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International Finance FINA 5331 Lecture 8: The market for foreign exchange, continued.

International Finance FINA 5331 Lecture 8: The market for foreign exchange, continued. Read: Chapters 5 Aaron Smallwood Ph.D. The Bid-Ask Spread. A dealer pricing pounds in terms of dollars would likely quote these prices as 02–08. Anyone trading $10m knows the “ big figure. ” … 1.59.

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International Finance FINA 5331 Lecture 8: The market for foreign exchange, continued.

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  1. International Finance FINA 5331 Lecture 8: The market for foreign exchange, continued. Read: Chapters 5 Aaron Smallwood Ph.D.

  2. The Bid-Ask Spread A dealer pricing pounds in terms of dollars would likely quote these prices as 02–08. Anyone trading $10m knows the “big figure.”… 1.59

  3. The Bid-Ask Spread • Notice that the reciprocal of the direct bid quote gives the ask price:

  4. Sample Problem • A businesswoman has just completed transactions in Italy and England. She is now holding €250,000 and £500,000 and wants to convert to RMB. • Her bank provides this quotation: GBP/RMB 0.10109 – 0.10112 RMB/EUR 8.2540 – 8.2588 Pounds: ? Euros: ? Total: ? • What are her proceeds from conversion?

  5. Proceeds • Pounds: We buy RMB in the market for RMB: • £500,000/0.10112=RMB 4,944,620.25 • Euros: We sell euros in the market for euros: • €250,000*8.2540 = RMB 2,063,500 • Total: RMB 7,008,120.25

  6. Spot FX Trading • In the interbank market, the standard size trade is about U.S. $10 million. • A bank trading room is a noisy, active place. • The stakes are high. • The “long term” is about 10 minutes.

  7. Cross rates with bid-ask spreads

  8. So? • What are the RMB/pound bid and ask prices? • Suppose a trader sells £10,000. How much do they receive? • The trader effectively sells pounds for RMB9.7559.

  9. What about selling yuan? • Suppose we sell RMB10,000 (buy pound). • We could figure the cross-currency rate, by asking: • - How much do we receive when we first buy dollars with RMB? • RMB10,000*0.1622 = $1,622 • - How much do we receive from selling dollar for pounds? • $1,622/1.5908 = £1,019.61. • Effectively RMB ask price for the pound: • 10,000/1,019.16= RMB 9.8076 • BID/ASK price: 9.7559 – 9.8076

  10. Concept of arbitrage • Suppose you are lucky enough to see two currency windows next to each other. At the first window you see the following quote for the euro: • RMB 8.2455 – 8.2498 • At the second window you observe the following: • RMB 8.2508 – 8.2555

  11. What? • Can easily profit: • Buy euros at the first bank for RMB8.2498. • Sell them at the second bank for RMB 8.2508. • Maybe not too realistic. Let’s consider triangular arbitrage: • Involves three markets. Let’s start with a simple example.

  12. Triangular Arbitrage $ Barclays S(¥/$)=100 Credit Lyonnais S($/£)=1.50 Credit Agricole S(¥/£)=125 ¥ £ Suppose we observe these banks posting these exchange rates. First calculate the implied cross rates to see if an arbitrage exists.

  13. Triangular Arbitrage $ Credit Lyonnais S($/£)=1.50 Credit Agricole S(¥/£)=125 ¥ £ The implied S(¥/£) cross rate is S(¥/£) = 150 Barclays S(¥/$)=100 Credit Agricole has posted a quote of S(¥/£)=125 so there is an arbitrage opportunity. So, how can we make money? Buy the £ @ ¥125; sell @ ¥150.

  14. Triangular Arbitrage Sell $100,000 for ¥ at S(¥/$) = 100 receive ¥10,000,000 • Sell ¥10,000,000 for £ at S(¥/£) = 125 receive £80,000 Sell £ 80,000 for $ at S($/£) = 1.50 receive $120,000 profit per round trip = $ 120,000- $100,000 = $20,000

  15. ¥ Tokyo S($/¥) =0.01002-0.01008 Budapest: S(¥/€) =126.8145-127.2045 Madrid S($/€)=1.29670-1.29675 $ € Review: Triangular Arbitrage Suppose we observe these banks posting these exchange rates. First calculate the implied cross rates to see if an arbitrage exists.

  16. Review: Triangular Arbitrage Sell $10,000,000 for ¥ at S($/ ¥) ask = $0.01008 receive ¥992,063,492.06 Sell our ¥992,063,492.06 for € at S(¥/ €) = ¥127.2045 receive €7,798,965.38 Sell €7,798,965.38 for $ at S($/€) =1.29670 receive $10,112,918.41 profit per round trip = $ 10,112.918.41- $10,000,000 = $112,918.41

  17. Triangular Arbitrage: One more • We want to consider another example with bid-ask spreads. • See example in the textbook, with the following quotes: • Market for pounds: $1.9712-17 • Market for euros: $1.4739-44 • Market for pounds: €1.3305-10 • Implied price in the third market is 1.3370-77. POUND UNDERVALED!

  18. Exploit the arbitrage opportunity • Suppose we start with $1,000,000 • First, we need to get euros so we can buy pounds in the 3rd market. • Start by selling dollars for euros: • We receive: $1,000,000/1.4744 = €678,242.00 • Sell euros for pounds: • We receive: €678,242.00/1.3310 = £509,573.25 • Finally, sell pounds for dollars • We receive: £509,573.25*1.9712 = $1,004,470.79 • PROFIT: $4,470.79.

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