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

2. The Bid-Ask Spread USD Bank Quotations American Terms European Terms
Pounds
1.5902
1.5908
.6286
.6289
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:
USD Bank Quotations
American Terms
European Terms
Bid
Ask
Pounds
1.5902
1.5908
.6286
.6289

4. What are her proceeds from conversion?
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 –
RMB/EUR –
Pounds: ?
Euros: ?
Total: ?
What are her proceeds from conversion?
$1,353,502.58

5. Proceeds
Pounds: We buy RMB in the market for RMB: £500,000/ =RMB 4,944, Euros: We sell euros in the market for euros: €250,000* = 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
USD Bank Quotations
American Terms
European Terms
Bid
Ask
Pounds
1.5902
1.5908
0.6286
0.6289
RMB
0.1622
0.1630
6.1350
6.1652

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 RMB

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* = $1,622 - How much do we receive from selling dollar for pounds? $1,622/ = £1, Effectively RMB ask price for the pound: 10,000/1,019.16= RMB BID/ASK price: –

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 –
At the second window you observe the following:
RMB –

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

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

13. Triangular Arbitrage $ ¥ £
The implied S(¥/£) cross rate is S(¥/£) = 150 $
Credit Lyonnais
S($/£)=1.50
Credit Agricole
S(¥/£)=125
Barclays
S(¥/$)=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; ¥150. 13

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 14

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

16. Review: Triangular Arbitrage
Sell $10,000,000 for ¥ at S($/ ¥) ask = $
receive ¥992,063,492.06
Sell our ¥992,063, for € at S(¥/ €) = ¥ receive €7,798,965.38
Sell € 7,798, for $ at S($/€) =
receive $10,112,918.41
profit per round trip = $ 10, $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: $
Market for euros: $
Market for pounds: €
Implied price in the third market is 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/ = €678,242.00
Sell euros for pounds:
We receive: €678,242.00/ = £509,573.25
Finally, sell pounds for dollars
We receive: £509,573.25* = $1,004,470.79
PROFIT: $4,