FINS3616 Tutorial 3

Pavle Radicevic

Section A: Q.1
What is an exchange rate?
An exchange rate is the relative price of
two currencies, like the U.S. dollar price
of the euro, the Thai baht price of the
Malaysian ringgit, or the Mexican peso
price of the Canadian dollar.

Section A: Q.2.
What is the structure of the foreign exchange
market? Is it like the New York Stock
Exchange?
The interbank foreign exchange market is a very
large, diverse, over-the-counter market, not a
physical trading place where buyers and sellers
gather to agree on a price to exchange currencies.
Traders, who are employees of financial institutions
in the major financial cities around the world, deal
with each other primarily over the phone or via
computer, with written or formal electronic
confirmations of transactions occurring only later.

Section A: Q.3.
What is a spot exchange rate contract?
When currencies in the interbank spot market are
traded, certain business conventions are followed.
For example, when the trade involves the U.S.
dollar, business convention dictates that spot
contracts are settled in 2 business daysthat is,
the payment of one currency and receipt of the
other currency occurs in 2 business days. One
business day is necessary because of the backoffice paperwork involved in any financial
transaction. The second day is needed because of
the time zone differences around the world.

Section A: Q.4.
What is an appreciation of the dollar
relative to the pound? What happens to
the dollar price of the pound in this
situation?
An appreciation of the dollar relative to the
pound means that it takes fewer dollars to
buy a pound, so the dollar price of the pound
falls. This situation is also described as the
dollar is stronger in the foreign exchange
market, the pound has depreciated versus
the dollar, and the pound is weaker in the
foreign exchange market.

Section A: Q.5.
Mississippi Mud Pies, Inc. needs to buy 1,000,000
Swiss francs (CHF) to pay its Swiss chocolate
supplier. Its banker quotes bidask rates of
CHF1.39901.4000/USD. What will be the dollar
cost of the CHF1,000,000?
The banks bid rate is CHF1.3990/$. That is the price at
which the bank is willing to buy $1 in return for
CHF1.3990. The bank sells dollars at its ask price
CHF1.4000/$. Mississippi Mud Pies must sell dollars to
the bank to buy CHF. Therefore Mississippi Mud Pies will
receive the banks bid rate of CHF1.3990/$. The dollar
cost of CHF1,000,000 is consequently
CHF 1,000,000 / CHF1.399/$ = $714,796

Section A: Q.6.
If the Japanese yenU.S. dollar exchange
rate is 104.30/$, and it takes 25.15
Thai bahts to purchase 1 dollar, what is
the yen price of the baht?
To prevent triangular arbitrage, the direct
quote of the yen price of the baht (/THB)
must equal the yen price of the dollar times
the dollar price of the baht (which is the
reciprocal of the baht price of the dollar):
104.30/$ *1/(THB25.15/$) =
=104.30/$*$0.03976/THB = 4.1471/THB

Making sense of triangular arbitrage

How to tell if the triangular arbitrage can produce profit?
When you arrange the quotes as follows, the cross multiplication
should equal one

CASE 1: If it is less than 1, sell the currencies in the numerator

to buy the currencies in the denominator of each quote.

Sell CAD 1.60 to buy USD 1.00.

Sell USD 1.00 and buy EUR 0.80.
Sell EUR 0.80 and buy CAD 2.00.
You now have CAD 0.4 more than when you started.
Note: Profit from arbitrage is (1/0.8) - 1= 0.25 or 25%

Making sense of triangular arbitrage

How to tell if the triangular arbitrage can produce profit?
When you arrange the quotes as follows, the cross
multiplication should equal one

CASE 2: If it is greater than 1, sell the currencies in the

denominator to buy the currencies in the numerator.

Sell USD 1.00 and buy CAD 1.60.

Sell CAD 1.60 and buy EUR 0.96.
Sell EUR 0.96 and buy USD 1.20.
You now have USD 0.2 more than when you started.
Note: Profit from arbitrage is (1.2) - 1= 0.2or 20%

Section A: Q.7.
As a foreign exchange trader, you see the following
quotes for Canadian dollars (CAD), U.S. dollars
(USD), and Mexican pesos (MXN):
USD0.7047/CAD
MXN6.4390/CAD MXN8.7535/USD
Is there an arbitrage opportunity, and if so, how
would you exploit it?
The direct quote for the cross-rate of MXN6.4390/CAD
should equal the implied cross-rate using the dollar as
an intermediary currency; otherwise there exists a
triangular arbitrage opportunity. The indirect cross rate
is
MXN8.7535/USD *USD0.7047/CAD = MXN6.1686/CAD

Section A: Q.7.
This indirect cross rate is less than the direct
quote so there is an arbitrage opportunity to
exploit between the three currencies. In this
situation, buying the CAD with MXN by first
buying USD with MXN and then buying the
CAD with the USD and finally selling that
amount of CAD directly for MXN would make
a profit because we would be buying the
CAD at a low MXN price and selling the CAD
at a high MXN price.

Q.7 (our method)

Set the equation:

As it is less than 1, sell the currencies in the

numerator to buy the currencies in the
denominator.
1. Sell USD 1.00 and buy CAD 1.4190.
2. Sell CAD 1.419 and buy MXN 9.1372.
3. Sell MEX 9.1369 and buy USD 1.0438.
4. You now have USD 0.0438 more than when you
started.

Section A: Q.8.
The Mexican peso has weakened considerably
relative to the dollar, and you are trying to decide
whether this is a good time to invest in Mexico.
Suppose the current exchange rate of the Mexican
peso relative to the U.S. dollar is MXN9.5/USD. Your
investment advisor at Goldman Sachs argues that
the peso will lose 15% of its value relative to the
dollar over the next year. What is Goldman Sachss
forecast of the exchange rate in 1 year?
One way to think of this is to say that the investment
advisor is referring to the fact that the Mexican peso
price of the dollar will be 15% higher next year. In this
case, the forecast of the MXN/USD exchange rate in year
1
MXN9.5/USD *1.15 = MXN 10.925/USD (not correct)

Section A: Q.8.
A 15% loss of value of the Mexican peso versus the
U.S. dollar technically means that dollar price of the
peso is 15% lower. We know that the current USD
price of the peso is
1 / (MXN9.5/USD) = USD0.105263/MXN

If this exchange rate falls by 15%, the new

exchange rate will be
0.85 *USD0.105263/MXN = USD0.089474/MNX

In this case the forecast for the future exchange

rate measured in pesos per dollar is
1 / (USD0.089474/MXN) = MXN11.1765/USD

The difference arises because the simple

percentage change in the exchange rate depends
on how the exchange rate is quoted.

Section A: Q.9.
Deutsche Bank quotes bidask rates of
$1.3005/ - $1.3007/ and 104.30 104.40/$. What would be Deutsche Banks
direct asking price of yen per euro? (use the
two rates)
The direct asking price of yen per euro (/) is the
amount of yen that the bank charges someone
who is buying euros with yen. The bank would
want this to be the same as the price at which it
sells dollars for yen (the banks ask price) times
the price at which it sells euros for dollars (also the
banks ask price). Thus, the asking price of yen per
euro should be:
(104.40/$)*($1.3007/) = 135.79/

Section A: Q.10.
Alumina Limited of Australia has called
Mitsubishi UFJ Financial Group to get its
opinion about the Japanese yenAustralian
dollar exchange rate. The current rate is
67.72/A$, and Mitsubishi thinks the
Australian dollar will weaken by 5% over the
next year. What is Mitsubishi UFJs forecast
of the future exchange rate?
If the Australian dollar weakens by 5% over the
next year, it will take 5% fewer Japanese yen to
purchase the Australian dollar. Thus, the
forecast is
67.72/A$ *(1 0.05) = 64.334/A$

Section B: True or False

1. In the spot market, trade is conducted in a single spot or
location.
2. In the forward currency markets, trades are made for future
delivery according to an agreed-upon delivery date,
exchange rate, and amount.
3. A bank that is making a market in lira stands ready to buy lira
at its offer price and sell lira at its bid price.
4. A bank offers you the following quote: $0.8841/C$ BID and
$0.8852/C$ ASK. The bank will buy U.S. dollars at
$0.8841/C$ or sell U.S. dollars at $0.8852/C$.
5. Commercial banks always quote foreign exchange rates with
`the domestic currency in the denominator of the quote.

Section B: True or False

6. The biggest traders in the foreign
exchange markets are corporations

7. When someone in the currency market

can buy a currency at a low price and sell
it for a higher price, it is known as
arbitrage
8. The currency market is the largest
financial market in the world measured in
dollar-volume trade

Section C: MC
1. The biggest traders in the foreign
exchange markets are ____.
a. commercial banks
b. corporations
c. government agencies
d. governments
e. individual investors

Section C: MC
2. Which one of the following features
is not part of the interbank foreign
exchange market?
a. derivative securities such as
foreign currency futures and options
b. trade in swaps and forward
contracts
c. immediate exchanges of monies
d. non-strategic loans
e. none of the above

Section C: MC
3. S$/ArPeso = $0.35/ArPeso and
SArPeso/Rand = ArPeso0.31/Rand.
What is SRand/$?
a. Rand0.886/$
b. Rand1.129/$
c. Rand3.226/$
d. Rand3.459/$
e. Rand9.217/$

Section C: MC
4. What do the market makers in the
currency markets provide?
a. insurance against default by the
buyers
b. solvency
c. stability
d. liquidity
e. collateral

Section C: MC
5. Which one of the following firms
dominates the foreign exchange
markets?
a. No one firm dominates.
b. Deutsche Bank
c. UBS
d. Citigroup
e. Rio Tinto

Section C: MC
6. The foreign exchange desks of
commercial banks typically make their
profits through ____.
a. arbitrage
b. government subsidies
c. investment banking
d. market making
e. speculation

Section C: MC
7. The spot rate is $1.00/ and the
one-year spot rate is $1.10/. What is
percentage change in the dollar?
a. 10%
b. 9.1%
c. 0%
d. -9.1%
e. -10%