Currency Exchange Rates

Copyright 2009 Pearson Prentice Hall. All rights reserved.
Chapter 1
Currency
Exchange
Rates
1 - 2
Chapter One - Outline
In this chapter we cover:
currency exchange rate quotations (direct and
indirect; spot and forward)
cross-rate calculations
nature of bid-ask quotes and spreads
calculation of forward premiums/discounts on
exchange rates.
covered interest rate parity
covered interest arbitrage
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Currency Abbreviations
Abbreviations are used to refer to the various
currencies. These abbreviations could be commonly
used symbols or official three-letter codes.
Financial newspapers such as the Financial Times
generally use symbols, while traders use three-letter
codes. Symbols include $ (U.S. dollar), ( Japanese
yen), (euro), (British pound), A$ (Australian
dollar), and Sfr (Swiss franc).
Three-letter codes for the same currencies are USD,
JPY, EUR, GBP, AUD, and CHF.
We will alternatively use in this book (as done in the
real world) the various currency abbreviations that are
commonly encountered. For example, the Japanese
yen can be referred to as , JPY, or yen.

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Currency Exchange Rate Quotations
A currency exchange rate is the rate used to
exchange two currencies. An exchange rate
states the price of one currency in terms of
units of another currency.
Examples: $:, :$, :$
Note: the notation in this new edition of the
text has changed relative to previous
editions.

1 - 5
Quote Convention used in this text
All quotes in this text will be presented as
a:b = S
where a is the quoted currency
b is the currency in which the price is expressed
S is the price of the quoted currency a in units
of currency b
For example, $: = 130 means the U.S. dollar is
quoted at 130 Japanese yen () per dollar. Or
the U.S. dollar is priced at 130 yen.
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Direct Exchange Quotes
A direct exchange rate is the domestic price of
foreign currency.
For example, an American investor seeing a direct
quote :$ = 1.34 knows she will pay $1.34 for one
euro.
To a European investor, the direct quote is $: =
0.74627 which says that 1 dollar (foreign
currency) is worth 0.74627 euro.
An appreciation of the foreign currency causes an
increase in the direct quote.
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Indirect Foreign Exchange Quotations
An indirect exchange rate is the amount of foreign
currency that one unit of domestic currency will
purchase.
For an American investor, the indirect quote $: =
0.74627 says that 1 dollar will purchase 0.74627
euro.
Direct quotes and indirect quotes are reciprocals
of each other.
An appreciation of the foreign currency causes a
decrease in the indirect quote.
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Example: Direct and Indirect Exchange
Rates
On July 1, the British pound () is quoted as
:$ = 1.80.
Is this a direct or indirect quote from the
viewpoint of an American and a British
investor?
A month later, the exchange rate moved to :$
= 1.90. Which currencies appreciated or
depreciated?
1 - 9
Example: Direct and Indirect Exchange
Rates - Continued
Answer: The pound is quoted in terms of
dollars. This quote is a direct quote from the
American viewpoint and an indirect quote
from the British viewpoint.
The pound is the quoted currency. Over a
month, the pounds price increased from
$1.80 to $1.90, so the pound appreciated
and the dollar depreciated.

1 - 10
Currency Movements and Exchange
Rate Quotations
1 - 11
Cross Rate Calculations
A cross rate is the exchange rate between two
countries inferred from each countrys
exchange rate with a third country.
For example, bank A gives the following
quotations:
:$ = 1.3364
$: = 123.52
Calculate the euro in yen (:) rate:
(:$) ($:) = 1.3364 123.52 = 165.07
The resulting quotation is: : = 165.07. One
euro is worth 165.07 yen.
1 - 12
Cross Rate Calculations Example 2
For example, bank B gives the following
quotations for the Korean won and the
Brazilian real:
$: won = 928.350
$: R$ = 1.9094
Calculate the R$:won rate:
($:won) ($:R$) = 928.35/1.9094 = 486.20
The resulting quotation is: R$:won = 486.20.
One Brazilian Real is worth 486.50 won.

1 - 13
Foreign Exchange Market
The international currency market has two
main components:
A worldwide Forex market between major banks
and specialized currency dealers. This is a
wholesale interbank market for large transactions.
It is an Over The Counter (OTC) market, by
telephone and electronic trading platforms, where
trading takes place 24 hours a day, 5 days a week.
It is the largest and most liquid financial market
in the world.
A retail market where investors and corporations
deal with local banks.

1 - 14
Forex Market Conventions 1
There is no need to quote both a direct and indirect
rate, e.g. both $: and :$. History mostly dictates
the exchange rate direction that is selected:
There is a decreasing order of seniority with the
British pound as the senior currency. The Forex
convention is to trade British pounds in units of
other currencies, so the quote showing on Forex
trading screens is the foreign exchange value of
one GBP, that is, GBP:EUR, GBP:USD, or
GBP:JPY.
1 - 15
(contd)
When the euro was introduced in 1999, it was
given seniority just behind its British
neighbor. Thus, the quote showing on Forex
trading screens is the foreign exchange value
of one euro, EUR:USD or EUR:JPY. The only
exception is the British pound where the
GBP:EUR is quoted.
Finally, the dollar is quoted in units of all
other currencies, for example, USD:JPY.
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Not all exchange rates are traded. In a world with
a large number of currencies, there are a very large
number of cross exchange rates. For example, with
20 currencies, there are 380 bilateral exchange
rates. The exchange rates between two minor
currencies are not traded on the Forex market. Only
the dollar exchange rate with each minor currency
is quoted.
Hence to achieve a transaction between two minor
currencies, one needs to perform two transactions
involving the dollar (such as between the South
Korean won and Brazilian real hence our
previous example with cross-rates).
1 - 17
(contd)
The obvious motivation for this rule is liquidity.
At a given time, there are few transactions
between two minor currencies, so it is more
efficient to group all transactions against one
major currency, the U.S. dollar.
1 - 18
In the Forex market, quotations on trading
screens are generally given with five
significant digits and three-letter codes. For
example, the USD:JPY quote could appear
as 120.10 and the EUR:USD as 1.2515.
Market makers quote both a bid and an ask
price, and there is no additional fee or
commission.

1 - 19
Bid-Ask Quotes
Bid price: the exchange rate at which the dealer is
willing to buy the quoted currency in exchange for
the second currency.
Ask (offer) price: the exchange rate at which the
dealer is willing to sell the quoted currency in
exchange for the second currency.
The difference between the bid and ask price is
called the spread.
Midpoint price = (ask + bid)/2
1 - 20
Bid-Ask Quotes - Example
Consider the following currency quote in
the United States:
$: = 0.9838 0.9841
The bid price is $: 0.9838
The ask price is $: 0.9841
The midpoint price is $: 0.98395
1 - 21
Additional terminology
A pip stands for price interest point and
represents the smallest price fluctuation in
the currency price. It is equivalent to the
tick on stock markets.
E.g. :$ = 1.3015 1.3019. The spread
equals 4 pips.

1 - 22
Bid-Ask Spread
Difference between bid and ask price.
Can also be calculated as a percentage:
Bid-ask spread = 100*(ask bid)/ask
Size of bid-ask spread increases with exchange
rate uncertainty (volatility) and lack of liquidity
because of the bank/dealer risk aversion.
Spreads are larger for currencies that have a low
trading volume (thinly traded currencies).
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Two Principles for bid and ask rates
The a:b ask exchange rate is the reciprocal
of the b:a bid exchange rate.
The a:b bid exchange rate is the reciprocal
of the b:a ask exchange rate.
Example:
the $: quote of $: = 150.51 152.52 is
equivalent to a :$ quote of:
:$ = (1/152.52) (1/150.51)
= 0.00655 0.00664
1 - 24
Arbitrage
Arbitrage involves the simultaneous purchase of an
undervalued asset or portfolio and sale of an
overvalued but equivalent asset or portfolio, in
order to obtain a risk free profit on the price
differential.
Arbitrage keeps exchange rates in line with each
other and with risk free interest rates.
For example, the $: rate must be the same, at a
given instant, in Frankfurt, Paris and New York.
1 - 25
Arbitrage Conditions with Exchange
Rates
An arbitrage could be created if it were profitable
to buy from one bank and sell to another bank.
When describing arbitrage, we are usually
discussing a riskless transaction that does not
require any invested capital.
1 - 26
Arbitrage Example
Consider the following three banks each providing
a $: quote :

Bank A Bank B Bank C
122.25-35 122.40-45 122.25-45
Does an arbitrage opportunity exist?

One could buy dollars from Bank A for 122.35 yen
per dollar and simultaneously sell them to Bank B
for 122.40 yen per dollar. A small gain, but it is
riskless and does not require any invested capital.
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Two types of arbitrage opportunities to
consider...
With respect to the exchange rate between two
countries, the bid-ask spread in one country should
be aligned with the bid-ask spread in the other. If
not, a bilateral arbitrage opportunity exists.
A triangular arbitrage opportunity occurs if the
quoted cross-rate between two currencies is higher
or lower than the cross-rate implied by the
exchange rates of the two currencies against a
third currency.
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Triangular Arbitrage
Triangular arbitrage involves three steps:
Pick the cross-rate currency
Determine whether the cross-rate bid-ask
quotes are in line with the direct quotes by
determining whether it is cheaper to buy
foreign currency directly or indirectly.
If the actual cross-rate quote is not in line with
the quoted cross-rate quotes, an arbitrage
opportunity exists.
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Forward Rates
Spot rates are quoted for immediate currency
transactions (although in practice delivery takes
place 48 hours later).
Forward exchange rates are contracted today but
with delivery and settlement in the future.
In a forward, or futures, contract a commitment is
irrevocably made on the transaction date, but
delivery takes place later, on a date set in the
contract.
1 - 30
Forward Premiums/Discounts
Forward exchange rates are often quoted
as a premium, or discount, to the spot exchange
rate.
When a trader announces that a currency quotes at
a premium, the premium should be added to the
spot exchange rate to obtain the value of the
forward exchange rate.
If a currency quotes at a discount, the discount
should be subtracted from the spot exchange rate
to obtain value of the forward exchange rate.
1 - 31
Forward Premiums/Discounts
Given an exchange rate of a:b, the annualized
forward premium on the quoted currency a equals:

% 100
.
12
|
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\
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\
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forward months No rate Spot
rate Spot rate Forward
1 - 32
Forward Premiums/Discounts - Example
If the 3 month forward exchange rate is
:$ = 1.23778 and the spot rate is :$ = 1.2500,
calculate the forward premium/discount.
Solution:

% 91 . 3 % 100
3
12
2500 . 1
2500 . 1 23778 . 1
=
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.
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\
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|
.
|
\
|

1 - 33
Forward Quotations with Bid-Ask
Spreads - Example
On the Forex market, you notice the following
quotes:
Spot: $: = 105.00 105.50
One year interest rate ($): 3 4% (0.035 0.04)
One year interest rate (): - 1% (0.005 0.01)

What should be the quote for the one year forward
exchange rate $:?

1 - 34
Forward Quotations with Bid-Ask
Spreads - Example
Solution:

Thus, the forward quotation is
$:: 107.60 109.174

6 . 107
01 . 1
035 . 1
00 . 105
174 . 109
005 . 1
04 . 1
50 . 105
=
|
.
|
\
|
=
=
|
.
|
\
|
=
BID
ASK
F
F
1 - 35
Interest Rate Parity
The interest rate parity relationship is that the
forward discount (premium) equals the interest
rate differential between the two currencies.
For two currencies, A and B, with the exchange rate
quoted as the number of units of B for one unit of A,

|
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.
|
\
|
+
=
|
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.
|
\
|

A
B A
r
r r
rate Spot
rate Spot rate Forward
1
1 - 36
Covered Interest Rate Arbitrage
The process of simultaneously borrowing
the domestic currency, transferring it into
foreign currency at the spot exchange rate,
lending it, and buying a forward exchange
rate contract to repatriate the foreign
currency into domestic currency at a known
forward exchange rate. The net result of
such an arbitrage should be nil.
1 - 37
Interest Rate Parity Example
Spot rate = 1.6400 $ per
90 day Forward rate = 1.6236 $ per
U.S. risk free rate = 1.15%
UK risk free rate = 3.75%
Annualized forward premium = 4.0%
Interest rate parity is violated.
Dollar is stronger, pound weaker
Borrow British pounds (), transfer at Spot rate in
dollars ($), invest in dollars ($), buy forward.

Currency Exchange Rates

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Currency Exchange Rates

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