1. 1 Quotation, Spot and Forward Markets

2. 2 Exchange Rate Quotes The exchange rate is the price of one currency in terms of another and can be quoted in two ways: Example: Lets assume that £1 is worth $1.90 Direct quote: is the number of home currency units per 1 unit of foreign currency – In the case of £UK - $USD: £0.5263/1$, which means that $1 is worth £0.5263 (or to buy $1 we need £0.5263). Indirect quote: is the number of foreign currency units that we buy with 1 unit of home currency – In the case of £UK - $USD: $1.90/£1, which means that £1 buys $1.90. The second quote is just the reciprocal of the first.

3. 3 Exchange Rate Quotes Direct and indirect quotes are equivalent and can both be used in exchange rate quotes. However, the rise or fall of the exchange rate of a currency against another have opposite effect on the value of the two quotes! Example: Lets assume that the ($1.90/£-spot rate) £ appreciates in value against the $. Therefore £1 is now worth $1.94 – The Indirect quote rate increases from $1.90 to $1.94/£1 With £1 now you can buy more $: i.e. $1.94 (against 1.90) for £1. – The Direct quote rate decreases from £0.5263 to £0.5155/1$ You now need less of the £ to buy $: i.e. £0.5155 (against 0.5263) to buy $1.

4. 4 Exchange Rate Quotes

5. 5 Previous Table lists only the mid-point quotes. In reality, there is a bid rate (at which the bank buys the currency) and an offer rate (ask rate or at which the bank sells the currency). The bid-offer spread is the profit margin of the bank. Example: If bid-offer rates for $ to £ are: $1.8275 – $1.8279: – Bid rate: $1.8275/£1 The bank gives you $1.8275 for £1, when it buys $ for £. – Offer rate: $1.8279/£1 The bank asks you $1.8279 for £1, when it sells you $ for £. – The spread of 4 bips (1 bip = 0.0001) is the profit of the bank.

6. 6 Exchange Rate Quotes Less heavily traded currencies, or the currencies having greater volatility, or unstable exchange rates have higher spreads, whereas currencies widely treaded or lower volatility or stable exchange rates have lower spreads. Transaction Costs for the buying bank: It is usually stated as a percentage cost of transaction in the foreign exchange market, which is computed as follows: Percent spread = Ask price – Bid price × 100 Ask price For example, with pound sterling quoted at $1. 4419 - 28, the percentage spread equal 0.062% Percent spread = 1.4428 - 1.4419 × 100 = 0.062% 1.4428

7. 7 Arbitrage in the FOREX market Close and direct contact sellers and buyers, increase transparency through the use of internet, which has created instantaneous arbitrage-free market, across currencies and financial centres in FOREX. – Arbitrage is the practice of taking advantage of a price differential between two or more markets There are two types of arbitrage in the Forex market: 1.Financial centre arbitrage: the exchange rate of two currencies is the same in all Forex exchanges (markets). 2.Cross-currency arbitrage: the exchange rate of two currencies against a third currency is linked to their exchange rate.

8. 8 Arbitrage in the FOREX market Financial centre arbitrage - Example: –If the exchange rate in Dollar-Pound is $1.81/£ in New York and $1.79/£ in London –it is profitable to buy £ against $ in London and sell them in NY (2 cents profit per £ sold). –The excessive demand for £ in London will push the price up and the excessive supply of £ in NY will push the price down. The equilibrium price should be somewhere in between, might be $1.80/£1. Cross-currency arbitrage - Example: – Assume that the exchange rates of a currency ($) to other two (£ and €) are: $1.80/£ and $1.20/€. – This implies that the exchange rate of Euro-pound should be: 1.80/1.20= €1.50/£. – If the actual market exchange rate €-£ is €1.75/£, you can make risk-free profit by usingpounds to buy € and selling $: Example: Sell £1 to buy €1.75 then use these proceeds to buy $2.10and use $2.10 of these proceeds to buy pounds (in short having profit of 16 pennies.).

9. 9 The Spot and Forward exchange rates The spot exchange rate: is the quote between two currencies for immediate delivery (the current rate). With the help of electronic FedWire the adjustment of accounts at Fed reserve bank (US) became possible at the same date but still the participating banks are exposed to currency exposure usually for 1-2 two days due to reasons of verification, clearing, and especially time zone e.g. a spot deal entered on Monday in Pakistan will not be settled until the Tuesday (as Pakistan is 11 hours ahead to America). Therefore It is possible, to get one-day or even same-day value, but the rates will be adjusted to reflect interest differentials on the currencies involved because of time zones. The forward exchange rate: the exchange rate for future delivery (at a specified future time – specified). – Usually 1 month (30 days) – 3 months (90 days) – 6 months (180 days) – or 1 year (160 days).

10. 10 Determining the spot exchange rate - A simple model There are various models and theories explaining the exchange rate behaviour. A simple model based on the principle of equilibrium of demand and supply was widely used. EXAMPLE: We use as an equilibrium example of demand and supply for £ to determine the exchange rate between £ and $: – This simple model suggests that the demand for £ is a derived demand, i.e. it is a result of the demand for what £ can buy, which is to pay for UK products imported by the US. – We next observe that what happens to the exchange rate $/£1 as the demand and supply of £ changes.

11. 11 Determining the spot exchange rate - A simple model

12. 12 Determining the spot exchange rate - A simple model As the £ appreciates against the $, the price (value) of UK exports increases in US, which results to lower quantity of imports for US from UK and thus reduced demand for £. Thus, the demand curve for £ to exchange rate has a downward slop.

13. 13 Determining the spot exchange rate - A simple model 800 In UK :

14. 14 Determining the spot exchange rate - A simple model The supply of £ in UK is a reflection of the demand for $ due to increase in demand of US products for UK buyers. As the £ appreciates against the $, the price of US imports decreases in £, which results to higher quantity of imports and thus to increased the supply of £. Thus, the supply curve of £ to exchange rate is an upward-slop.

15. 15 Determining the spot exchange rate - A simple model The demand of UK products in the US and that of US products in the UK are determined by a number of factors such as taste, income, technology etc. Therefore, the spot exchange rate of dollar-pound is determined at the level where demand and supply are equal. This equilibrium between the demand and supply for £ and $ will determine the exchange rate $/£1.

16. 16 Determination of Forward Exchange Rate The forward exchange rate: the exchange rate for future delivery (at a specified future time). A currency is at forward premium when the forward exchange rate quotation represents an appreciation of the current quotation. – A currency in forward premium buys more units of another on the forward market than does in the spot market. A currency is at forward discount when its forward exchange rate quotation represents a depreciation for that currency compared to its spot quotation. – A currency in forward discount buys less units of the other currency in the forward market than in the spot market.

17. 17 Determination of Forward Exchange Rate The forward premium or discount are usually expressed as a percentage of the spot exchange rate: The presence of arbitrageurs ensures that the Covered Interest Parity (CIP) condition holds continually in the exchange rate market: or F = (1 + r * ) * S (indirect quote) (1 + r) Where: F is the one-year forward exchange rate quotation in foreign currency per unit of domestic currency (indirect quote); S is the spot exchange rate; r is the one year domestic interest rate and r* is the one-year foreign interest rate. NOTE: The one-year interest rates have to be adjusted divided by 4 for the 3-month forward exchange rate and dividing by 2 for the six-month forward exchange rate.

18. 18 Determination of Forward Exchange Rate Covered Interest Parity (CIP) - Example: The UK (home) interest rate (on borrowing) is 8% and the US (foreign) interest rate is 5% (on borrowing). The spot rate of pound to dollar is $1.60/£1 (must take indirect quote). Calculate the one- year forward rate using the covered interest parity (CIP) formula and explain whether the dollar is at forward premium or discount. ANSWER: Therefore, the one-year forward pound rate is at an annual forward discount, since £1 forward buys less dollars (1.5555) against the spot rate of 1.60. The discount is: (F-S)/S = [(1.5555-1.60)/1.60] = -0.0278 or -2.78% 0.08)

19. 19 Arbitrage Opportunity Steps involve: 1.First to check Arbitrage equilibrium exists or not: Arbitrage equilibrium dictates that the future dollar proceeds from investing in the two equivalent investments must be the same, implying that: (1 + r * ) = (F/S)(1 + r) 2.If not, then notice which side got less factor value. Borrow the loan in the currency which got less factor value and invest in other.

20. 20 Illustration Suppose that the annual interest rate in the USA is 5% and 8% in the UK. And that the spot exchange rate is $1.5/£ and the forward exchange rate with one year maturity is $1.48/£. In terms of our notation, i $ =5%, i £ =8%, S =$1.50 and F = $1.48. Assume that the arbitrager can borrow up to $1,000,000 or £666,667. which is equivalent to $1,000,000 at the current spot rate. (1 + 0.05) = (1.48/1.5) (1 + 0.08) 1.05 < 1.0656 (means borrow in $’s and invest in pounds) borrow $1,000,000 and convert them in pounds that is £666,667 and invest them at 8%. £666,667 x 1.08 = £720,000 (after a year have the interest with principal amount) £720,000 x $1.48/£ = 1,065,600 convert them back to $’s you will have 65,600 in excess that is about (65600/1,000,000) x 100 = 6.56% in $ term and 6.64% in £’s term.

21. 21 Major Players in Forward Exchange Rate The major players in the forward exchange rate market are: – Hedgers – Arbitrageurs and – Speculators. Hedgers: usually firms that seek to secure a fixed future cash flow – EXAMPLE: Currently, at 1 Jan 2008, a UK importer has to pay $15,500 to his US supplier, at the end of Dec 2008. The current spot exchange rate is $1.60/£1 and the one-year forward rate is $1.55/£1. Explore the alternative cost if the spot exchange rate at Dec 2008 is 1.50 or 1.80. – ANSWER: Buying dollars forward, the importer assures that he needs £10,000 ($15,500/1.55). – If the exchange rate in one-year’s time is worse (1.50), not having purchase forward $, he has to pay £10,333 (=15,500/1.50) – Alternatively, if the exchange rate is better (1.80), he has to pay only £8,611 (15,500/1.80). Arbitrageurs are usually banks that seek to profit from discrepancies between exchange rates differentials (forward discount or forward premium).

22. 22 Major Players in Forward Exchange Rate Speculators are individuals or firms who take large risks, especially with respect to anticipating future price movements, in the hope of making quick, large gains in forward markets. Speculators are typically sophisticated, risk-taking investors having expertise in the market forecasting. They speculate to have more returns through money market by exposing there investments to uncertain future economic conditions.