International Financial Management

Foreign Exchange Market

In tonight's class, we will discuss function and structure of foreign exchange market, the spot market,
and the cross rates, and triangular arbitrage.

Function and structure of the FX market:

The spot and forward foreign exchange markets are OTC markets. There is no central marketplace,
rather it is a worldwide linkage of different market participants. Market participants include

international banks,
their customers,
nonbank dealers,
FX brokers, and
Central banks.

FX market is a two-tiered market:

wholesale or interbank market

retail or client market

The interbank market is a network of correspondent banking relationships, where large commercial
banks maintain demand deposit accounts with one another, which facilitates the efficient functioning of
the FX market.

The Spot Market:

The spot market involves immediate (up to two business days) purchase or sale of foreign exchange.
Spot rate currency quotations can be stated in direct or indirect terms.

Direct Quotation: the price of one unit of the foreign currency in U.S. dollars. For example, the spot
quote for Japanese yen is $.010854

Indirect Quotation: the price of one US dollar in the foreign currency. For example, the spot quote for
one dollar is .8171

Most currencies in the interbank market are quoted in either European Terms (An indirect quote from
US perspective) or in American Terms (A direct quote from US perspective)

Spot rate notation: S(j/k) means the spot rate of one unit of currency k in terms of currency j

Direct and indirect quotes are reciprocals of each other

Example: What is the indirect quote of S($/)=1.4655?

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Cross rates: A cross-exchange rate is an exchange rate between a currency pair where neither currency
is the US dollar. In other words, a cross-rate is an unobserved rate that is calculated from two observed
rates.

Example: if S($/)=1.4655 and S($/)=1.2238, then find S(/) ?

Easy way to find cross-rate: Product of direct and indirect quote

The Bid-Ask Spread:

The bid price is the price a dealer is willing to pay you for something.

The ask price is the amount a dealer wants you to pay for something.

The bid-ask spread is the difference between the bid and ask prices.

Cross rates with bid-ask spreads:

$/ bid-ask prices: $1.4650-$1.4655

/$ bid-ask prices: .6824-.6826

$/ bid-ask prices: $1.2233-$1.2238

/$ bid-ask prices: .8171-.8175

Now Sb(/)=1.4650*.8171=1.1971

Reciprocal of Sb(/)=Sa(/)=1/1.1971=.8354

Now Sa(/)=1.4655*.8175=1.1980

Reciprocal of Sa(/)=Sb(/)=1/1.1980=.8347

So / bid-ask prices: 1.1971-1.1980

and / bid-ask prices: .8347-.8354

Example: A bank is quoting the following exchange rates against the dollar for the Swiss franc and the
Australian dollar:

SFr/$=1.5960-70

A$/$=1.7225-35

An Australian firm asks the bank for an A$/SFr quote. What cross-rate would the bank quote?

Answer: Sb(A/S)=1/1.5970*1.7225

=1.0786

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Sa(A/S)=1/1.5960*1.7235

=1.0799

Hence the cross-rate will be: 1.0786-1.0799

Triangular Arbitrage:

Triangular or geographic arbitrage gives the opportunity for riskless profit when the currency's exchange
rates do not exactly match up. This is the process of converting one currency to another, converting it
again to a third currency, and finally converting it back to the original currency within a short time span.
Triangular arbitrage opportunity lasts for very short period of time, may be a few seconds.

Example: Suppose you have $1 million and you are provided with the following exchange rates:

/$=0.8631

/=1.4600

$/=1.6939

With these exchange rates there is an arbitrage opportunity:

Sell dollars for euros: $1 million x 0.8631 = 863,100 euros

Sell euros for pounds: 863,100/1.4600 = 591,164.40 pounds
Sell pounds for dollars: 591,164.40 x 1.6939 = $1,001,373 dollars

$1,001,373 - $1,000,000 = $1,373

From these transactions, you would receive an arbitrage profit of $1,373 (assuming no transaction costs
or taxes).

Example: Suppose the pound sterling is bid at $1.5422 in New York and the euro is offered at $0.9251 in
Frankfurt. At the same time, London banks are offering pounds sterling at 1.6650. Is there any
arbitrage opportunity available from the exchange rates? If you trade $1 million, how much will be your
profit from the transaction?

Answer: $1200 approximately ($1239.05)

Triangular Arbitrage with bid-ask spread:

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