1 (of 24) IBUS 302: International Finance Topic 5-The Market for Foreign Exchange II Lawrence Schrenk, Instructor

2 (of 24) Learning Objectives 1. Determine if triangular arbitrage exists and find the arbitrage profit. ▪ 2. Explain the forward rate. 3. Calculate forward cross-exchange rates. 4. Calculate the forward premium/discount.▪

3 (of 24) Triangular Arbitrage

4 (of 24) Arbitrage 1. Guaranteed Profit 2. No Cost (self-financing trading strategy) 3. No Risk Example: IBM $100 in New York and $102 in Chicago. ▪ How do you take advantage of the opportunity? What is the arbitrage profit? Law of One Price ▪

‘Arbitrage’ Types Pure Arbitrage: No risk nothing and earn more than the riskless rate Near Arbitrage: Assets are identical or almost, but there is no guarantee of profit Speculative Arbitrage: Investors take advantage of what they see as mispriced and similar (though not identical) assets 5 (of 24)

6 (of 24) Triangular Arbitrage Convert money through three currencies $ → £→ € → $ Arbitrage opportunity if the ending dollar value does not equal the beginning dollar value. £€ $ ≠ $

7 (of 24) Case 1 $1 → £0.52 → €1.33 → $1.10GAIN $0.10 Triangular Arbitrage: Example £0.52€1.33 $1 ≠ $1.10

8 (of 24) Case 2 (using different FX rates) $1 → £0.49 → €1.20 → $0.90LOSS ($0.10) ▪ If you get a loss of ($0.10), just go the opposite direction beginning with $0.90 and you will gain $0.10. ▪ Triangular Arbitrage: Example £0.49€1.20 $1.00 ≠ $0.90

9 (of 24) Finding Triangular Arbitrage Is there an arbitrage opportunity? $ → € → C$ → $ ▪ $ → € : $1.00 x = € € → C$: € x = C$ C$ → $: C$ x = $ Arbitrage Profit of $ $1.00 x x x = $ ▪

10 (of 22) The Forward Market

11 (of 22) The Forward Market Buying and selling ‘forward’, i.e., into the future. Transfer purchasing power across currencies and across time Market expectations Forward markets are insurance markets for hedging or eliminating currency risk. Online Data: OZForexOZForex

12 (of 22) Terminology Forward Rate: The exchange rate to trade sometime in the future. Forward Contract: A customized contract settled today for future delivery/receipt of FX. Futures Contract: A standardized contract settled today for future delivery/receipt of FX.

13 (of 22) NOTE: Quotation in American Terms SourceSource Forward Rates (9/11/2008)

14 (of 22) Forward Rates (9/11/2008)

15 (of 22) Bid-Ask Spread (9/11/2008)

16 (of 22) Forward Rate Features Common Maturities 1, 3, 6, 9 and 12 months Perspectives Direct versus Indirect American versus European Limited to Major Currencies

17 (of 22) Forward Rate Notation Notation F N (j/k) number of j needed to buy 1 k in N months Difference from Spot Rate Notations ‘F’ not ‘S’ N because you always need to specify the time of a forward rate NOTE: S(j/k) = F 0 (j/k)

18 (of 22) Premium versus Discount Premium: A currency is trading at a premium when (in American terms) the forward rate is increasing. Market Expectation: The currency will appreciate and the US dollar will depreciate. Discount: A currency is trading at a discount when (in American terms) the forward rate is decreasing. Market Expectation: The currency will depreciate and US dollar will appreciate.

19 (of 22) Example: Trading at a Discount Pound is trading at a discount to the dollar Market expects dollar to appreciate with respect to the pound

20 (of 22) Market Expectations Psychology–The ‘Black Box’ Forward Rates are only market expectations (unless you lock them in with a contract). All prices, rates, etc. are based on the current ‘information set’. New information (‘News’)

21 (of 22) Long versus Short Positions LongShort Buy StockShort Sell Stock Buy a Forward ContractSell a Forward Contract Buy an OptionSell an Option Buy a BondSell a Bond LendBorrow

22 (of 22) Speculation versus Hedging Speculation: Taking a position that increases the risk of your portfolio. Hedging: Taking a position that decreases the risk of your portfolio. In practice, the distinction can be blurred.

23 (of 22) Forward Cross-Exchange Rates Same as spot cross-exchange rates. Find F 2 (¥/€)–How many yen for a euro in two months? If F 2 ($/€) = and F 2 ($/¥) = Notes: Both are in American terms. The first currency ( ¥) goes into the denominator (bottom) The second currency ( €) goes into the numerator (top)

24 (of 22) Swaps versus Forward Transactions Forward Transaction Sale of currency in the future Uncovered Swap Transaction Sale (purchase) now and forward purchase (sale) in the future Hedged More on swaps later.

25 (of 22) Forward Premium/Discount Premium or discount (f) as an annualized percentage change from the spot rate. Notation f N,j is the forward premium at N of currency j in American terms. f N,$ is the forward premium at N of US dollars in European terms. Essentially, this gives you, in percentage terms, how much the forward rate is expected to moves from the spot annually.

Holding Period Return 26 (of 22) Premium Formula Annualizing Factor ▪ NOTE: N is the normally the number of months, and needs to be converted into days for this calculation.

S($/£)= F 1 ($/£)= (of 22) Example: Premium Calculation