# Foreign Exchange Market INTERNATIONAL FINANCE. Function and Structure of FX Market. Market Characteristics. Market Attributes. Trading in Markets

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3 Cross-Exchange Rate (Cross-rate) Exchange rate between two currencies based on each of their exchange rates with a third currency U.S. perspective: You have \$/ and \$/ exchange rates Cross rate would be / calculated using \$ exchange rates / = ( /\$) x (\$/ ) Cross Rates Suppose that (\$/ ) =.50 i.e. \$.50 =.00 and that S(\$/ ) = 0.0 i.e. \$0.0 0 =.00 What must the / cross rate be?.00 \$0.0 = \$ or,.00 = Cross-Rate Importance Most interbank trading goes through the U.S. dollar Suppose a bank customer wants to trade out of British pounds into Swiss francs (referred to as a currency-against-currency trade) The bank frequently handles this trade by selling British pounds for dollars and then selling dollars for Swiss francs Some banks do make markets in other currencies 5-4 If markets exist for foreign currencies relative to the dollar and relative to each other: There must be some mechanism to ensure that the prices in the various markets are the same Triangular arbitrage serves that purpose for currency markets The implied cross-rate and the actual exchange rate for the two foreign currencies must be the same or traders will profit from the difference 5-5 Suppose we observe these banks posting these exchange rates. Barclays: /\$ = 0 Credit Lyonnais: /\$ = 0.5 Credit Agricole: / = 240 The implied cross rate using the dollar based quotes is: 0.50 \$.00 \$.00 0 = The difference in the implied cross rate and the actual exchange rate for / offers an arbitrage opportunity 5-6 Implied cross rate: one pound costs 220 yen Actual exchange rate: one pound costs 240 yen More yen per pound with the actual rate How do we profit? Convert dollars to pounds Then covert pounds to yen (using actual rate) Then convert yen to dollars Use \$00,000 for example 5-7 3

5 Hedging Lower Risk U.S. firm to be paid 500,000 in one month Enter -month forward contract at \$.9044/.00 to sell 500,000 Receive: ( 500,000)(.9044) 000)( = \$952, U.S. firm to pay 500,000 in one month Enter -month forward contract at \$.9044/.00 to buy 500,000 Pay: ( 500,000) (.9044) = \$952,200 No exchange rate risk remains 5-24 Speculating Increase Risk Use \$,000,000 as contract size Expect pound to be worth more than \$.9044/.00 in one month long forward (guarantees buy price) If spot rate is \$.944/.00 in one month Buy pounds using forward contract: \$,000,000/.9044 = 525, Sell pounds in spot market: 525, X.944 = \$,005,25 Profit = \$5,25 Note: If spot rate is less than.9044, you have a loss 5-25 Speculating Increase Risk Use \$,000,000 as contract size Expect pound to be worth less than \$.9044/.00 in one month short forward (guarantees sell price) If spot rate is \$.8944/.00 in one month Buy pounds in spot market: \$,000,000/.8944 = 527,87.62 Sell pounds using forward contract: 527,87.62 X.9044 = \$,005, Profit = \$5, Note: If spot rate is larger than.9044, you have a loss 5-26 Summary Spot versus forward market Bid-Ask Spread Cross-Rates Hedging and Speculation

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