FOREIGN EXCHANGE

MARKETS AND EXCHANGE

RATES

Foreign Exchange Markets and

Exchange Rates
Foreign exchange market is the worlds
largest financial market.
In this market, one countrys currency is
traded for anothers.
Most of the trading takes place in a few
currencies:
U.S. dollar ($)
British pound sterling ()
Japanese yen ()
Euro ()

Exchange Rates
The price of one countrys currency
expressed in terms of another countrys
currency.
Most currency is quoted in terms of dollars.
Consider the following quote:
Euro
$1.3170/
0.7593/$
The first number (1.3170) is how many U.S.
dollars it takes to buy 1 Euro
The second number (0.7593) is how many
Euros it takes to buy $1
The two numbers are reciprocals of each
other (1/1.3170 = 0.7593)

Exchange Rates

Direct quote = the amount of home

currency per unit of foreign currency.
RM4.2 / $1
Indirect quote = the amount of
foreign currency per unit of home
currency
$0.23 / RM1

Example

Suppose you have $10,000.

How many Swiss Francs can you buy?
Exchange rate = 1.0884 Francs per dollar
Buy 10,000 x 1.0884 = 10,884 Francs
(or 10,000 / 0.9188 = 10,884 Francs)

Example

Suppose you are visiting Bombay and you

want to buy a souvenir that costs 1,000 Indian
Rupees. How much does it cost in U.S. dollars?
Exchange rate = 46.490 rupees per dollar
Cost = 1,000 / 46.490 = $21.51
(Or 1,000 x 0.02151 = $21.51)

Example

If a Porsche costs 100,000 euro, how

many dollars will you need to buy it?

ANSWER

Cross Rates

The exchange rate between two

currencies when both are quoted in
some third currency.
The value of 1 unit of any non-dollar
currency in terms of another is its
value in dollar divided by the other
currencys value in dollar.

Cross Rates
Suppose we observe the following for
the euro () and the Swiss franc (SF):
$1 /
$0.5 / SF
(assume $ is home currency)
Then the value of 1 SF in euro is:
value of SF in $ / value of in $
= 0.5 / 1 = 0.5/SF1

Cross Rates

Suppose the peso is worth $0.07 and

the Canadian dollar is worth $0.70.
The value of 1 peso in Canadian
dollar (C$) is:
Value of peso in $ / Value of C$ in $
= 0.07 / 0.70
= C$0.10 / peso

Exercise 1

Assume Polands currency (the zloty)

is worth $0.17 and the Japanese yen
is worth $0.008.
How many yen equal a zloty?

Answer

Triangular Arbitrage
Suppose we observe the following for
the euro () and the Swiss franc (SF):
$1 /
$0.50 / SF
Suppose you have $100 and the cross
rate is quoted as per SF = 0.40.
What would you do?

Triangular Arbitrage

Cross rate is quoted as 0.40 per SF

The actual value is:
Value of SF in $ / Value of in $
= 0.50 / 1
= 0.50 / SF
At 0.40 per SF:
SF is cheaper than its actual value.
What would you do?

Triangular Arbitrage

To make money, buy low and sell

high.
So, sell euros to buy Swiss francs.

Triangular Arbitrage
Assume you have $100
Buy 100 euros for $100
Use the 100 euros to buy Swiss francs:
The exchange rate is 0.40 / SF
100 / 0.40 = SF250
3. Use the SF250 to buy dollars:
The exchange rate is $0.50 / SF
SF250 x 0.50 = $125

You make a profit of $25

1.

2.

3.

Exercise 2
Suppose:
$1.67 /
$0.50 / SF
and the cross rate is quoted as SF3 / .
Explain how to go about making some
money.
Assume you have $100.

Answer

Exercise 3

Which would you rather to have, $100 or

100? Explain
2. Which would you rather to have, SF100 or
100? Explain

Answer

$100 or 100?

Answer

SF100 or 100?

Exercise 4
Suppose the Japanese yen exchange
rate is 1 = $0.009, and the British
pound exchange rate is 1 = $1.65.
What is the cross-rate in terms of yen
per pound?
2. Suppose the cross-rate is 185 = 1.
Is there an arbitrage opportunity here?
If there is, explain how to take
advantage of
the mispricing.

Answer 1
1.

Cross rate ( / ) :

Answer 2

Exercise 5
Value of Canadian dollar in U.S. dollar is
$0.90
Value of New Zealand dollar in U.S. dollar
is $0.30.
Value of Canadian dollar in New Zealand
dollar is NZ$3.02
Question:
Is triangle arbitrage possible? Assume you
have $1 million, explain your strategy.

Answer

Exercise 6
Today you notice the following exchange
rate quotations:
$1 is equal to 3.00 Argentine pesos
1 Argentine peso = 0.50 Canadian
dollars
You need to purchase 100,000 Canadian
dollars with U.S. dollars.
How many U.S. dollars will you need for
your purchase?

Answer

Exercise 7

Assume the euro appreciated against

the dollar.
Did the direct exchange rate of the
euro increase or decrease?
Did the indirect exchange rate of the
euro increase or decrease?

ANSWER