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Chapter 1

Chapter 1. Currency Exchange Rates. Currency Abbreviations. Abbreviations are used to refer to the various currencies. These abbreviations could be commonly used symbols or “official” three-letter codes.

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Chapter 1

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  1. Chapter 1 Currency Exchange Rates

  2. Currency Abbreviations • Abbreviations are used to refer to the various currencies. These abbreviations could be commonly used symbols or “official” three-letter codes. • Financial newspapers such as the Financial Times generally use symbols, while traders use three-letter codes. Symbols include $ (U.S. dollar), ¥ ( Japanese yen), € (euro), £ (British pound), A$ (Australian dollar), and Sfr (Swiss franc). • Three-letter codes for the same currencies are USD, JPY, EUR, GBP, AUD, and CHF. • We will alternatively use in this book (as done in the real world) the various currency abbreviations that are commonly encountered. For example, the Japanese yen can be referred to as ¥, JPY, or yen.

  3. Currency Exchange Rate Quotations • A currency exchange rate is the rate used to exchange two currencies. An exchange rate states the price of one currency in terms of units of another currency. • Examples: $:€, €:$, ¥:$ • Note: the notation in this new edition of the text has changed relative to previous editions.

  4. Quote Convention used in this text • All quotes in this text will be presented as a:b = S • where a is the quoted currency • b is the currency in which the price is expressed • S is the price of the quoted currency a in units of currency b • For example, $:¥ = 120 means the U.S. dollar is quoted at 120 Japanese yen (¥) per dollar. Or the U.S. dollar is priced at 120 yen.

  5. Direct Exchange Quotes • A direct exchange rate is the domestic price of foreign currency. • For example, an American investor seeing a direct quote €:$ = 1.25 knows she will pay $1.25 for one euro. • To a European investor, the direct quote is $:€ = 0.8 which says that 1 dollar (foreign currency) is worth 0.8 euro. • An appreciation of the foreign currency causes an increase in the direct quote.

  6. Indirect Foreign Exchange Quotations • An indirect exchange rate is the amount of foreign currency that one unit of domestic currency will purchase. • For an American investor, the indirect quote $:€ = 0.8 says that 1 dollar will purchase 0.8 euro. • Direct quotes and indirect quotes are reciprocals of each other. • An appreciation of the foreign currency causes a decrease in the indirect quote.

  7. Example: Direct and Indirect Exchange Rates • On July 1, the British pound (£) is quoted as £:$ = 1.80. • Is this a direct or indirect quote from the viewpoint of an American and a British investor? • A month later, the exchange rate moved to £:$ = 1.90. Which currencies appreciated or depreciated?

  8. Example: Direct and Indirect Exchange Rates - Continued • Answer: The pound is quoted in terms of dollars. This quote is a direct quote from the American viewpoint and an indirect quote from the British viewpoint. • The pound is the quoted currency. Over a month, the pound’s price increased from $1.80 to $1.90, so the pound appreciated and the dollar depreciated.

  9. Currency Movements and Exchange Rate Quotations

  10. Cross Rate Calculations • A cross rate is the exchange rate between two countries inferred from each country’s exchange rate with a third country. • For example, bank A gives the following quotations: • €:$ = 1.25 • $:¥ = 120 • Calculate the euroinyen (€:¥) rate: • (€:$)  ($:¥) = 1.25  120 = 150 • The resulting quotation is: €:¥ = 150. One euro is worth 150 yen.

  11. Cross Rate Calculations – Example 2 • For example, bank B gives the following quotations for the Korean won and the Brazilian real: • $: won = 1012.5 • $: R$ = 2.297 • Calculate the R$:won rate: • ($:won) ÷ ($:R$) = 1012.5/2.297 = 440.79 • The resulting quotation is: R$:won = 440.79. One Brazilian Real is worth 440.79 won.

  12. Foreign Exchange Market • The international currency market has two main components: • A worldwide Forex market between major banks and specialized currency dealers. This is a wholesale interbank market for large transactions. It is an OTC market, by telephone and electronic trading platforms, where trading takes place 24 hours a day, 5 days a week. It is the largest and most liquid financial market in the world. • A retail market where investors and corporations deal with local banks.

  13. Forex Market Conventions • In the Forex market, quotations on trading screens are generally given with five significant digits and three-letter codes. For example, the USD:JPY quote could appear as 120.10 and the EUR:USD as 1.2515. • Market makers quote both a bid and an ask price, and there is no additional fee or commission.

  14. Bid-Ask Quotes • Bid price: the exchange rate at which the dealer is willing to buy the quoted currency in exchange for the second currency. • Ask (offer) price: the exchange rate at which the dealer is willing to sell the quoted currency in exchange for the second currency. • The difference between the bid and ask price is called the spread. • Midpoint price = (ask + bid)/2

  15. Bid-Ask Quotes - Example • Consider the following currency quote in the United States: €:$ = 1.2011 – 1.2014 • The bid price is €:$=1.2011 • The ask price is €:$=1.2014 • The midpoint price is €:$=1.2013

  16. Bid-Ask Spread • Difference between bid and ask price. • Size of bid-ask spread increases with exchange rate uncertainty (volatility) and lack of liquidity because of the bank/dealer risk aversion. • Spreads are larger for currencies that have a low trading volume (thinly traded currencies).

  17. Two Principles for bid and ask rates • The a:b ask exchange rate is the reciprocal of the b:a bid exchange rate. • The a:b bid exchange rate is the reciprocal of the b:a ask exchange rate. • Example: the €:$ quote of €:$ = 1.2011 – 1.2014 is equivalent to a $:€ quote of: $:€ = 0.83236 – 0.83257

  18. Arbitrage • Arbitrage involves the simultaneous purchase of an undervalued asset or portfolio and sale of an overvalued but equivalent asset or portfolio, in order to obtain a risk free profit on the price differential. • An arbitrage could be created if it were profitable to buy from one bank and sell to another bank. • When describing arbitrage, we are usually discussing a riskless transaction that does not require any invested capital.

  19. Arbitrage Example • Consider the following three banks each providing a $:€ quote : Bank A Bank B Bank C 0.80000-20 0.79985-95 0.79995-15 Does an arbitrage opportunity exist? One could buy dollars from Bank B for € 0.79995 per dollar and simultaneously sell them to Bank A for € 0.8 per dollar. A small gain, but it is riskless and does not require any invested capital.

  20. Triangular Arbitrage • Example 1.4

  21. Forward Rates • Spot rates are quoted for immediate currency transactions (although in practice delivery takes place 48 hours later). • Forward exchange rates are contracted today but with delivery and settlement in the future.

  22. Forward Premiums/Discounts • Forward exchange rates are often quoted as a premium, or discount, to the spot exchange rate. • Given an exchange rate of a:b, the annualized forward premium on the quoted currency a equals:

  23. Forward Premiums/Discounts - Example • If the 1 month forward exchange rate is €:$ = 1.24688 and the spot rate is €:$ = 1.2500, calculate the forward premium/discount. • Solution: • € is weak relative to $.

  24. Interest Rate Parity • For two currencies, A and B, with the exchange rate quoted as the number of units of B for one unit of A,

  25. Interest Rate Parity Example • Example p16~p17 • Example 1.5 • Example 1.6

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