Foreign Exchange Market: Chapter 7 Chapter Objectives & Lecture Notes FINA 5500
Chapter Objectives: FINA 5500 Chapter 7 / FX Markets 1. To be able to interpret direct and indirect quotes in the spot market for foreign currencies published in the financial press 2. To be able to use direct and indirect quotes in the spot market to convert a given amount of one currency into another currency 3. To be able to estimate the percentage appreciation and depreciation of foreign currencies based on direct and indirect quotes in the spot market 4. To be able to estimate the percentage appreciation and depreciation of the US dollar (from the foreign country s view point) based on direct and indirect quotes 5. To be able to compute a currency s bid-ask spread, based on its bid and ask quotes in the spot market 6. To be able to calculate the dollar cost of making a round trip transaction based on its bid and ask quotes in the spot market 7. To be able to identify and exploit a locational arbitrage opportunity in the FX market 8. To be able to estimate the cross-exchange rates (and bid-ask quotes) between two currencies based their respective direct and indirect (and bid-ask) quotes in the spot market 9. To be able to identify and exploit a triangular arbitrage opportunity in the FX market 10. To be able to explain in your own words, the rational for the forward market for foreign currencies 11. To be able to interpret direct and indirect quotes in the forward market for foreign currencies published in the financial press 12. Based on direct and indirect quotes in the forward market for foreign currencies, you should be able to calculate the dollar values of the long and short positions taken in the forward market, as well as profit or loss from taking these positions 13. To be able to compare and contrast the role of a hedger and a speculator in the forward market for foreign currencies 14. To be able to estimate the annualized forward premium or discount
OVERVIEW: CHAPTER 7 Spot Market for Foreign Exchange» Market characteristics» Interpreting quotes» Cross exchange rates Forward Market for Foreign Exchange» Why is it used» Market characteristics» Estimating forward premium and discount 1 Spot Market Transactions at the same point in time. The market is a network Large money center banks are wholesalers Major currencies: US $; Yen ; Euros; Swiss Francs; Australian $; Canadian $ Spot Rate : The price at which a foreign currency can be bought/sold, today. Each spot exchange rate can be expressed in two ways:» Direct quote: price of the foreign currency expressed in units of the home currency (example: 1BP = USD 2.00)» Indirect quote: price of one unit of the home currency expressed in units of the foreign currency (example: 1USD = BP 0.50) 2 1
FX Price Quote Source: http://finance.yahoo.com/currency 3 Spot Foreign Exchange Quotes Direct Quote: U.S. dollar equivalent» Online Quotes 1 BP = $1.8845 1 SF = $0.8393» Direct quote = 1 / Indirect quote 1 BP = 1 / 0.5306 = $1.8845 1 SF = 1 / 1.1914 = $0.8393 Indirect Quote: Currency per USD» Online Quotes 1 USD = BP0.5306 1 USD = SF1.1914» Indirect quote = 1 / Direct quote 1 USD = 1 / 1.8845 = BP0.5306 1 USD = 1 / 0.8393 = SF1.1914 4 2
Applying Direct and Indirect Quotes to Convert Currency Currency Conversion Formulas: Converting USD into FC Converting FC into USD Using DQ USD / DQ = FC FC * DQ = USD Using IQ USD * IQ = FC FC / IQ = USD DQ = Direct quote IQ = Indirect quote USD = US Dollars FC = Foreign currency 5 Bid and Ask Quotes and Spread Ask Quote (currency dealer s selling price)» $ 1.8845 / 1 British Pound. Bid Quote (currency dealer s buying price)» $ 1.8820 / 1 British Pound. Ask price > Bid price Bid-Ask Quotes: $1.8820-45 or just 20-45 Bid-Ask Spread (in %) = 100 * (Ask - Bid) / Ask» 100 * (1.8845 - $ 1.8820) / 1.8845 = 0.1327% 6 3
Indirect Price Quotes (Foreign Currency / USD) Symbol Currency Close Bid Ask USDJPY Yen 103.67 103.67 103.70 USDEUR Euro 0.7672 0.7672 0.7675 USDGBP British Pound 0.5306 0.5306 0.5308 USDMXN Mexican Peso 11.135 11.135 11.145 USDCHF Swiss Franc 1.1931 1.1931 1.1936 7 Long-term FX Rates: USD & Yen (Indirect Quote) 8 4
Long-term FX Rates: USD & Euro (Direct Quote) 9 Long-term FX Rates: USD with Major Currencies Source: http://research.stlouisfed.org/fred2 10 5
Percentage Change: Direct Quotes Formula: % change in DQ = 100*(DQ1 DQ0) / DQ0 DQ0 = Direct quote, at the beginning of the period DQ1 = Direct quote, at the end of the period Interpretation: Measures appreciation or depreciation of the foreign currency, in terms of the USD. As seen from the US viewpoint Example: On 1/1/X1 the DQ for SF was $0.50, on 1/1/X2 it was $0.60, and on 1/1/X3 it was $0.57 Period Percentage Change in DQ Interpretation 20X1-20X2 100*(0.60-0.50) / 0.50 = 20.00% SF appreciated by 20% 20X2-20X3 100*(0.57-0.60) / 0.60 = - 5.00 % SF depreciated by 5% 11 Percentage Change: Indirect Quotes Formula: % change in IQ = 100*(IQ1 IQ0) / IQ0 IQ0 = Indirect quote, at the beginning g of the period IQ1 = indirect quote, at the end of the period Interpretation: Measures appreciation or depreciation of the USD, in terms of the foreign currency. As seen from the foreign country s viewpoint Example: On 1/1/X1 the IQ for MP was 10.00, on 1/1/X2 it was 9.00, and on 1/1/X3 it was 11.25 Period Percentage Change in IQ Interpretation 20X1-20X2 100*(9.00-10.00) / 10.00= -10.00% USD depreciated by 10% 20X2-20X3 100*(11.25-9.00) / 9.00= 25.00% USD appreciated by 25% 12 6
Percentage Change in Direct Quotes: Using Indirect Quotes % change in DQ = 100*[100 / (100 + % change in IQ) - 1] Example: Suppose, on 1/1/X1 the IQ for JY was 120, and on 1/1/X2 it was 100. It means that during this period, USD depreciated by 20% from the Japanese viewpoint. What was the % change in the value of JY from the US viewpoint? Solution: During the 20X1-X2, IQ for JY changed by 20% Percentage in DQ (over the same period): 100* [100 / (100 20) 1] = 100* [(100/80) 1] = + 25% During this period, JY appreciated by 25% (from US view point) 13 Percentage Change in Indirect Quotes: Using Direct Quotes % change in IQ = 100*[100 / (100 + % change in DQ) - 1] Example: Suppose, on 1/1/X1 the DQ for SF was $0.50, and on 1/1/X2 it was $0.55. It means that during this period, SF appreciated by 10% from the US viewpoint. What was the % change in the value of USD from the Swiss viewpoint? Solution: During 20X1-X2, DQ for SF changed by + 10% Percentage in IQ (over the same period): 100* [100 / (100 + 10) 1] = 100* [(100/110) 1] = - 9.09% During this period, USD depreciated by 9.09% from the Swiss viewpoint 14 7
Cross Exchange Rates Quotes Deriving the exchange rates between two currencies from their respective direct quotes» Example: Use the direct dollar quotes for SF and BP to calculate: how many SF per BP how many BP per SF» Direct dollar quotes: (SF= $ 0.8393, BP = $ 1.8845)» Cross exchange rates: The price of BP in terms of SF = (DQ of BP / DQ of SF) (1.8845 / 0.8393) = SF 2.2453 / BP One BP = SF 2.2453 The price of SF in terms of BP = (DQ of SF / DQ of BP) (0.8393 / 1.8845) = BP 0.4454 / SF One SF = BP 0.4454 15 Cross Exchange Rates Quotes:With Bid and Ask Quotes Direct dollar quotes:» For Swiss Francs: Bid price: $ 0.6805 Ask price: $ 0.6839 Quote: $0.6805-39» For Hong Kong Dollar: Bid price = $ 0.1291 Ask Price = $0.1331 Quote: $0.1291-331 Cross exchange rates: Find the direct bid-ask quote for Swiss Francs in Hong Kong, stated in HK $ 16 8
LOCATIONAL ARBITRAGE Buy low in one location & sell high in another location» In the FX market The buying price (ask price) in one bank is lower than the selling price (bid price) of another bank Market adjustments which will eliminate locational arbitrage» In the FX market: The ask price will rise and bid price will fall Till ask price (of one bank) is greater than or equal to bid price (of another bank) 17 LOCATIONAL ARBITRAGE PROFIT Case 1: Arbitrage Possible New York Bank Quotes» Ask $1.84 / 1 BP» Bid $1.81 / 1 BP London Bank Quotes» Ask $1.89 / 1 BP» Bid $1.86 / 1 BP Case 2: No Arbitrage Possible Chicago Bank Quotes» Ask $0.64 / 1 SF» Bid $0.60 / 1 SF Berlin Bank Quotes» Ask $0.66 / 1 SF» Bid $0.62 / 1 SF 18 9
Triangular Arbitrage: When Implied & Actual Cross Rates are Different 1 BP = $1.50 1 SF = $0.50 Implied cross rate: 1 BP = 1.5/0.5 = 3.0 SF If actual cross rate: 1 BP = 3.50 SF (It is better to sell BP in return for SF) If actual cross rate: 1 BP = 2.50 SF (It is better to buy BP with SF) $ $ BP SF BP SF 19 Triangular Arbitrage: When Implied Cross Rate is Less than Actual Cross Rate 1 BP = $1.50 1 SF = $0.50 Implied cross rate: 1 BP = 1.5/0.5 = 3.0 SF If actual cross rate: 1 BP = 3.50 SF. Have $1,000 $ 1,000 $1,166.67 BP 666.67 SF 2,333.33 666.67 X 3.5 20 10
Triangular Arbitrage: When Implied Cross Rate is Less than Actual Cross Rate $ exchanged for BP» The price of BP rises against the $: ($1.50 /BP ) BP exchanged for SF» The price of BP falls against SF: (SF 3.50/BP ) SF exchanged for $» The price of SF falls against the $: ($ 0.50/SF ) The implied cross rate approaches the actual cross rate 21 Triangular Arbitrage: When Implied Cross Rate is Greater than Actual Cross Rate 1 BP = $1.50 1 SF = $0.50 Implied cross rate: 1 BP = 1.5/0.5 = 3.0 SF If actual cross rate: 1 BP = 2.50 SF. Have $1,000 $ 1,200 $1,000 BP 800 SF 2,000 2,000 / 2.5 22 11
Triangular Arbitrage: When Implied Cross Rate is Greater than Actual Cross Rate $ exchanged for SF» The price of DM rises against the $: ($0.50 /SF ) SF exchanged for BP» The price of BP rises against SF: (SF 2.50/BP ) BP exchanged for $» The price of BP falls against the $: ($ 1.50/BP ) The implied cross rate approaches the actual cross rate 23 Forward Currency Market Market where Forward Contracts by traded Forward Contracts are agreements to deliver (or take delivery of) a specified amount of foreign currency at a fixed future date and at a fixed exchange rate. Used by businesses and currency traders to:» Hedge against currency (exchange rate) risk» Speculate (make trading profits) 24 12
Forward Exchange Rate The dollar price at which a foreign currency can be bought and sold at future date. This rate is set at the time when the contract is signed. No money is exchanged at this time. 25 Forward Rate Quotes Direct Dollar Quotes from WSJ (attached):» Swiss Franc (FF) spot rate (direct quote): $0.8401 6-months forward rate (direct quote): $0.8492» Japanese Yen (JY) spot rate (direct quote): $0.009646 6-months forward rate (direct quote): $0.009788 26 13
Using Forward Contracts Two major applications of forward contracts:» Hedging» Speculation 27 Using Forward Contracts for Hedging: Theory Buy Forward Contracts (take a Long Position in the FM):» When you expect to make a payment in Foreign currency, at a future date: You gain when the spot rate at the future date is higher than the forward exchange rate You lose when the spot rate at the future date is lower than the forward exchange rate Sell Forward Contracts (take a Short Position in the FM):» When you expect to receive a payment in Foreign currency, at a future date: You gain when the spot rate at the future date is lower than the forward exchange rate You lose when the spot rate at the future date is higher than the forward exchange rate 28 14
Using Forward Contracts for Hedging: Examples Toyota of Richardson, plans to buy 10 Lexus to be delivered in 3 months. A Payment of JY 30 million needs to be made to Toyota in 6 months Buy 6-month forward contract for 30 million JY How many $ will Toyota of Richardson need 6 months later? Aetna receives a bi-annual insurance premium of 1 million SF from a Swiss customer. The next receipt is due in six months» Sell 6-month forward contract for 1 million SF How many $ will Aetna receive 6 months later? 29 Using Forward Contracts for Speculation: Theory Buy Forward Contracts (take a Long Position in the FM):» When you expect the future spot rate to be higher then the current forward rate: You will gain when the future spot rate is higher than the current forward exchange rate You will lose when the future spot rate is lower than the current forward exchange rate Sell Forward Contracts (take a Short Position in the FM):» When you expect the future spot rate to be lower then the current forward rate: You will gain when the future spot rate is lower than the current forward exchange rate You will lose when the future spot rate is higher than the current forward exchange rate 30 15
Using Forward Contracts for Speculation: Examples Today, the 6-month forward rate on SF is $0.8492» If you expect that 6-months from today, the spot rate of SF will be greater than $0.8492: The you should BUY SF forward contracts If 6-months latter, the SR for SF is $0.8495:» you make (0.8495 0.8492) = $0.0003 / SF (profit) If 6-months latter, the SR for SF is $ 0.8485:» you make (0.8485 0.8492) = - $0.0007 / SF (loss)» If you expect that t 6-months from today, the spot rate of SF will be less than $0.8492: Then you should SELL SF forward contracts If 6-months latter, the SR for SF is $0.8495:» you make (0.8492 0.8495) = - $0.0003 / SF (loss) If 6-months latter, the SR for SF is $0.8485:» you make (0.8492 0.8485) = $0.0007 / SF (profit) 31 Forward Premium (or Discount) Annualized % premium (discount)» [(Forward - Spot) / Spot ] * [ 360/ Days to Maturity] * 100 180 day forward premium for Swiss Franc:» [($0.8492 - $0.8401) / $0.8401 ] * [ 360/180] * 100 = 2.17 % 180 day forward premium for Japanese Yen:» [($0.009788 - $0.009646) / $0.009646] * [ 360/180] * 100 = 2.94 % 32 16
Currency Conversion Problem Set #1 Please use the following quotes, to answer the questions listed below: Currency Quotes Direct or Indirect? Swiss francs 1 SF for $0.50 Mexican pesos 10 MP for 1 USD British pounds 0.75 BP for 1 USD 1. $3,000,000 can be converted into British pounds 2. SF 1,500,000 can be converted into USD 3. MP 600,000 can be converted into Swiss francs 4a. How many SF does it take to buy 1 BP? 4b. How many BP does it take to buy 1 SF?
Currency Conversion Problem Set #2 1/1/X0 1/1/X1 BP quotes $2.00 per BP $2.18 per BP SF quotes SF 2.50 per USD SF 2.00 per USD JY quotes JY100 per USD JY 120 per USD For the time period: 1/1/X0-1/1/X1, please calculate: 1. The percentage appreciation / depreciation of BP in terms of the USD 2. The percentage appreciation / depreciation of USD in terms of SF 3. The percentage appreciation / depreciation of JY from the US viewpoint 4. Suppose during this time period the indirect quote for MP decreased by 15%. (i) By what % did the MP appreciate/depreciate from the US viewpoint? (ii) By what % did the USD appreciate/depreciate from the Mexican viewpoint?
Currency Conversion Problem Set #3 Currency Quotes on 1/1/X1 Quote on 1/1/X2 Canadian dollars 1 CD = $0.50 1 CD = $0.54 Swiss francs SF 1.80 = 1 USD SF 1.90 = 1 USD Japanese yen 1 USD = JY 100 1 USD = JY 120 a. Based on the 1/1/X2 quote, convert 8,000,000 Canadian dollars into US dollars: b. Based on the 1/1/X2 quotes, convert $25,000,000 into Swiss francs: c. During the one-year period, what was the percentage appreciation / depreciation of the Japanese yen from the US point of view? d. During the one-year period, what was the percentage appreciation / depreciation of the US dollar from the Swiss point of view?
Bid-Ask Spread Problem Set #1 The following table presents bid and ask quotes for BP from currency dealers in New York and London: Currency Dealer in New York London Bid Quote for BP $ 1. 58 $ 1.65 Ask Quote for BP $ 1. 68 $ 1.70 1. Assume that you dealt with the New York currency dealer only. You converted $100,000 into pounds, and immediately afterwards sold the pounds for dollars. Estimate the dollar amount you lost in this round trip transaction. 2. Assume that you dealt with the London currency dealer only. What is the percentage bid-ask spread for this dealer? 3. Which dealer (s) would you buy from, and sell to?
Cross Exchange Rates Quotes With Bid and Ask Quotes: In-Class Exercise Direct dollar quotes: For Swiss Francs: Bid-Ask Quote: $0.5205-50 For Canadian Dollar: Bid-Ask Quote: $0.8510-95 Cross exchange rates: Find the direct bid-ask quote for Canadian dollars, stated in Swiss Francs 1
EXAMPLE: FX FORWARD MARKET BASICS Today: 1/1/XX Six Months Latter: 6/1/XX Spot Rate for BP = $1.50 6-Month Forward Rate for BP = $1.60 FC BUYER / LONG POSITION HOLDER: 6-Month Forward Contract for BP 1,000,000 Current Financial Obligations: None FC SELLER / SHORT POSITION HOLDER: 6-Month Forward Contract for BP 1,000,000 Current Financial Obligations: None Financial Obligations of Forward Contract Buyer: Pay: 1.60 x 1,000,000 = $1,600,000 Receive: BP 1,000,000 Suppose on 6/1/XX SR = $1.63 SR = $1.58 Then for BP 1,000,000 You have paid: $1,600,000 And it is worth: $1,630,000 Your profit/loss: $ 30,000 Then for BP 1,000,000 You have paid: $1,600,000 And it is worth: $1,580,000 Your profit/loss: - $ 20,000 Financial Obligations of Forward Contract Seller: Pay: BP 1,000,000 Receive: 1.60 x 1,000,000 = $1,600,000 Suppose on 6/1/XX SR = $1.63 SR = $1.58 Then for BP 1,000,000 You have received: $1,600,000 And it is worth: $1,630,000 Your profit/loss: - $ 30,000 Then for BP 1,000,000 You have received: $1,600,000 And it is worth: $1,580,000 Your profit/loss: $ 20,000
EXERCISE: FX FORWARD MARKET BASICS Today: 1/1/XX Six Months Latter: 6/1/XX Spot Rate for Euro = $1.15 6-Month Forward Rate for E = $1.20 FC BUYER / LONG POSITION HOLDER: 6-Month Forward Contract for E 5,000,000 Current Financial Obligations: Pay: Receive: Financial Obligations of Forward Contract Buyer: Suppose on 6/1/XX E = $1.13 E = $1.25 Then for E 5,000,000 Then for E 5,000,000 You have paid: $ You have paid: $ And it is worth: $ And it is worth: $ Your profit/loss: $ Your profit/loss: $ FC SELLER / SHORT POSITION HOLDER: 6-Month Forward Contract for E 5,000,000 Current Financial Obligations: Pay: Receive: Financial Obligations of Forward Contract Seller: Suppose on 6/1/XX E = $1.13 E = $1.25 Then for E 5,000,000 Then for E 5,000,000 You have received: $ You have received: $ And it is worth: $ And it is worth: $ Your profit/loss: $ Your profit/loss: $
FX Spot / Forward Market Transactions Problem Set #1 Forward and Spot Prices Quotes for Foreign Currencies: From Wall Street Journal Today: 01/15/XX (Wednesday) 1-month latter: 02/15/XX (Tuesday) 6-months latter: 07/15/XX (Monday) 1. Today (1/15/XX), you bought 100 million JY in the spot market from Credit Suisse First Boston (CSFB), and sold it back to CSFB one month latter: Your cash flows today, are: Your cash flows on 2/15/XX are: Your profit/loss is: CSFB s cash flows today, are: CSFB s cash flows on 2/15/XX are: CSFB s profit/loss: 2. Today (1/15/XX), you bought a one-month forward contract for 100 million JY from Credit Suisse First Boston (CSFB) : Your cash flows today, are: Your cash flows on 2/15/XX are: Your profit/loss (in the FM) is: CSFB s cash flows today, are: CSFB s cash flows on 2/15/XX are: CSFB s profit/loss (in the FM) is:
FX Spot / Forward Market Transactions Problem Set #1 (Contd.) 3. Today (1/15/XX), you sold a six-month forward contract for 100 million JY to Credit Suisse First Boston (CSFB) : Your cash flows today, are: Your cash flows on 7/15/XX are: Your profit/loss (in the FM) is: CSFB s cash flows today, are: CSFB s cash flows on 7/15/XX are: CSFB s profit/loss (in the FM) is: 4. Today (1/15/XX), you bought a one-month forward contract for 1 million BP from Credit Suisse First Boston (CSFB) : Your cash flows today, are: Your cash flows on 2/15/XX are: Your profit/loss (in the FM) is: CSFB s cash flows today, are: CSFB s cash flows on 2/15/XX are: CSFB s profit/loss (in the FM) is: 5. Today (1/15/XX), you sold a six-month forward contract for 10 million SF to Credit Suisse First Boston (CSFB) : Your cash flow today, is: Your cash flows on 7/15/XX is: Your profit/loss (in the FM) is: CSFB s cash flow today, is: CSFB s cash flows on 7/15/XX is: CSFB s profit/loss (in the FM) is:
Formula: Currency Conversion Quotes: DQ (direct quote): The dollar price of one unit of foreign currency (FC) IQ (indirect quote): Number of units of FC per one dollar; DQ = 1 / IQ and IQ = 1 / DQ DQ 0 = DQ now; DQ 1 = DQ 1-year later; IQ 0 = IQ now; IQ 1 = IQ 1-year later Calculating Percentage Change in DQ and IQ: % change in DQ = 100 * (DQ 1 -DQ 0 ) / DQ 0 = 100*[100 / (100 + % change in IQ) - 1] % change in IQ = 100 * (IQ 1 -IQ 0 ) / IQ 0 = 100*[100 / (100 + % change in DQ) - 1 Currency Conversion: Converting USD into FC Converting FC into USD Using DQ Using IQ USD / DQ = FC USD * IQ = FC FC * DQ = USD FC / IQ = USD Ask Price (A): The buying price for one unit of FC from the currency dealer; Bid Price (B): The selling price for one unit of FC to the currency dealer; Bid-Ask Spread = 100* (A B) / A Cross-Quotes: DQ1= $ price of FC1; DQ2 = $ price of FC2; The price of FC1 in terms of FC2 (how many unit of FC2 does it take to buy one FC1) = DQ1 / DQ2 The price of FC2 in terms of FC1 (how many unit of FC1 does it take to buy one FC2) = DQ2 / DQ1 Forward Premium or Discount: [(forward rate spot rate) / spot rate] * [360/days to maturity] * 100