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The Foreign Exchange Markets Spot Quotes, Bid-Ask Spreads, Spot

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The Foreign Exchange Markets Spot Quotes, Bid-Ask Spreads, Spot Week 3 The Foreign Exchange Markets Spot quotes, bid-ask spreads, triangular arbitrage. Forward rates FINOPMGT 413 Spot and Forward Markets • Foreign exchange trading occurs in two separate, but connected, markets: Spot and the Forward market. • Spot market: Buying and selling of f/x with settlibidfdlement in 2 business days from today. • Forward market: Settlement occurs at some future dtdate. – That is, you may enter into a forward contract to buy 10 million Yen 90 days from today . FINOPMGT 413 F/X Rate Quotes • We can view F/X rates as quotes in direct or indirect terms. • Direct: a direct f/x quote is in units of domestic currency per unit of foreign currency [DC/FC]. – For exampp,le, a q uote of the USD-British Pound is direct for the US$ if it is quoted as 1.9631US$/BP. • Indirect: an indirect f/x quote is in units of foreign currency per unit of domestic currency [FC/DC]. – Example: 106.86 Yen/US$ is an indirect quote for the US$ (but direct quote for the Yen). • We will interpret every quote as being “direct”: DC/FC. Therefore , we will always think of whichever country is in the denominator as being the “foreign” country. Please always remember this convention. FINOPMGT 413 Appreciation/Depreciation • A currency is said to appreciate (depreciate) against a foreign currency if you can buy more (less) foreign currency per unit of domestic currency . • Examples: The WSJ reported the following on Wednesday – “Yesterday afternoon in New York, the euro was at $1.4635 from $1. 4827 late Monda y” . The E uro b uys less dollars on TesdaTuesday as opposed to Monday; therefore, the Euro depreciated (and the $ appreciated). – If the Yen-$ rate changed from 106.86 Yen/$ to 106.74 Y/$, has the Yen appreciated or depreciated? [Answer: Depreciated] • When the currency is quoted in direct terms then an increase (decrease) in the quote is an appreciation (depreciation) of the foreign currency. • When its quoted in indirect terms, then an increase in the rate is an appreciation of the domestic currency . FINOPMGT 413 Cross Rates • The cross rate is the exchange rate for converting one foreign currency to another . For example , the rate for Yen/BP would be a called a cross rate. If we know the exchange rate for US$-Yen and US$-BP, we can easily calculate the cross rate . • Example: Friday, Sept 14, 2007 • US$/BP=2.0068, Yen/US$ = 115.30, US$/Euro=1.3878 • What is the Yen/BP cross rate? (Answer: 231.38 Yen/BP) • What is the Euro/BP cross rate? (Answer: 1.4460 Euro/BP) • Qt: Given the rates of the previous week did the Yen appreciate or depreciate against the BP? FINOPMGT 413 Arbitraging Cross Rates (1/2) • Suppose a bank quotes you the following rates: US$/BP= 1.8193, Yen/US$ = 110.27, and 199 Yen/BP. • The implied Yen/BP cross rate (from the $/BP, Yen/$ quotes) is 200.61 Yen/BP. • If the implied cross rate does not equal the quoted cross rate, there there exists an arbitrage opportunity (in this case, the arbitrage opportunity has a specific name - “triangular arbitrage”) . • How would you actually implement such an arbitrage? Buy low, sell high. • In other words, you buy the currency where it is cheaper, and sell where it is more expensive. FINOPMGT 413 Arbitraggging Cross Rates ( 1/2) • The Yen is cheaper at 200.61 Y/BP and more expensive at 199 Yen/BP. • So you buy Yen @ 200.61 (sell BP) and sell Yen @ 199 (buy BP). • How do you implement the arbitrage trade? You simultaneously make the following trades: • Buy Yen for US$ @110.27, Sell Yen for BP @199 , Sell BP for U S$ @ 1. 8193. – US$ 1 => 110.27 Yen (@110.27Yen/$) – Yen 110.27 => (110.27/199) = 0.5541 BP (@ 199 Yen/BP) – BP 0.5541=> 1.0081 US$ (@1.8193$/BP) • You make gains of $8,100 for every $1 million in capital. FINOPMGT 413 Summarizing Steps in Triangular Arbitrage • Assume that the three currencies are the US$ and two other foreign cu rrencies and that y ou w ant to make y ou r arbitrage in US$ . • 1. Identify the weaker non-US currency between implied cross rate and quoted cross rate. – Yen is weaker at imppplied cross rate of 200.61 Yen/BP as compared with actual quote of 199 Yen/BP. • 2. Buy the weak currency low. – Buy Yen @ 110.27 Y/US$. – $1 => 110 .27 Yen • 3. Sell the currency you bought in (2.) high at the cross-rate to buy the other currency cheap – Sell Yen @ 199 Yen/BP. – 110.27 Yen =>0.5541 BP • 4. Sell the currency high to buy the US$ cheap. – Sell BP @ 1.8193 US$/BP – 0. 5541 BP => $1. 0081 FINOPMGT 413 Bid-Ask Spreads • As the dealer who trades foreiggyyn currency with you has to make money, there is a bid-ask spread associated with the quote, i.e. the price for buying the foreign currency is different from the price for selling the currency . • Bid: the price at which the dealer is willing to buy the foreign currency • Ask or Offer: the price at which the dealer is willing to sell the foreign currency. FINOPMGT 413 Examples of Bid-Ask Spreads • BP-US$: 1 .8220 -1. 8229 $/BP • The quote of 1.8220 is the bid or the price at which the dealer will buy the BP (foreign currency) and 1.8229 is the ask price. • Qt: On a $1,000,000 round-trip transaction with the BP, what is the cost that you incur because of the bid -ask spread on BP? Ans: $494 FINOPMGT 413 Bid-AkRAsk Rates an dIdid Indirect Quotes •Suppose the rate is q uoted in indirect terms. What is the bid (ask)? • Example: Yen/USD 107.66 – 107.72 • We have to be careful of how the currency is quoted to figure out the bid and ask (using the principle that the dealer will buy foreign currency low and sell FC high). • Thus: th e d eal er will b uy ( bid) Y en at 107 .72 and sell (offer) at 107.66 (and the dealer will buy USD at 107.66 and sell at 107.72.) • If the currency is quoted in direct (indirect) then the lower (higher) number is the bid. • A word of warning: Its easy to get confused unless you always use one convention. FINOPMGT 413 Bid-Ask and Cross Rates (1/2) • Suppose a US bkbank quotes 1.7019-36 $/BP, an d 0.9850-67 $/Euro. What would be the cross rate for Euro/BP in Frankfurt? • In Frankfurt, the dealer will buy BP at the lower rate and sell BP at a higher rate (in terms of the Euro). So the cross rate w ill refl ect thi s. • Bid: the dealer buys BP at $1.7019 (lower price, bid), and sells Euro at 0.9867 ((ghigher p rice, ask ) = 1.7019/0.9867=1.7250 Euro/BP. FINOPMGT 413 Bid-Ask and Cross Rates (2/2) •Sim ilarl y, to get th e off er rate: th e d eal er will sell BP at th e higher rate (in terms of Euro). • So: Dealer sells BP for USD at offer or ask rate of US$1.7036/BP, and buys Euro at bid rate of $0.9850. So the offer rate for Euro/BP is:1.7036/0.9850=1.7295 E/BPEuro/BP. • Therefore: the cross rate is 1.7250-1.7295 Euro/BP. FINOPMGT 413 Triangular Arbitrage with Bid-Ask Spreads (1/2) • 1. 1. 7019-36 $/BP •2. 0.9850-67$/Euro • 3. 1. 7200-1. 7300 Euro/BP • The implied cross rate is 1.7248-95 Euro/BP. • Does this cons titut e a t ri angul ar arbit rage? FINOPMGT 413 Triangular Arbitrage with Bid-Ask Spreads (2/2) • For there to be a trianggg,yular arbitrage, you have to be able to buy low and sell high. • Dealer 1 (implied cross rate): 1.7248-95 • Dealer 2 : 1.7200-1.7300. • Can you buy the BP low and sell it high? – No. Because one dealer sells you BP @ 1 .7290 while the second buys @ 1.7200. You cannot reverse the transaction also because the second dealer will sell you at 1.7300, and the first dealer buys at 1.7248. In each case, you lose money. • Qt: Can you give examples of a quote that would allow for arbitrage? Provide two examples, one where the BP is pridiced too low, and one wh ere i iit is pri idced too hi hihgh. FINOPMGT 413 Forward Rate Basics (1/2) • What is a ffgorward rate agreement? • The forward exchange contract is an agreement to exchange currencies in the future at a fixed exchange rate. • How does one determine the forward exchange rate? • Answer: by the basic pricing principle that the forward exchange rate should be such that it does not allow for arbitrage. FINOPMGT 413 Basics (2/2) • According to the WSJ, on 2/6/2008, the spot for the Japanese Yen was at 106.86, the 3 month forward was at 106.24, the 6-month forward at 105.76. • Thus, the Yen traded at a premium (was stronger) in the futures market. – Does the futures prices indicate that the market expects the Yen to appreciate over the next year? FINOPMGT 413 What determines the Forward Rate • Expectations do not determine the forward exchange rate . It does not matter that people think or feel that the currency is going to depreciate or appreciate.
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