Foreign Exchange
Foreign Exchange
Foreign Exchange
Exchange Rate
An exchange rate is the rate at which one
currency can be exchanged for another.
In other words, it is the value of another
country's currency compared to that of own
country
Foreign exchange markets provide the facility of
exchanging different currencies.
The price of one currency in terms of another is
known as exchange rate.
Functions
1. Transfer of funds or Purchasing power
from one currency and nation to another
2. Minimize foreign exchange risk
Four level of participants
1. Tourists 2. C. B.
3. F. E. Brokers 4. Central Banks
Spot market is the market where transactions of buying and selling are done for
immediate delivery. In real practice, cash settlement is made after two working
(business) days, excluding holidays. In some cases, it takes less than two days also.
For example, the trades between US dollar and Canadian dollar or Mexican peso are
settled in one day.
London market is the first market not only in terms of volume but also in terms of the
number of currencies traded there. The most significant currencies in terms of volume
of their trade are dollar, yen, euro, UK pound and Swiss franc.
The spot exchange market is an over-the-counter (OTC) market. This
market is a worldwide linkage of currency traders, non-bank dealers, foreign
exchange brokers who are connected to one another via a network of
telephones, computer terminals and automated dealing systems. The largest
vendors of quote screen monitors used in the currency trading are Reuters,
Bloomberg etc
F E Quotation
Is the price of a currency expressed in
units of another currency
FD = FR < SR
FP = FR > SR
Premium, Discount
SR =$ 0.8576
FR =$0.8500
For a 90 day contract
Prem or Dis = FR-SR * 4 * 100
SR
FD = 0.8500 - 0.8576 * 4 * 100
0.8576
= 3.54%
71.479
46.700
.0139
.0214
Arbitrage
If the dollar price of pounds were $1.98 in New
York and $2.01 in London, an arbitrager (usually
a commercial bank or a foreign exchange
dealer) would purchase pounds at $1.98 in New
York and immediately resell them in London for
$2.01, thus realizing a profit of $0.03 per pound.
If the transaction involved 1 million, the profit
would be $30,000 for only a few minutes work
BID (Buy)
ASK (Sell)
US $ per 1 Belgian Franc
Spot rate $ 0.02368 $ 0.02370
1 Month $ 0.02372
$0.02375
3 Month $ 0.0236
$0.02363
6 Month $ 0.02354 $ 0.02358
US $ per 1 Belgian Franc
Interest Arbitrage
Interest arbitrage refers to the international
flow of short-term liquid capital to earn a
higher return abroad. Interest arbitrage
can be covered or uncovered.
UNCOVERED INTEREST ARBITRAGE
If the interest rate on three-month treasury
bills is 13 per cent at an annual basis in
Germany and 18 per cent in London.
COVERED INTEREST ARBITRAGE
Question
1. Spot Rate: Rs 42.0010 = $1
6 month forward rate: Rs 42.8020 = $1
Annualized interest rate on 6 month rupee : 12
per cent
Annualized interest rate on 6 month dollar: 8 per
cent.
Calculate the arbitrage possibilities
Solution: The rule is that if the interest rate
differential is greater than the premium or
discount, place the money in the currency that
has a higher rate of interest or vice-versa.