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CHAPTER 6 THE FOREIGN EXCHANGE MARKET

Chapter 6 is basically institutional in nature although it opens by discussing the rationale for a foreign exchange market, namely to facilitate the transfer of purchasing power denominated in one currency to purchasing power denominated in another currency. Like other financial markets, the foreign exchange market facilitates trading in financial assets by lowering transaction costs. The balance of the chapter provides the institutional framework of the foreign exchange market, both spot and forward transactions. It discusses pricing conventions, costs, size, and participants, and goes through some of the mechanics of foreign exchange trading. I always illustrate this subject matter with quotes found in The Wall Street Journal. Every issue of the Journal contains a story on the foreign exchange market, providing spot quotations for the Canadian dollar, pound sterling, Swiss francs, euros, and Japanese yen. The financial section also carries a more extensive listing of spot and forward prices for about forty currencies.

SUGGESTED ANSWERS TO CHAPTER 6 QUESTIONS

1. a. Answer the following questions based on data in Exhibit 6.4. How many Swiss francs can you get for one dollar?

ANSWER . The indirect quote is $1 = SFr 1.7153.

b. How many dollars can you get for one Swiss franc?

ANSWER . The direct quote is SFr1 = $0.5830.

c. What is the three-month forward rate for the Swiss franc?

ANSWER . The three-month forward rate is SFr1 = $0.5875.

d. Is the Swiss franc selling at a forward premium or discount?

ANSWER . Since the forward rate is greater than the spot rate, the Swiss franc is selling at a forward premium.
e. What is the 90-day forward discount or premium on the Swiss franc?

ANSWER . The 90-day forward premium is

[$0.5875 - $0.56830)/$0.5830] x 4 = 3.09% 2. What risks confront dealers in the foreign exchange market? How can they cope with these risks?

ANSWER. Foreign exchange dealers must cope with exchange risk, because of the foreign currency positions they take.
They also bear credit risks since the counterparties to the trades they enter into may not honor their obligations.

66 INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 4TH ED. They can cope with currency risk by using forward contracts and currency options (see Chapter 10), widening their bidask quotes, and limiting the position they are willing to take in any one currency. They can limit credit risk by restricting the position they are willing to take with any one customer and by setting margin requirements that vary with the riskiness of their customers (banks will generally not do this). 3. Suppose a currency increases in volatility. What is likely to happen to its bid-ask spread? Why?

ANSWER . As a currency's volatility increases, it becomes riskier for traders to take positions in that currency. To
compensate for the added risks, traders quote wider bid-ask spreads. 4. Who are the principal users of the forward market? What are their motives?

ANSWER . The principal users of the forward market are currency arbitrageurs, hedgers, importers and exporters, and
speculators. Arbitrageurs wish to earn risk-free profits; hedgers, importers and exporters want to protect the home currency values of various foreign currency-denominated assets and liabilities; and speculators actively expose themselves to exchange risk to benefit from expected movements in exchange rates. 5. How does a company pay for the foreign exchange services of a commercial bank?

ANSWER . Companies compensate banks for foreign exchange services through the bid-ask spread. The bank will buy
foreign exchange at the bid rate (low) and sell at the ask rate (high). 6. What factors might lead to persistent covered interest arbitrage opportunities among countries?

ANSWER . This question more properly belongs in Chapter 8. In any event, the principal factor would be the existence
of political risk, particularly the fear that at some point the government would impose exchange controls, not allowing capital to be removed. Another possible factor is differential tax laws which could lead to similar after-tax returns, even if before-tax returns differ. 7. How have forward premiums and discounts relative to the dollar changed over annual intervals during the past five years for the Japanese yen, British pound, French franc, and Deutsche mark? Use beginning of year data.

ANSWER . This question can only be answered by reference to the data. SUGGESTED SOLUTIONS TO CHAPTER 6 PROBLEMS
1. The $:DM exchange rate is DM 1 = $0.35, and the DM:FF exchange rate is FF 1 = DM 0.31. What is the FF:$ exchange rate?

ANSWER . FF1 = DM 0.31 x .35 = $0.1085.

2. Suppose the direct quote for sterling in New York is 1.1110-5. What is the direct quote for dollars in London?

ANSWER. The direct quote for the dollar in London is just the reciprocal of the direct quote for the pound in New York
or 1/1.1115 - 1/1.1110 = 0.8997-0.9001. 3. Suppose the quote on pounds is $1.624-31. a. If you converted $10,000 to pounds and then back to dollars, how many dollars would you end up with?

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ANSWER . For $10,000, you would buy pounds at the price of $1.631, giving you 6,131.21 ($10,000/1.631) and resell
them at the bid price of $1.624. The latter transaction would yield $9,957.08, resulting in a round-trip cost of $42.92. b. Suppose you could buy pounds at the bid rate and sell them at the ask rate. How many dollars would you have to transact in order to earn $1,000 on a round-trip transaction (buying pounds for dollars and then selling the pounds for dollars)?

ANSWER . For every pound you could buy at the bid and sell at the ask, you would earn the spread of $0.007. To earn
$1,000, you would have to transact 142,857.14 ($1,000/$0.0007). At the current bid rate of $1.624,this is equivalent to $232,000 (142,857.14 x $1.624). 4. Using the data in Exhibit 6.4, calculate the 30-day, 90-day, and 180-day forward discounts for the British pound.

ANSWER . In reality, the pound is selling at a forward premium. Here are the relevant rates for the pound:
Spot: 30-day forward: 90-day forward: 180-day forward : The 30-day forward premium is: The 90-day forward premium is: 1 = $1.4487 1 = $1.4498 1 = $1.4511 1 = $1.4529 [($1.4498 - $1.4487)/$1.4487] x 12 = 0.91% [($1.4511 - $1.4487)/$1.4487] x 4 = 0.66%

The 180-day forward premium is: [($1.4529 - $1.4487)/$1.4487] x 2 = 0.58% In this case, the forward premiums at these maturities are very small, indicating that British and U.S. interest rates are virtually identical. 5. a. An investor wishes to buy French francs spot (at $0.1080) and sell French francs forward for 180 days (at $0.1086). What is the swap rate on French francs?

ANSWER . A premium of 6 points.

b. What is the premium on 180-day French francs?

ANSWER . The 180-day premium is (0.1086 - 0.1080)/0.1080 x 2 = 1.11%.

6. The spot and 90-day forward rates for the pound are $1.1376 and $1.1350, respectively. What is the forward premium or discount on the pound?

ANSWER . The forward premium (discount) on the British pound is

[(f 1 - e 0)/e0] x (360/n) = [(1.1350 - 1.1376)/1.1376] x 4 = -.91% which is a forward discount of .91%. 7. a. Suppose Credit Suisse quotes spot and 90-day forward rates of $0.7957-60, 8-13. What are the outright 90-day forward rates that Credit Suisse is quoting?

68 INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 4TH ED.

ANSWER . The outright forwards are: bid rate = $0.7965 (0.7957 + 0.0008) and ask rate = $0.7973 (0.7960 + 0.0013).
b. What is the forward discount or premium associated with buying 90-day Swiss francs?

ANSWER . The annualized forward premium = [(0.7973 - 0.7960)/0.7960]x 4 = 0.65%.

c. Compute the percentage bid-ask spreads on spot and forward Swiss francs.

ANSWER . The bid-ask spread is calculated as follows: Percent spread = Ask price - Bid price x 100 Ask price

Substituting in the numbers yields a spot bid-ask spread of (0.7960 - 0.7957)/0.7960 = 0.04%. The corresponding forward bid-ask spread is (0.7973 - 0.7965)/0.7973 = 0.10%. 8. a. Suppose the spot quote on the Deutsche mark is $0.3302-10, and the spot quote on the French franc is $0.1180-90. Compute the percentage bid-ask spreads on the DM and franc.

ANSWER . The percentage bid-ask spreads on the DM and franc are calculated as follows:
DM bid-ask spread = (0.3310 - 0.3302)/0.3310 = 0.24% FF bid-ask spread = (0.1190 - 0.1180)/0.1190 = 0.84% b. What is the direct spot quote for the franc in Frankfurt?

ANSWER . In order to sell one franc for DM, first sell the franc for $0.1180 and then convert $0.1180 into DM at the
ask rate of $0.3310. Thus the bid rate for the franc is 0.1180/0.3310 = DM.3565. Similarly, to acquire one franc, sell DM for dollars and then sell dollars for francs. Specifically, it costs $0.1190 to buy FF1. Because DM1 can be converted into $0.3302, it takes DM0.1190/0.3302 = DM0.3604 to buy $0.1190. Thus the ask rate for francs is DM0.3604. The bid-ask quote on the franc in Frankfurt is therefore DM0.3565-604. 9. a. Suppose Dow Chemical receives quotes of $0.009369-71 for the yen and $0.03675-6 for the Taiwan dollar (NT$). How many U.S. dollars will Dow Chemical receive from the sale of 50 million?

ANSWER . Dow must sell yen at the bid rate, meaning it will receive from this sale $468,450 (50,000,000 x 0.009369).
b. What is the U.S. dollar cost to Dow Chemical of buying 1 billion?

ANSWER . Dow must buy at the ask rate, meaning it will cost Dow $9,371,000 (1,000,000,000 x 0.009371) to buy 1
billion. c. How many NT$ will Dow Chemical receive for U.S.$500,000?

ANSWER . Dow must sell at the bid rate for U.S. dollars (which is the reciprocal of the ask rate for NT$, or 1/0.03676),
meaning it will receive from this sale of U.S. dollars NT$13,601,741 (500,000/0.03676). d. How many yen will Dow Chemical receive for NT$200 million?

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ANSWER. To buy yen, Dow must first sell the NT$200 million for U.S. dollars at the bid rate and then use these dollars
to buy yen at the ask rate. The net result from these transactions is 784,334,649.45 (200,000,000 x 0.03675/0.009371). e. What is the yen cost to Dow Chemical of buying NT$80 million?

ANSWER . Dow must sell the yen for dollars at the bid rate and then buy NT$ at the ask rate with the U.S. dollars. The
net yen cost to Dow from carrying out these transactions is 313,886,220.51 (80,000,000 x 0.03676/0.009369) 10. Suppose you observe the following direct spot quotations in New York and Toronto, respectively: 0.8000-50 and 1.2500-60. What are the arbitrage profits per $1 million?

ANSWER . Converting the direct quotes in Toronto into indirect quotes yields bid-ask rates for the Canadian dollar in
terms of the U.S. dollar of U.S.$.7962-.8000. Hence, there is no arbitrage opportunity. 11. Suppose the DM is quoted at 0.2074-80 in London, and the pound sterling is quoted at 4.7010-32 in Frankfurt. a. Is there a profitable arbitrage situation? Describe it.

ANSWER . Buy DM for .2080. Buy pounds for DM 4.7032. This is equivalent to selling DM for .2126. There is a
net profit of .0046 per DM bought and sold--a percentage yield of 2.21% (.0046/.2080). b. Compute the percentage bid-ask spreads on the pound and DM.

ANSWER . The percentage bid-ask spreads on the pound and DM are calculated as follows:
bid-ask spread = (4.7032 - 4.7010)/4.7032 = 0.05% DM bid-ask spread = (.2080 - .2074)/ .2080 = 0.29% 12. Assuming no transaction costs, suppose 1 = $2.4110 in New York, $1 = FF 3.997 in Paris, and FF 1 = 0.1088 in London. How could you take profitable advantage of these rates?

ANSWER . Sell pounds in New York for $2.4110 apiece. Sell the dollars in Paris for FF 3.997, and sell the francs in
London for .1088. This sequence of transactions yields 2.4110 x 3.997 x .1088 pounds or 1.0485 per pound initially traded. 13. As a foreign exchange trader at Sumitomo Bank, one of your customers would like a yen quote on Australian dollars. Current market rates are: Spot 30-day 101.37-85/U.S.$1 15-13 A$1.2924-44/U.S.$1 20-26 a. What bid and ask yen cross rates would you quote on spot Australian dollars?

ANSWER . By means of triangular arbitrage, we can calculate the market quotes for the Australian dollar in terms of
yen as 78.31-81/A$1 These prices can be found as follows. For the yen bid price for the Australian dollar, we need to first sell Australian dollars for U.S. dollars and then sell the U.S. dollars for yen. It costs A$1.2944 to buy U.S.$1. With U.S.$1 we can buy 101.37. Hence, A$1.2944 = 101.37, or A$1 = 78.31. This is the yen bid price for the Australian dollar.

70 INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 4TH ED.

The yen ask price for the Australian dollar can be found by first selling yen for U.S. dollars and then using the U.S. dollars to buy Australian dollars. Given the quotes above, it costs 101.85 to buy U.S.$1, which can be sold for A$1.2924. Hence, A$1.2924 = 101.85, or A$1 = 78.81. This is the yen ask price for the Australian dollar. As a foreign exchange trader, you would try to buy Australian dollars at slightly less than 78.31 and sell them at slightly more than 78.81. Buying and selling Australian dollars at the market price will leave you with no profit. How much better than the market prices you can do depends on the degree of competition you face from other traders and the extent to which your customers are willing to shop around to get better quotes. b. What outright yen cross rates would you quote on 30-day forward Australian dollars?

ANSWER . Given the swap rates, we can compute the outright forward direct quotes for the yen and Australian dollar
by adding or subtracting the forward points as follows Spot 101.37-85/U.S.$1 A$1.2924-44/U.S.$1 30-day 15-13 20-26 30-day outright forward rates 101.22-72/U.S.$1 A$1.2944-70/U.S.$1

By means of triangular arbitrage, we can then calculate the market quotes for the 30-day forward Australian dollar in terms of yen as 78.04-58/A$1 These prices can be found as follows. For the yen bid price for the forward Australian dollar, we need to first sell Australian dollars forward for U.S. dollars and then sell the U.S. dollars forward for yen. It costs A$1.2970 to buy U.S.$1 forward. With U.S.$1 we can buy 101.22. Hence, A$1.2970 = 101.22, or A$1 = 78.04. This is the yen bid price for the forward Australian dollar. The yen ask price for the Australian dollar can be found by first selling yen forward for U.S. dollars and then using the U.S. dollars to buy forward Australian dollars. Given the quotes above, it costs 101.72 to buy U.S.$1, which can be sold for A$1.2944. Hence, A$1.2944 = 101.71, or A$1 = 78.58. This is the yen ask price for the forward Australian dollar. c. What is the forward premium or discount on buying 30-day Australian dollars against yen delivery?

ANSWER . As shown in parts a and b, the ask rate for 30-day forward Australian dollars is 78.58 and the spot ask rate
is 78.81. Thus, the Australian dollar is selling at a forward discount to the yen. The annualized discount equals -3.43%, computed as follows: Forward premium Forward rate Spot rate 360 78.58 - 78.81 360 = x = x = - 3.43% Forward contract or discount Spot rate 78.81 30 number of days

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14. Suppose Air France receives the following indirect quotes in New York: FF 5.72 - 6 and 0.63 - 4. Given these quotes, what range of /FF bid and ask quotes in Paris will permit arbitrage?

ANSWER . Triangular arbitrage can take place in either of two ways: (1) Convert from francs to dollars (at the ask rate),
then from dollars to pounds (at the bid rate), or (2) convert from pounds to dollars (at the ask rate), then from dollars to francs (at the bid rate). The first quote will give us the bid price for the franc in terms of the pound and the second quote will yield the ask price. Using the given rates, Air France would end up with the following amounts: (1) Francs to pounds = = = = = FF/U.S.$ (ask) x 5.76 x FF 9.1429/ or 0.1094/FF /U.S.$ (ask) 0.64 0.1189/FF x x U.S.$/ (bid) 1/0.63

(2) Pounds to francs

U.S.$/FF (bid) 1/5.72

The import of the figures in method (1) is that Air France can buy pounds in New York for FF 9.1429/, which is the equivalent of selling francs at a rate of 0.1094/FF. So, if Air France can buy francs in Paris for less than 0.1094/FF (which is the equivalent of selling pounds for more than FF 9.1429/), it can earn an arbitrage profit. Similarly, the figures in method (2) tell us that Air France can buy francs in New York at a cost of 0.1189/FF. Given this exchange rate, Air France can earn an arbitrage profit if it can sell these francs for more than 0.1189/FF in Paris. Thus, Air France can profitably arbitrage between New York and Paris if the bid rate for the franc in Paris is greater than 0.1189/FF or the ask rate is less than 0.1094/FF. 15. Suppose the DM is quoted at $0.5782-92, while the yen is quoted at $0.001760-69. a. Given these quotes for the DM and yen, what is the maximum bid-ask spread in the /DM rate for which there is no arbitrage?

ANSWER . The /DM bid rate based on triangular arbitrage is 326.85/DM 1 (0.5782/0.001769). Similarly, the /DM
ask rate based on triangular arbitrage is 329.09/DM 1 (0.5792/0.001760). Hence, the bid-ask spread based on triangular arbitrage is 329.09 - 326.85 = 2.24. This spread is the maximum one would expect. Beyond this spread, it would be profitable to engage in triangular arbitrage. b. What is the maximum bid-ask spread in percentage terms?

ANSWER . The maximum bid-ask spread in percentage terms equals the maximum spread divided by the bid price or
2.24/326.85 = 0.69%. Relative to the ask price, this percentage is 0.68% (2.24/329.09). 16. Assume the pound sterling is worth FF 9.80 in Paris and SFr 5.40 in Zurich. a. Show how British arbitrageurs can make profits given that the Swiss franc is worth two French francs. What would be the profit per pound transacted?

ANSWER . Sell pounds in Zurich for SFr 5.40. Sell Swiss francs in Zurich for FF2. Then buy pounds in Paris for
FF9.80. This yields (5.40 x 2)/9.8 = 1.102 or a profit of .102 per pound transacted. b. What would be the eventual outcome on exchange rates in Paris and Zurich given these arbitrage activities?

ANSWER . The Swiss franc price of the pound would decline in Zurich. The Swiss franc would depreciate relative to
the French franc. The pound would appreciate relative to the French franc in Paris.

72 INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 4TH ED. c. Rewo rk Part a, assuming that transaction costs amount to 0.6% of the amount transacted. What would be the profit per pound transacted?

ANSWER . Each transaction costs 0.6%. Thus, at each stage the arbitrageur receives 99.4% of what he previously
received. Thus after the three transactions undertaken in part a, the arbitrageur receives 1.102 x (.994) 3 = 1.0823 for a profit per pound sold equal to .0823. d. Suppose the Swiss franc is quoted at FF 2 in Zurich. Given a transaction cost of 0.6% of the amount transacted, what are the minimum/maximum French franc prices for the Swiss franc that you would expect to see quoted in Paris?

ANSWER . With a transaction cost of .6%, an arbitrageur will receive 99.4% of what she would receive absent these
costs. To find the maximum and minimum French franc prices for the Swiss franc that would be quoted in Paris, it is sufficient to invoke the following no-arbitrage conditions: 1. Converting FF1 into Swiss francs in Zurich and then converting the Swiss francs back into French francs in Paris should yield no more than one FF1. Converting SFr 1 into French francs in Zurich and then converting the French francs back into Swiss francs in Paris should yield no more than SFr1.

2.

If e is the direct quote for the Swiss franc in Paris, the first no-arbitrage condition says that 0.5 x 0.994 x e x 0.994 < 1 or e < 2.0242 According to the second no-arbitrage condition, 2 x 0.994 x (1/e) x 0.994 < 1 or e > 1.9761 Combining these two inequalities yields the minimum and maximum exchange rates or 1.9761 < e < 2.0242. 17. Examine the following currency cross rates. The quotes are expressed as units of the currency represented in the left-hand column per unit of currency shown in the top row. Consider the dollar rates to be the quotes off which the cross rates are set. Currency DM FF a. DM -3.3818-25 .41227-35 78.381-496 FF .29570-76 -.12381-90 23.178-251 2.4256-67 8.2031-41 -190.121-390 0.1276-78 0.4315-19 .00526.29 -U.S.$ 1.5780-86 5.3021-33 .6502-10 123.569-707

Do any triangular arbitrage opportunities exist among these currencies? Assume that any deviations from the theoretical cross rates of 5 points or less are due to transaction costs.

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ANSWER. Unfortunately, there are no shortcuts here. It is necessary to try out each possibility. Here are the 4 arbitrage
opportunities that I found. If anyone finds any additional ones, please contact me at (213) 740-6556. 1. Convert dollars to DM, DM to FF, and FF back to dollars. The profit per dollar equals $1 x 1.5780 x 3.3818/5.3033 - $1 = $0.0063. Convert dollars to FF, FF to pounds, and pounds back to dollars. The profit per dollar equals $1 x 5.3021 x .12381/.6510 - 1 = $0.0084. Convert dollars to pounds, pounds to FF, and FF back to dollars. The profit per dollar equals $1 x .6502 x 8.2031/5.3033 - 1 = $0.0057. Convert dollars to yen, yen to FF, and FF back to dollars. The profit per dollar equals $1 x 123.569 x .04315/5.3033 - 1 = $0.0054.

2.

3.

4.

b.

How much profit could be made from a $5 million transaction associated with each arbitrage opportunity?

ANSWER . All the answers are based on rounding the arbitrage profit per dollar to the fourth decimal place.
1. 2. 3. 4. The profit for the $/DM/FF/$ arbitrage will be $5,000,000 x 0.0063 = $31,500. The profit from the $/FF//$ arbitrage will be $5,000,000 x 0.0084 = $42,000. The profit from the $//FF/$ arbitrage will be $5,000,000 x 0.0057 = $28,500. The profit from the $//FF/$ arbitrage will be $5,000,000 x 0.0054 = $27,000.

74 INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 4TH ED.

NOTES ON FOREIGN EXCHANGE QUOTES

1. Spot rate - rate at which foreign exchange can be bought or sold for immediate delivery. DM1 = $.4107 FF1 = $.1340 a) Actual rates are given in pairs: a bid (buy) rate and ask (sell) rate DM1 = $.4107-10 FF1 = $.1340-42 b) Cross rates: DM1 = FF3.0649 (.4107/.1340) DM1 = FF3.0604-72 (.4107/.1342 - .4110/.1340) c) Measuring currency changes Thursday, January 9, 1986: DM1 = $.4107 or $1 = DM2.4350 Thursday, January 31, 1985: DM1 = $.3163 or $1 = DM3.1615 The DM is said to have appreciated against the dollar by (.4107 - .3163)/.3163 = 29.85%. Alternatively, the dollar is said to have depreciated against the DM by (2.4350 - 3.1615)/3.1615 = - 22.98%. Thursday, January 9, 1986: Cr$1 = $.00009615 or $1 = Cr$10400 Thursday, January 31, 1985: Cr$1 = $.0002899 or $1 = Cr$3449.50 The Brazilian cruzeiro has depreciated against the dollar by (.00009615 - .0002899)/.0002899 = - 66.83%.. Alternatively, the dollar has appreciated against the cruzeiro by (10400 - 3449.5)/3449.5 = 201.49%. Note: The new Brazilian currency is now the real. This example dates back to a time when the Brazilian currency was running a very high rate of inflation and so was continually devaluing 2. Forward rate - rate at which foreign exchange can be bought or sold today for delivery at a fixed future date, typically in multiples of 30 days, e.g., 30, 60, 90, or 180 days. Forward quotations 30 day forward rates DM1 = $.4120 FF1 = $.1338

a)

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b) Forward premium (+) or discount (-) (annualized) = [(forward rate - spot rate)/spot rate] x (360/n) where n is the number of days in the forward contract. Thus, the DM is selling at an annualized forward premium of [(0.4120 - 0.4107)/0.4107] x 12 = 3.80%. The French franc is selling at an annualized forward discount of [(0.1338 - 0.1340)/0.1340] x 12 = - 1.79%. c) Swap rates Spot rates: DM1 = $.4107-10 FF1 = $.1340-42 30-day forward rates: DM1 = $.4120-25 FF1 = $.1338-41 Expressed as: DM1 = $0.4107-10 13-15 FF1 = $0.1340-42 2-1

d) Cross rates on a 30-day forward contract: DM1 = FF3.0723-830 (0.4120/0.1341 - 0.4125/0.1338)