Copyright © 2009 Pearson Prentice Hall. All rights reserved. Chapter 1 Currency Exchange Rates

Copyright © 2009 Pearson Prentice Hall. All rights reserved 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.

Copyright © 2009 Pearson Prentice Hall. All rights reserved 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.

Copyright © 2009 Pearson Prentice Hall. All rights reserved 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.

Copyright © 2009 Pearson Prentice Hall. All rights reserved 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.

Copyright © 2009 Pearson Prentice Hall. All rights reserved 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.

Copyright © 2009 Pearson Prentice Hall. All rights reserved Example: Direct and Indirect Exchange Rates  On July 1, the British pound (£) is quoted as £:$ =  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 £:$ = Which currencies appreciated or depreciated?

Copyright © 2009 Pearson Prentice Hall. All rights reserved 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.

Copyright © 2009 Pearson Prentice Hall. All rights reserved Currency Movements and Exchange Rate Quotations

Copyright © 2009 Pearson Prentice Hall. All rights reserved 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  $:¥ = 120  Calculate the euro in yen (€:¥) rate:  (€:$)  ($:¥) = 1.25  120 = 150  The resulting quotation is: €:¥ = 150. One euro is worth 150 yen.

Copyright © 2009 Pearson Prentice Hall. All rights reserved Cross Rate Calculations – Example 2  For example, bank B gives the following quotations for the Korean won and the Brazilian real:  $: won =  $: R$ =  Calculate the R$:won rate:  ($:won) ÷ ($:R$) = /2.297 =  The resulting quotation is: R$:won = One Brazilian Real is worth won.

Copyright © 2009 Pearson Prentice Hall. All rights reserved 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.

Copyright © 2009 Pearson Prentice Hall. All rights reserved 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 and the EUR:USD as  Market makers quote both a bid and an ask price, and there is no additional fee or commission.

Copyright © 2009 Pearson Prentice Hall. All rights reserved 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

Copyright © 2009 Pearson Prentice Hall. All rights reserved Bid-Ask Quotes - Example  Consider the following currency quote in the United States: €:$ = –  The bid price is €:$=  The ask price is €:$=  The midpoint price is €:$=1.2013

Copyright © 2009 Pearson Prentice Hall. All rights reserved 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).

Copyright © 2009 Pearson Prentice Hall. All rights reserved 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 €:$ = – is equivalent to a $:€ quote of: $:€ = –

Copyright © 2009 Pearson Prentice Hall. All rights reserved 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.

Copyright © 2009 Pearson Prentice Hall. All rights reserved Arbitrage Example  Consider the following three banks each providing a $:€ quote : Bank ABank BBank C Does an arbitrage opportunity exist? One could buy dollars from Bank B for € 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.

Copyright © 2009 Pearson Prentice Hall. All rights reserved Triangular Arbitrage  Example 1.4

Copyright © 2009 Pearson Prentice Hall. All rights reserved 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.

Copyright © 2009 Pearson Prentice Hall. All rights reserved 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:

Copyright © 2009 Pearson Prentice Hall. All rights reserved Forward Premiums/Discounts - Example  If the 1 month forward exchange rate is €:$ = and the spot rate is €:$ = , calculate the forward premium/discount.  Solution:  € is weak relative to $.

Copyright © 2009 Pearson Prentice Hall. All rights reserved 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,

Copyright © 2009 Pearson Prentice Hall. All rights reserved Interest Rate Parity Example  Example p16~p17  Example 1.5  Example 1.6