2. The Spot Market Spot Rate Quotations The Bid-Ask Spread Spot FX trading Cross Rates

3. Spot Rate Quotations The direct quote for British pound is: £1 = $1.688

4. Spot Rate Quotations The indirect quote for British pound is: £.5924 = $1

5. Spot Rate Quotations Note that the direct quote is the reciprocal of the indirect quote:

6. Triangular Arbitrage $ £ ¥ Credit Lyonnais S(£/$)=1.50 Credit Agricole S(¥/£)=85 Barclays S(¥/$)=120 Suppose we observe these banks posting these exchange rates. First calculate the implied cross rates to see if an arbitrage exists.

7. Triangular Arbitrage $ £ ¥ Credit Lyonnais S(£/$)=1.50 Credit Agricole S(¥/£)=85 Barclays S(¥/$)=120 The implied S(¥/£) cross rate is S(¥/£) = 80 Credit Agricole has posted a quote of S(¥/£)=85 so there is an arbitrage opportunity. So, how can we make money?

8. Triangular Arbitrage $ £ ¥ Credit Lyonnais S(£/$)=1.50 Credit Agricole S(¥/£)=85 Barclays S(¥/$)=120 As easy as 1 – 2 – 3: 1. Sell our $ for £, 2. Sell our £ for ¥, 3. Sell those ¥ for $.

9. Triangular Arbitrage Sell $100,000 for £ at S(£/$) = 1.50 receive £150,000 Sell our £ 150,000 for ¥ at S(¥/£) = 85 receive ¥12,750,000 Sell ¥ 12,750,000 for $ at S(¥/$) = 120 receive $106,250 profit per round trip = $ 106,250- $100,000 = $6,250

10. Spot Foreign Exchange Microstructure Market Microstructure refers to the mechanics of how a marketplace operates. Bid-Ask spreads in the spot FX market: increase with FX exchange rate volatility and decrease with dealer competition. Private information is an important determinant of spot exchange rates.

11. The Forward Market Forward Rate Quotations Long and Short Forward Positions Forward Cross Exchange Rates Swap Transactions Forward Premium

12. The Forward Market A forward contract is an agreement to buy or sell an asset in the future at prices agreed upon today. If you have ever had to order an out-of-stock textbook, then you have entered into a forward contract.

13. Forward Rate Quotations The forward market for FOREX involves agreements to buy and sell foreign currencies in the future at prices agreed upon today. Bank quotes for 1, 3, 6, 9, and 12 month maturities are readily available for forward contracts. Longer-term swaps are available.

14. Forward Rate Quotations Consider the example from above: for Japanese yen, the spot rate is ¥115.75 = $1.00 While the 180-day forward rate is Y112.80 = $1.00 Whats up with that?

15. Spot Rate Quotations Clearly the market participants expect that the yen will be worth MORE in dollars in six months.

16. Long and Short Forward Positions If you have agreed to sell anything (spot or forward), you are short. If you have agreed to buy anything (forward or spot), you are long. If you have agreed to sell forex forward, you are short. If you have agreed to buy forex forward, you are long.

17. Payoff Profiles 0 S 180 ($/¥) F 180 ($/¥) =.009524 Short positionloss profit If you agree to sell anything in the future at a set price and the spot price later falls then you gain. If you agree to sell anything in the future at a set price and the spot price later rises then you lose.

18. Payoff Profiles loss 0 S 180 (¥/$) F 180 (¥/$) = 105 -F 180 (¥/$) profit Whether the payoff profile slopes up or down depends upon whether you use the direct or indirect quote: F 180 (¥/$) = 105 or F 180 ($/¥) =.009524. short position

19. Payoff Profiles loss 0 S 180 (¥/$) F 180 (¥/$) = 105 -F 180 (¥/$) When the short entered into this forward contract, he agreed to sell ¥ in 180 days at F 180 (¥/$) = 105 profit short position

20. Payoff Profiles loss 0 S 180 (¥/$) F 180 (¥/$) = 105 -F 180 (¥/$) 120 If, in 180 days, S 180 (¥/$) = 120, the short will make a profit by buying ¥ at S 180 (¥/$) = 120 and delivering ¥ at F 180 (¥/$) = 105. 15¥ profit short position

21. Payoff Profiles loss 0 S 180 (¥/$) F 180 (¥/$) = 105 Long position-F 180 (¥/$) F 180 (¥/$) short position profit Since this is a zero-sum game, the long position payoff is the opposite of the short.

22. Payoff Profiles loss 0 S 180 (¥/$) F 180 (¥/$) = 105 Long position -F 180 (¥/$) profit The long in this forward contract agreed to BUY ¥ in 180 days at F 180 (¥/$) = 105 If, in 180 days, S 180 (¥/$) = 120, the long will lose by having to buy ¥ at S 180 (¥/$) = 120 and delivering ¥ at F 180 (¥/$) = 105. 120 –15¥

23. SWAPS A swap is an agreement to provide a counterparty with something he wants in exchange for something that you want. Swap transactions account for approximately 51 percent of interbank FX trading, whereas outright trades are less than 9 percent.

24. Comparative Advantage as the Basis for Swaps Consider two firms A and B: firm A is a U.S.–based multinational and firm B is a U.K.–based multinational. Both firms wish to finance a project in each others country of the same size. Their borrowing opportunities are given in the table below.

25. A is the more credit-worthy of the two firms. A pays 2% less to borrow in dollars than B and A pays.4% less to borrow in pounds than B: Comparative Advantage as the Basis for Swaps A has a comparative advantage in borrowing in dollars B has a comparative advantage in borrowing in pounds.

26. One Feasible Swap: Company A Swap Bank $8%£12% $8% £11% £12% $9.4% Company B

27. $8%£12% $8% £11% £12% $9.4% As net position is to borrow at £11% One Feasible Swap: Company A Swap Bank Company B

28. $8%£12% $8% £11% £12% $9.4% Bs net position is to borrow at $9.4% One Feasible Swap: Company A Swap Bank Company B

29. $8%£12% $8% £11% £12% $9.4% One Feasible Swap: Company A Swap Bank Company B A saves £.6%

30. $8%£12% $8% £11% £12% $9.4% B saves $.6% One Feasible Swap: Company A Swap Bank Company B A saves £.6%

31. $8%£12% $8% £11% £12% $9.4% B saves $.6% One Feasible Swap: Company A Swap Bank Company B A saves £.6% The swap bank makes money too.

32. SWAPS A swap can be viewed as a portfolio of spot and forward positions. In the above example, firm A would borrow in dollars and then swap for pounds with the bank and simultaneously enter into a series of forward contracts with the bank to exchange dollars for pounds.

33. Forward Premium Its just the interest rate differential implied by forward premium or discount. For example, appreciating from S($/DM) =.5235 to F 180 ($/DM) =.5307 The forward premium is given by: