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CHAPTER 07

CHAPTER 07. Foreign Exchange Markets. Foreign Exchange Market. What is the foreign exchange market? Who are the major participants?. Foreign Exchange Market. Characteristics of the foreign exchange market Large number of diverse buyers and sellers (breadth)

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CHAPTER 07

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  1. CHAPTER 07 Foreign Exchange Markets

  2. Foreign Exchange Market • What is the foreign exchange market? • Who are the major participants?

  3. Foreign Exchange Market • Characteristics of the foreign exchange market • Large number of diverse buyers and sellers (breadth) • Significant market activity (buy/sell) with any change in value (depth) • Worldwide trading

  4. Foreign Exchange Market • What is the exchange rate? • An exchange rate is the price of a unit of one currency in terms of another. • How are exchange rates determined? • By supply and demand for the most part (governments also play a role)

  5. Foreign Exchange Market

  6. Foreign Exchange Market • An exchange rate is either a spot rate or a forward rate • Spot rate (S): • Forward rate (F):

  7. Foreign Exchange Market • How are exchange rates quoted? There are two types of quotations: • Direct: • Indirect:

  8. International Arbitrage • We will look at three types of international arbitrage: • Locational arbitrage • Triangular arbitrage • Covered interest arbitrage

  9. Locational Arbitrage • What is locational arbitrage? • When is locational arbitrage possible? • Bid price: • Ask price: • Locational arbitrage is possible when:

  10. Locational Arbitrage • Example: • British pound quote: • Bank A Bank B • Bid price $1.61 per pound $1.63 per pound • Ask price $1.62 per pound $1.64 per pound • Profit on $1,000: • (1000/1.62)*1.63 = $1006.17 • So profit from locational arbitrage is $6.17

  11. Triangular Arbitrage • What is triangular arbitrage? • When is it possible? • What is a cross exchange rate:

  12. Triangular Arbitrage • How is the theoretical cross exchange rate calculated? • Value of Currency X in terms of US dollar • Value of Currency Y in terms of US dollar

  13. Triangular Arbitrage • Example: • 1 British pound = $1.60 • 1 Brazilian real= $0.20 • 1 pound = 8.10 reals • Theoretical cross rate: • 1.6/.20 = 8.00 reals per pound • Thus, triangular arbitrage is possible since the quoted rate (8.10) differs from the theoretical (8.00)

  14. Triangular Arbitrage • To capitalize on the price discrepancy (assuming you have $1,000): • 1. Buy overvalued • Overvalued currency: pound • 1,000/1.60 = $625 pounds • 2. Convert to undervalued • Undervalued currency: real • 625*8.10 = 5062.50 real

  15. Triangular Arbitrage • 3. Reconvert to home currency (dollar) • 5062.50*.20 = $1012.50 • Arbitrage profit = $12.50

  16. Covered Interest Arbitrage (CIA) • What is CIA? • To understand CIA we must understand: • Interest rate differentials: • Forward differentials: (F-S/S) * 360/n • where n is the number of days • When is CIA possible?

  17. Covered Interest Arbitrage • Example: • US investor with $1,000,000 • US interest rate = 6% • Mexican interest rate = 8% • Spot rate: 1 peso = $0.50 • 1 year forward rate: 1 peso =$0.55 • Is CIA possible? Let’s see….

  18. Covered Interest Arbitrage • Convert dollars to pesos: • $1,000,000/0.50 = 2,000,000 pesos • Invest at 8 percent for 1 year • 2,000,000* 1.08 = 2,160,000 pesos • Reconvert to dollars: • 2,160,000*0.55 = $1,188,000 • So, was CIA worthwhile?

  19. Government Intervention in Foreign Exchange Markets • Why do governments intervene? • To smooth exchange rates • To execute objectives of the central banks • To establish implicit boundaries

  20. Government Intervention in Foreign Exchange Markets • How do governments intervene: • Direct Intervention • Sterilized • Unsterilized

  21. Government Intervention in Foreign Exchange Markets • Indirect Intervention

  22. Summary • Basics of Foreign Exchange Market • Characteristics of the market • Major participants • Spot versus forward rates • Types of quotations • International Arbitrage • Government Intervention

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