the currency against which all other currencies are priced. Any
exchange rate (AUDCAD for instance) that does not involve the USD is considered a "cross
rate". Currency cross rates are not usually quoted outside of a few significant market pairs:
EURGBP, EURJPY, EURCHF and AUDNZD.

If you are trying to derive the rate at which you would change your base currency and it does
not involve USD you may need to find the cross rate.

In order to do this you have to find two currency pairs: one that contains your home currency
and the other must contain the foreign currency that you want to exchange it with. Next,
determine what type of quote each of your two selected currency pairs is and apply the
corresponding rule for deriving a cross rate.

Direct Quote: 1 foreign currency unit = x home currency units

Indirect Quote: 1 home currency unit = x foreign currency units

How to Derive a Cross Rate from a Direct Quote & Direct Quote:
Rule: Divide the terms currency by the base currency on the opposite side.

 Example:

Derive the rate for JPYAUD

  Bid Ask  

USDJPY 119.25 119.65 USD is base, JPY is term

USDAUD 1.0485 1.0535 USD is base, AUD is term

The JPYAUD Bid rate = divide the term currency bid by the base currency ask

  = 1.0485 / 119.65 = 0.008763

  *this is the rate at which the market buys JPY and sells AUD

The = divide the term currency ask by the base currency bid
JPYAUD Ask rate

  = 1.0535 / 119.25 = 0.008834

  *this is the rate at which the market sells JPY and buys AUD

How to Derive a Cross Rate from a Direct Quote & Indirect Quote:
Rule: multiply on the same side
 Example:

Derive the rate for EURAUD

  Bid Ask  

EURUSD 1.3798 1.3858

USDAUD 1.0432 1.0502

The EURAUD Bid rate = Multiply the term currency bid by the base currency ask

= 1.3798 x 1.0432 = 1.4394

this is the rate at which the market buys EUR and sellsAUD

The = Multiply the term currency ask by the base currency bid
EURAUD Ask rate

= 1.3858 x 1.0502 = 1.4553

this is the rate at which the market sells EUR and buysAUD

Fixed and Flexible Exchange Rate Management:

(A) Fixed Exchange Rate:

A fixed exchange rate is an exchange rate that does not fluctuate or that changes within a pre-
deter- mined rate at infrequent intervals. Government or the central monetary authority inter-
venes in the foreign exchange market so that exchange rates are kept fixed at a stable rate.
The rate at which the currency is fixed is called par value. This par value is allowed to move
in a narrow range or ‘band’ of ± 1 per cent.

If the sum of current and capital account is negative, there occurs an excess supply of domes-
tic currency in world markets. The government then intervenes using official foreign
exchange reserves to purchase domestic currency.

The fixed or pegged exchange rate can be explained graphically. Let us suppose that India’s
demand for US goods rises. This increased demand for imports causes an increase in the
supply of domestic currency, rupee, in the exchange market to obtain US dollars. Let DD and
SS be the demand and supply curves of dollar in Fig. 5.7. These two curves intersect at point
A and the corresponding exchange rate is Rs. 40 = $1. Consequently, the supply curve shifts
to S1S1 and cuts the demand curve DD at point B. This means a fall in the exchange rate.

To prevent this exchange rate from falling, the Reserve Bank of India will now demand more
rupee in exchange for the US dollars. This will restrict the excess supply of rupee and there
will be an upward pressure in exchange rate. Demand curve will now shift to DD1. The end
result is the restoration of the old exchange rate at point C.

Thus, it is clear that the maintenance of fixed exchange rate system requires that foreign
exchange reserves are sufficiently available. Whenever a country experiences inadequate
foreign currency reserves it won’t be able to purchase domestic currency in suffi cient
quantities. Under the circumstance, the country will devalue its currency. Thus, devaluation
means an official reduction in the value of one currency in terms of another currency.

(B) Flexible Exchange Rate:

Under the flexible or floating exchange rate, the exchange rate is allowed to vary to
international foreign exchange market influences. Thus, government does not intervene.
Rather, it is the market forces that determine the exchange rate. In fact, automatic variations
in exchange rates consequent upon a change in market forces are the essence of freely
fluctuating exchange rates.

A deficit in the BOP account means an excess supply of the domestic currency in the world
markets. As price declines, imbalances are removed. In other words, excess supply of
domestic currency will automatically cause a fall in the exchange rate and BOP balance will
be restored.

Flexible exchange rate mechanism has been explained in Fig. 5.8 where DD and SS are de-
mand and supply curves. When Indians buy US goods, there arises supply of dollar and when
US people buy Indian goods there occurs demand for rupee. Initial exchange rate—Rs. 40 =
$1—is determined by the intersection of DD and SS curves in both the Figs. 5.8(a) and 5.8(b).
An increase in demand for India’s exportables means an increase in the demand for Indian
rupee. Consequently, demand curve shifts to DD1 and the new exchange rate rises to Rs. 50 =
$1. At this new exchange rate, dollar appreciates while rupee depreciates in value [Fig.
5.8(a)].

Fig. 5.8(b) shows that the initial exchange rate is Rs. 40 = $1. Supply curve shifts to SS1 in
response to an increase in demand for US goods. SS1 curve intersects the demand curve DD
at point B and exchange rate drops to Rs. 30 = $1. This means that dollar depreciates while
Indian rupee appreciates.

(C) Managed Exchange Rate:

Under the managed exchange rate, floating exchange rates are ‘managed’ partially. That is to
say, exchange rates are determined in the main by market forces, but central bank intervenes
to stabilise fluctuations in exchange rates so as to bring ‘orderly’ conditions in the market or
to maintain the desired exchange rate values.

Determinants of Exchange Rates

Numerous factors determine exchange rates. Many of these factors are related to the trading
relationship between the two countries. Remember, exchange rates are relative, and are
expressed as a comparison of the currencies of two countries. The following are some of the
principal determinants of the exchange rate between two countries. Note that these factors are
in no particular order; like many aspects of economics, the relative importance of these
factors is subject to much debate.

1. Differentials in Inflation

Typically, a country with a consistently lower inflation rate exhibits a rising currency value,
as its purchasing power increases relative to other currencies. During the last half of the 20th
century, the countries with low inflation included Japan, Germany, and Switzerland, while the
U.S. and Canada achieved low inflation only later. Those countries with higher inflation
typically see depreciation in their currency about the currencies of their trading partners. This
is also usually accompanied by higher interest rates.

2. Differentials in Interest Rates

Interest rates, inflation, and exchange rates are all highly correlated. By manipulating interest
rates, central banks exert influence over both inflation and exchange rates, and changing
interest rates impact inflation and currency values. Higher interest rates offer lenders in an
economy a higher return relative to other countries. Therefore, higher interest rates attract
foreign capital and cause the exchange rate to rise. The impact of higher interest rates is
mitigated, however, if inflation in the country is much higher than in others, or if additional
factors serve to drive the currency down. The opposite relationship exists for decreasing
interest rates – that is, lower interest rates tend to decrease exchange rates.

3. Current Account Deficits

The current account is the balance of trade between a country and its trading partners,
reflecting all payments between countries for goods, services, interest, and dividends.
A deficit in the current account shows the country is spending more on foreign trade than it is
earning, and that it is borrowing capital from foreign sources to make up the deficit. In other
words, the country requires more foreign currency than it receives through sales of exports,
and it supplies more of its own currency than foreigners demand for its products. The excess
demand for foreign currency lowers the country's exchange rate until domestic goods and
services are cheap enough for foreigners, and foreign assets are too expensive to generate
sales for domestic interests.

4. Public Debt

Countries will engage in large-scale deficit financing to pay for public sector projects and
governmental funding. While such activity stimulates the domestic economy, nations with
large public deficits and debts are less attractive to foreign investors. The reason? A large
debt encourages inflation, and if inflation is high, the debt will be serviced and ultimately paid
off with cheaper real dollars in the future.

In the worst case scenario, a government may print money to pay part of a large debt, but
increasing the money supply inevitably causes inflation. Moreover, if a government is not
able to service its deficit through domestic means (selling domestic bonds, increasing the
money supply), then it must increase the supply of securities for sale to foreigners, thereby
lowering their prices. Finally, a large debt may prove worrisome to foreigners if they believe
the country risks defaulting on its obligations. Foreigners will be less willing to own securities
denominated in that currency if the risk of default is great. For this reason, the country's debt
rating (as determined by Moody's or Standard & Poor's, for example) is a crucial determinant
of its exchange rate.

5. Terms of Trade

A ratio comparing export prices to import prices, the terms of trade is related to current
accounts and the balance of payments. If the price of a country's exports rises by a greater rate
than that of its imports, its terms of trade have favorably improved. Increasing terms of trade
shows' greater demand for the country's exports. This, in turn, results in rising revenues from
exports, which provides increased demand for the country's currency (and an increase in the
currency's value). If the price of exports rises by a smaller rate than that of its imports, the
currency's value will decrease in relation to its trading partners.

6. Strong Economic Performance

Foreign investors inevitably seek out stable countries with strong economic performance in
which to invest their capital. A country with such positive attributes will draw investment
funds away from other countries perceived to have more political and economic risk. Political
turmoil, for example, can cause a loss of confidence in a currency and a movement of capital
to the currencies of more stable countries.

Forex Hedge

A forex hedge is a transaction implemented to protect an existing or anticipated position from

an unwanted move in exchange rates. Forex hedges are used by a broad range of market
participants, including investors, traders and businesses. By using a forex hedge properly, an
individual who is long a foreign currency pair or expecting to be in the future via a
transaction can be protected from downside risk. Alternatively, a trader or investor who is
short a foreign currency pair can protect against upside risk using a forex hedge.

Understanding a Forex Hedge

It is important to remember that a hedge is not a money making strategy. A forex hedge is
meant to protect from losses, not to make a profit. Moreover, most hedges are intended to
remove a portion of the exposure risk rather than all of it, as there are costs to hedging that
can outweigh the benefits after a certain point.

So, if a Japanese company is expecting to sell equipment in U.S. dollars, for example, it may
protect a portion of the transaction by taking out a currency option that will profit if the
Japanese yen increases in value against the dollar. If the transaction takes place unprotected
and the dollar strengthens or stays stable against the yen, then the company is only out the
cost of the option. If the dollar weakens, the profit from the currency option can offset some
of the losses realized when repatriating the funds received from the sale.

Currency Arbitrage

A currency arbitrage is a forex strategy in which a currency trader takes advantage of

different spreads offered by brokers for a particular currency pair by making trades. Different
spreads for a currency pair imply disparities between the bid and ask prices. Currency
arbitrage involves buying and selling currency pairs from different brokers to take advantage
of the miss priced rates. 

Understanding Currency Arbitrage

Currency arbitrage involves the exploitation of the differences in quotes rather than
movements in the exchange rates of the currencies in the currency pair. Forex
traders typically practice two-currency arbitrage, in which the differences between the spreads
of two currencies are exploited. Traders can also practice three-currency arbitrage, also
known as triangular arbitrage, which is a more complex strategy. Due to the use of computers
and high-speed trading systems, large traders often catch differences in currency pair quotes
and close the gap quickly.

The most important risk that forex traders must deal with while arbitraging currencies is
execution risk. This risk refers to the possibility that the desired currency quote may be lost
due to the fast-moving nature of forex markets.

Forex Arbitrage

Forex arbitrage is the strategy of exploiting price disparity in the forex markets. It may be
effected in various ways but however it is carried out, the arbitrage seeks to buy currency
prices and sell currency prices that are currently divergent but extremely likely to rapidly
converge. The expectation is that as prices move back towards a mean, the arbitrage becomes
more profitable and can be closed, sometimes even in milliseconds.

For example, if Company XYZ's stock trades at $5.00 per share on the New York Stock
Exchange (NYSE) and the equivalent of $5.05 on the London Stock Exchange (LSE), an
arbitrageur would purchase the stock for $5 on the NYSE and sell it on the LSE for $5.05 --
pocketing the difference of $0.05 per share.

1.Locational Arbitrage with Bid/Ask

Now consider East quotes USD 1.50/1.55 for GBP, and West quotes USD 1.56/1.58. The
notation refers to the bid/ask. Is there an arbitrage opportunity?

Yes, buy 1 GBP from East for USD 1.55, and sell it to West for USD 1.56, earning USD 0.01
per GBP traded.
What about if East quotes USD 1.50/1.55 for GBP, and West quotes USD 1.54/1.58? Is there
an arbitrage opportunity?

No, you would be buying a GBP at East for USD 1.55 and selling at West for USD 1.54,
thereby losing USD 0.01 per GBP traded.

Currency Cross Rates

Before talking about triangular arbitrage, it is helpful to define a ‘cross rate.’

A currency cross-rate is an exchange rate that does not involve the USD.

For example, EUR/CHF and GBP/AUD are cross rates. CHF/USD is not a cross-rate.

Calculating Cross-Rates
Given direct or indirect quotes (quotes involving the USD) we can calculate the cross-rate.

For example, say it is USD 1.5/GBP and USD 0.8/CHF. Then it is 1.50.8=CHF 1.875USD.

To know that 1.875 is the amount of CHF for a GBP, you can manipulate the units
algebraically: USDGBPUSDCHF=USDGBPCHFUSD=CHFGBP
Or simply note that it must be more than 1 CHF for a GBP, and not vice versa.

2.Triangular Arbitrage

Triangular arbitrage takes advantage of mispriced cross-rates. For example, if you open your
terminal and see the following quotes:
USD 1.2/EUR
USD 1.5/GBP
EUR 1.3/GBP
Is there an arbitrage opportunity?

Triangular Arbitrage
Let’s check. The cross-rate implied by the USD/EUR and USD/GBP quotes is EUR
1.25/GBP. However, the quote on our terminal is EUR 1.3/GBP, so yes, there is an arbitrage.

We’ll replicate buying the cross rate at EUR 1.25/GBP by trading through the USD/EUR and
USD/GBP. We’ll also sell GBP for the quoted rate of EUR 1.3/GBP. Doing so correctly will
earn us EUR 0.05.

Triangular Arbitrage
Starting in USD, we first have to decide if we buy EUR or GBP. The key is to note that at
EUR 1.3/GBP we are given too many EUR for 1 GBP. So we want to sell GBP for EUR here.

This tells us we want to go from USD to GBP, then from GBP to EUR, and finally back to
USD. The arbitrage gets its name from the triangular route which we are taking through
currencies.

Triangular Arbitrage
So starting with USD 1.5, we convert it into GBP 1.
We then take the GBP 1 and convert it into EUR 1.3.
Finally we cover the EUR 1.3 into EUR 1.3 * USD 1.2/EUR = USD 1.56.
We return the USD 1.5, and are left with a profit of USD 0.06. Note, USD 0.06 converts into
a profit of EUR 0.05 (0.06/1.2). This matches the profit we expected from the beginning: the
difference in the cross rates.

3.Covered Interest Arbitrage

Given spot FX rates and interest rates, covered interest arbitrage will tell us what the
forward/futures rate must be.

Covered interest arbitrage exploits interest rate differentials using forward/futures contracts to
mitigate FX risk.

It ensures that you get a reasonable futures price for currency if you are trading in a liquid
market.

A Simple Example
Say both the spot and one-year forward rate of the GBP is USD 1.5/GBP. Let the one-year
interest rate in the US and UK be 2% and 5% respectively.

An arbitrage exists. Borrow USD 1.5 at 2% and convert it into GBP 1 and lend it at 4%. Also
enter into a forward to sell GBP 1.04 one year forward at USD 1.5/GBP.

At the end of 1 year, you receive your GBP 1.04, convert it to USD 1.56, and repay the USD
1.53 you owe from your loan, leaving you with a USD 0.03 arbitrage profit.

THE BRETTON WOODS AGREEMENT

The Bretton Woods agreement of 1944 established a new global monetary system. It replaced
the gold standard with the U.S. dollar as the global currency. By so doing, it established
America as the dominant power in the world economy. After the agreement was signed,
America was the only country with the ability to print dollars.1 

The agreement created the World Bank and the International Monetary Fund (IMF).

These U.S.-backed organizations would monitor the new system.

The Bretton Woods Agreement

The Bretton Woods agreement was created in a 1944 conference of all of the World War II
Allied nations. It took place in Bretton Woods, New Hampshire.

Under the agreement, countries promised that their central banks would maintain fixed

exchange rates between their currencies and the dollar.How exactly would they do this? If a
country's currency value became too weak relative to the dollar, the bank would buy up its
currency in foreign exchange markets.

Purchasing currency would lower the supply of the currency and raise its price. If a currency's
price became too high, the central bank would print more. This would increase the supply and
lower the currency's price. This is a monetary policy often used by central banks to control
inflation.

Members of the Bretton Woods system agreed to avoid trade wars.For example, they wouldn't
lower their currencies strictly to increase trade. But they could regulate their currencies under
certain conditions. For example, they could take action if foreign direct investment began to
destabilize their economies. They could also adjust their currency values to rebuild after a
war.

How It Replaced the Gold Standard

Before Bretton Woods, most countries followed the gold standard. That meant each country
guaranteed that it would redeem its currency for its value in gold. After Bretton Woods, each
member agreed to redeem its currency for U.S. dollars, not gold.

Why dollars? The United States held three-fourths of the world's supply of gold. No other
currency had enough gold to back it as a replacement. The dollar's value was 1/35 of an ounce
of gold. Bretton Woods allowed the world to slowly transition from a gold standard to a U.S.
dollar standard.

The dollar had now become a substitute for gold. As a result, the value of the dollar began to
increase relative to other currencies.

This created more demand for dollars, even though its worth in gold remained the same. This
discrepancy in value planted the seed for the collapse of the Bretton Woods system three
decades later.

Why It Was Needed

Until World War I, most countries were on the gold standard. However, they cut the tie to
gold so they could print the currency needed to pay for their war costs. This
caused hyperinflation, as the supply of money overwhelmed the demand. After the war,
countries returned to the safety of the gold standard.5

Hyperinflation caused the value of money to fall so dramatically that, in some cases, people
needed wheelbarrows full of cash just to buy a loaf of bread.

All went well until the Great Depression. After the 1929 stock market crash, investors
switched to commodities trading. It drove up the price of gold, resulting in people redeeming
their dollars for gold.7 The Federal Reserve made things worse by defending the nation's gold
reserve by raising interest rates.

The Bretton Woods system gave nations more flexibility than strict adherence to the gold
standard. It also provided less volatility than a currency system with no standard at all. A
member country still retained the ability to alter its currency's value, if needed, to correct a
"fundamental disequilibrium" in its current account balance.

Role of the IMF and World Bank

The Bretton Woods system could not have worked without the IMF.9 Member countries
needed it to bail them out if their currency values got too low. They'd need a kind of global
central bank they could borrow from in case they needed to adjust their currency's value and
didn't have the funds themselves. Otherwise, they would just slap on trade barriers or raise
interest rates.

The Bretton Woods countries decided against giving the IMF the power of a global central
bank. Instead, they agreed to contribute to a fixed pool of national currencies and gold to be
held by the IMF. Each member country of the Bretton Woods system was then entitled to
borrow what it needed, within the limits of its contributions. The IMF was also responsible
for enforcing the Bretton Woods agreement.

The IMF was not designed to print money and influence economies with monetary policies.

The World Bank, despite its name, was not (and isn't) the world's central bank. At the time of
the Bretton Woods agreement, the World Bank was set up to lend to the European countries
devastated by World War II. The purpose of the World Bank changed to one of loaning
money to economic development projects in emerging market countries.

The Collapse of the Bretton Woods System

In 1971, the United States was suffering from massive stagflation.Stagflation is a combination

of inflation and recession, which causes unemployment and low economic growth.

In response to a dangerous dip in value caused by too much currency in circulation,  President
Nixon started to deflate the dollar's value in gold. Nixon revalued the dollar to 1/38 of an
ounce of gold, then 1/42 of an ounce.

The devaluation plan backfired. It created a run on the U.S. gold reserves at  Fort Knox as
people redeemed their quickly devaluing dollars for gold. In 1971, Nixon unhooked the value
of the dollar from gold altogether. Without price controls, gold quickly shot up to $120 per
ounce in the free market, ending the Bretton Woods system.

The creation of Bretton Woods resulted in countries pegging their currencies to the U.S.
dollar. In turn, the dollar was pegged to the price of gold, and the U.S. became dominant in
the world economy. The U.S. was the only nation that could print the globally accepted
currency, and countries had more flexibility than they did with the old gold standard.

When the dollar ceased to be pegged to the price of gold, it became the monetary standard
with other currencies pegging their currencies to it.

Solved Problems

1.From the following Original exchange rate find out the Reciprocal rate

(a) €1 = US$0.8420

(b) £1 = US$1.4565

(c) NZ$1 = US$0.4250

Solution

US$1 = €(1/0.8420)= € 1.1876

US$1 = £(1/1.4565)=£0.6866

US$1 = NZ$(1/0.4250)=NZ$ 2.3529

2.Given that
US$1 = ¥123.25
£1 = US$1.4560
A$ = US$0.5420
Calculate the cross rate for pounds in yen terms.
Calculate the cross rate for Australian dollars in yen terms.
Calculate the cross rate for pounds in Australian dollar terms.
Solution

£1 = US$1.4560

1US $= ¥123.25

So, £1=¥ (1.4560*123.25)= ¥179.452

A$=US$0.5420

1US $= ¥123.25

A$=¥(123.25*0.5420)=¥66.801

£1 = US$1.4560

A$ = US$0.5420

or , 1 US$=A$ (1/0.5420)

£1 = A$(1.4560)*(1/0.5420)=A$28
3. Calculate the realized profit or loss as an amount in dollars when C8,540,000 are purchased
at a rate of C1 = $1.4870 and sold at a rate of C1 = $1.4675.

Solution

Purchase =>C1 = $1.4870

Sale Price => C1 = $1.4675

Total Dollars Purchased=$8540000*1.4870=$12698980 (X) 12698980

Total Dollars Sales=$8540000*1.4675=$12532450 (Y) 12532450

Gain in dollar terms=X-Y 166530

(b) Calculate the unrealized profit or loss as an amount in pesos on P17,283,945 purchased at
a rate of Rial 1 = P0.5080 and that could now be sold at a rate of R1 = P0.5072.

Quanity of Rials used to purchase= 17283945/0.5080 (X) 34023513.78

Quanity of Rials received when sold= 17283945/0.5072 (Y) 34077178.63

Gain in Rials (Y-X) 53664.85

The above Rial gain can be converted into Peso

Gain in Peso=0.5072*53664.85 27218.81

4. Calculate the profit or loss when C$9,360,000 are purchased at a rate of C$1 = US$1.4510
and sold at a rate of C$1 = US$1.4620.

Solution

Total US $ used to purchase C$9360000=9360000*1.4510 (X) 13581360

Now when C$ are sold , $ received=9360000*1.4620 (Y) 13684320

So gain in $ =Y-X 102960

5. Calculate the unrealized profit or loss on Philippine pesos 20,000,000 which were
purchased at a rate of US$1 = PHP47.2000 and could now be sold at a rate of US$1 =
PHP50.6000.

Solution

US $ used for purchase of Peso=20000000/47.20 (X) 423728.81

Now, the Peso can be converted into $ or Dollar can be
395256.92
repurchased=20000000/(50.60) (Y)

Loss in $ =Y-X -28471.90

6.Two banks are quoting the following US$ rates:

Bank A : 46.7510 – 7630
Bank B : 46.7680 – 7770
Find out the arbitrage opportunities.
(Ans.: He would make profit of $ 107)
Solution

Bank A

Buying Dollar 46.751

Selling Dollar 46.763

Bank B

Buying Dollar 46.768

Selling Dollar 46.777

Let the investor invests $1000000

He buys Rupee from Bank-B =1000000*46.768 46768000.00

Now he sells the Rupee to Bank-A to get $=46768000/46.763 1000106.922

Net Gain=1000106.922-1000000 106.92

7.Two banks are quoting the following US$ rates:

Bank A : USD INR 39.20 / 39.30
Bank B : USD INR 39.40 / 39.50
Find out the arbitrage opportunities.
(Ans.: 2,545 on Investment of 1 million )

Solution

Bank A

Buying Dollar 39.2

Selling Dollar 39.3

Bank B
Buying Dollar 39.4

Selling Dollar 39.5

Let the investor invests $1000000

He buys Rupee from Bank-B =1000000*39.4 (X) 39400000.00

Now he sells the Rupee to Bank-A to get $=X/39.3 1002544.53

Gain=1002544.53-1000000 2544.53

8.Two banks are quoting the following US$ rates:

Bank A : 46.7510 – 7670
Bank B : 46.7650 – 7770
Find out the arbitrage opportunities.
(Ans.: There is no arbitrage opportunity)

Solution

Bank A

Buying Dollar 46.751

Selling Dollar 46.767

Bank B

Buying Dollar 46.765

Selling Dollar 46.777

Let the investor invests $1000000

He buys Rupee from Bank-A =1000000*46.751 (X) 46751000.00

Now he sells the Rupee to Bank-B to get $=X/46.777 999444.17

So there is no gain in this option

He buys Rupee from Bank-B =1000000*46.765 (Y) 46765000

Now he sells the Rupee to Bank-A to get $=Y/46.767 999957.23

So there is no gain in this option

9.Consider following spot quotations:

 USD CHF 1.4950/1.4965 Zurich Bank
CHF USD 0.6690 / 0.6700 Bank of New York
Are there any arbitrage-gains possible?
(Gain : 155 SFr)
Solution

Zurich Bank

Buying Dollar 1.495

Selling Dollar 1.4965

New York Bank

Buying CHF 0.669

Selling CHF 0.67

Let the investor puts in CHF 1000000

He converts CHF to Dollar at New York Bank=1000000*0.669(X) 669000

He then converts that Dollars to CHF at Zurick Bank=X*1.4965 1000155

Gain=(1000155-1000000) CHF 155

10.Two banks are quoting the following Euro rates:

Bank A : 47.98 – 48.53
Bank B : 48.64 – 48.83
Find out the arbitrage opportunities. Calculate gains using 1 million.
(Ans.: Possible gains are 2267 Rupees through arbitrage)

Solution

Bank A

Buying Euro (Euro/Rupee) 47.98

Selling Euro (Euro/Rupee) 48.53

Bank B

Buying Euro (Euro/Rupee) 48.64

Selling Euro (Euro/Rupee) 48.83

The investor invests 100000 Rupees. So he will buy Euro

Euro received=1000000/48.53 20605.81

Investor will sell Euro qat Bank B

Rupee Received=20605.81*48.64 1002266.60

Gain=1002266.60-1000000 2266.6

11.Consider following spot quotations:

1.4960/1.4975 SFr per US$ Zurich Bank
0.6685/0.6690 US$ per SFr Bank of New York

If there any arbitrage-gains possible, calculate it for USD 1 million.

(Ans.: Thus gain of 76 US $)

Solution

Zurich Bank

$/SFr (Bid) Buying $ 1.496

$/SFr(Ask) Selling $ 1.4975

Bank of New York

SFr to $

SFr/$(Bid) Buying SFr 0.6685

SFr/$(Ask) Selling SFr 0.669

The investor will first convert $1000000 at Zurich Bank to get SFr

So the SFr that he will get=$1000000*1.4960 1496000

The investor will then convert the SFr to $ at Bank of New

1000076
York=1496000*0.6685

Net Gain=$1000076-$1000000=$76

12.From following 3 quotes, examine if any arbitrage gains are possible and if yes, calculate
the same for USD 1 million.

0.5591 UK Pound per USD

1.4521 Euro per UK Pound
0.8128 Euro per USD
 (Ans.: 1,147 $)

Solution

We will start from Euro/Dollar

1 Dollar=0.8128 Euro

1000000 Dollar=0.8128*1000000 =812800 Euro

Now we will convert the Euro to UK Pound

1.4521 Euro=1 UK Pound

1 Euro=(1/1.4521) UK Pound

812800 Euro=812800*(1/1.4521)=559741.06 UK Pound

Now we will convert UK Pound to Dollar

0.5591 UK Pound= 1 Dollar

1 UK Pound=(1/0.5591) Dollar

559741.06 Pound=(1/0.5591)*559741.06=1001146.60 Dollar

Gain =1001146.60Dollar-1000000 Dollar=1146.60 Dollar

13.Following rates are quoted by 3 different dealers:

0.6405 UK£ per US$ Dealer A
2.8606 AU$ per UK£ Dealer B
1.8402 AU$ per US$ Dealer C
Are there any arbitrage-gains possible? Consider investment of $100000
(Ans.: Thus there is a net gain of 436 US$)

Solution

Let the investor invests $1000000

=1.8402 * 1000000 AU $ 1840200

=(1/2.8606)*1840200 UK Pound 643291.62

=(1/0.6405)*643291.62 $ 1004358.50
Net gain=(1004358.50-1000000) $ 4358.50

14. JPY GBP 0.0052

GBP CHF 2.2832
JPY CHF 0.0130
(Ans.: Yen 94,954)

Solution

Let there is an investment of 1000000 JPY

=0.0130*1000000 CHF 13000

=(1/2.2832)*13000 GBP 5693.76

=(1/0.0052)*5693.76 JPY 1094953.85

Gain=1094953.85-1000000 JPY 94953.85

  15.From following 3 quotes, examine if any arbitrage gains are possible and if yes, calculate
the same for SGD 1 million.

64.85         JPY per SGD

0.0113       CHF per JPY

0.7345       CHF per SGD

(Ans.: SGD 2,313/1 million SGD)

Solution

Investment made is 1000000 SDG

=0.7345*1000000 CHF 734500

=(1/0.0113)*734500 JPY 65000000

=(1/64.85)*65000000 SDG 1002313

Profit=1002313-1000000 2313

 16.Following rates are quoted:

55.5000 = 1 Pound in London

45.625 = 1 US$ in Delhi

$ 1.2182 = 1 Pound in New York

Are Arbitrage gains possible?

(Ans.: Yes. 1,448 Gain)

Solution

Let the investment is 1000000 Pound

=1.2182*1000000 Dollar 1218200

=(1218200*45.625) Rupees 55580375.00

=(1/55.5)*55580375.00 Pound 1001448.20

Gain=(1001448-1000000) Pound 1448

17.Consider the following: Spot Rate: $ 0.65/DM German 1-yr interest rate: 9% US 1-yr
interest rate: 5%

a. Calculate the theoretical price of a one year futures contract.

b. What would you do if the futures price was quoted at $0.65/DM in the market place?
Where would you borrow? Lend? Calculate the gain on a $100 million arbitrage transaction.

c. What would you do if the future price was quoted at $ 0.60/DM in the market place? Where
would you borrow? Lend? Calculate the gain on a $100 million arbitrage transaction.

Solution

a. F = S*(1 + r$) / (1 + rFC) = .65*(1.05)/1.09 = $.626/DM

b. b. Borrow $ at 5%; Exchange into DM at spot rate; Invest in DM at 9%; Sell forward at
$.65/DM. Earn interest differential on nominal amount with no loss or gain on currency. Gain
= $100,000,000 * (.09 - .05) = $4,000,000.

c. c. Borrow DM at 9%; Exchange into $ at spot rate; Invest in the US at 5%; Buy forward at
$.60/DM. Gain on currency more than offsets negative interest rate differential. Gain =
100,000,000 * (.05 - .09) + 100,000,000 * (1/0.60 - 1/0.65) = $882,051

FERA & FEMA

FERA

Foreign Exchange Regulation Act, shortly known as FERA, was introduced in the year 1973.
The act came into force, to regulate foreign payments, securities, currency import and export
and purchase of fixed assets by foreigners. The act was promulgated in India when the
position of foreign reserves wasn’t satisfactory. It aimed at conserving foreign exchange and
its optimum utilisation in the development of the economy.

The act applies to the whole country. Therefore, all the citizens of the country, inside or
outside India are covered under this act. The act extends to branches and agencies of the
Indian multinationals operating outside the country, which is owned or controlled by the
person who is the resident of India.
FEMA

FEMA expands to Foreign Exchange Management Act, which was promulgated in the year
1999, to repeal and replace the earlier act. The act applies to the whole country and to all the
branches and agencies of the body corporate operating outside India, whose owner or
controller is an Indian resident and also any violation committed by the person covered under
the Act, outside India.

The main objective of the act is to facilitate foreign trade and to encourage systematic
development and maintenance of forex market in the country. There are total seven chapters
contained in the act which are divided into 49 sections, out of which 12 sections deal with the
operational part while the remaining 37 sections cover penalties, contravention, appeals,
adjudication and so on.

Key Differences Between FERA and FEMA

The primary differences between FERA and FEMA are explained in the following points:

FERA is an act which is enacted to regulate payments and foreign exchange in India . FEMA
an act initiated to facilitate external trade and payments and to promote orderly management
of the forex market in the country.

FEMA came out as an extension of the earlier foreign exchange act FERA.

FERA is lengthier than FEMA, regarding sections.

FERA came into force when the foreign exchange reserve position in the country wasn’t good
while at the time of introduction of FEMA, the forex reserve position was satisfactory.

The approach of FERA, towards forex transaction, is quite conservative and restrictive, but in
the case of FEMA, the approach is flexible.

Violation of FERA is a non-compoundable offence in the eyes of law. In contrast violation of

FEMA is a compoundable offence and the charges can be removed.

Citizenship of a person is the basis for determining residential status of a person in FERA,
whereas in FEMA the person’s stay in India should not be less than six months.

Contravening the provision of FERA may result in imprisonment. Conversely, the

punishment for violating the provisions of FEMA is a monetary penalty, which may turn into
imprisonment if the fine is not paid on time.