Foreign Exchange Markets and Foreign Exchange RatesChapter objective:examines the functions, actual operation of the FOREX markets including exchange rate and international financial markets. 3

Outline 1.Foreign Exchange Market2.Foreign Exchange Rates3.Spot and Forward Rates, Currency Swaps, Futures and Options4.Foreign Exchange Risks, Hedging, and Speculation5.Interest Arbitrage 6.Offshore Financial Markets

1. FOREX Market

(1)concept (2)Function and Structure

(1) conceptFOREX market is the market in which individuals ,firms,and banks buy and sell foreign currencies or foreign exchange. Broadly define: FOREX market encompasses the conversion of purchasing power from the currency into another, bank deposits of foreign currency, the extension of credit denominated in a foreign currency, foreign trade financing, and trading in foreign currency options and futures contracts.

the largest financial market, open 365 days a year, 24 hours a daycentral marketplace over the counter(OTC) Reuters, Telerate, Bloombergthree major market segments:Australasia, Europe, North America

(2)Function and Structure of the FOREX Market 1)Function2)Structure

1)Function:the transfer of funds or purchasing power from one nation and currency to anotheroperate as clearinghouses for the foreign exchange demanded and suppliedthe credit functionthe facilities for hedging and speculation

2)Structure Wholesale or interbank market Retail or client market Participants: Four levels central bank FX brokers commercial banks customers (tourists,importers, exporters, investors)

(2)Function and Structure of the FOREX Market

3.Foreign Exchange Rates

(1)Equilibrium exchange rates(2)Foreign exchange rate quotations(3) Exchange rates categories (4)Arbitrage

(1) Equilibrium exchange rates

R D S

E

Million /dayAppreciation and Depreciation

(2)FX rate quotations(Direct quotations) the price of one unit of the foreign currency priced in domestic currency. See case study FX quotations:p.463 WednesdayThe dollar price of the euro:$1.0551/1(Indirect quotations) The price of one domestic currency in the foreign currency. Case study p.463:The euro price of the dollar: 0.9478/$

(3) Exchange Rates CategoriesCross exchange rate Ignore the transaction costsA cross exchange rate is an exchange rate between a currency pair where neither currency is the U.S. dollar. If S($/)=1.5683 S($/ )= 0.5235 then / S( /)= S($/)/S($/ ) = 1.5683 / 0.5235=2.9958Effective exchange rateNominal exchange rateReal exchange rate

(4)ArbitrageMake a profitTwo-point arbitrage:The exchange rate between any two currencies is kept the same in different monetary centers. example: in the same time in Hong Kong $100=HKD778.07 in New York $100=HKD775.07 one Hong Kong bank sold 1million dollars in Hong Kong, and in New York sold 7.7507million Hong Kong dollars, gained 1 million dollars. Profit:30 thousand HKD

(4)ArbitrageTriangular arbitrage: three currencies and three monetary centers are involved. example: in the same time =$2 in London $0.4= SF1in New YorkThe corresponding cross rate is /SF=($/SF)/($/ )=0.4/2=0.2. If we observe the market where one of the three exchange rates is not out of line with the other two, arbitrage opportunity.

(4)ArbitrageSuppose in Zurich /SF=0.2,while in New York $/SF=0.4,but in London $/ =1.9.one trade could buy 1million in London for $1.9million.using pounds to buy francs at /SF=0.2,so 1million=SF5million, then in New York using SF5million to buy dollars,so that SF5million=$2million.The initial $1.9million could be turned into $2million.earning $0.1million.

(4)ArbitrageRemember:The different financial centers operate in different time zones. Therefore, it only makes senses to compare quotations at a time when the markets overlap. Could not compare $/ quotes in New York with those in Tokyo because there is no overlap between the trading time.

3.Spot and Forward Rates, Currency Swaps, Futures and Options

(1)spot and forward rates1)Spot transaction and spot rate2)forward transaction and forward rate(2)currency swaps(3)foreign exchange futures and options1) foreign exchange futures 2) foreign exchange options

3.Spot and Forward Rates1)spot transaction and spot rateBe quoted at specific time,based on large trades Example :the U.S importer Spot transaction:FX transaction involves the payment and receipt of FX within two business days after the day the transaction is agree upon. Spot rate:The exchange rate at which the spot transaction take place .

2)forward transaction and forward rateForward transaction: contracting today for the specified future purchase or sale of foreign exchange at a rate agreed upon today.(the forward rate)The forward price :At premium : it is higher than the spot price.At discount: it is lower than the spot price.Maturities: 1,3,6,9,12 months, beyond one year,for good bank customers, extending 5

3.Spot and Forward Rates

(2)Currency SwapAn agreement to trade currencies at one date and reverse the trade at later date.Forward trades, is the simultaneous sale or purchase of spot foreign exchange against a forward purchase or sale of a approximately an equal amount of the foreign currency. outright 11% swap transactions 55% spot 34%Swap rate: is the difference between the spot and forward rates in the currency swap.

(2)Currency SwapBe quoted in basis points a basis point 0.0001Not care about the actual spot and forward rate, but the difference between themMeet a banks needs ,combine two separate transactions into one dealThe names of the banks making bids and offers are not known until a deal is reached.

(3)Foreign exchange futures and options1)FuturesThe futures market is a market where foreign currencies may be bought and sold for delivery at a future day.Futures contract is a forward contract for standardized currency amounts and selected calendar dates traded on an organized market. (contract size and maturity date)Standard features:Contract size, maturity date, delivery months see p.469The futures market differs from a forward market

Futures ForwardOrganized exchangeStandardized amountDaily settlement done by the clearinghouse through the participants margin accountStandardized delivery dateDelivery seldom made, reversing trade is transacted to exit the marketFor small firms

OTCTailor-madeBuy or sell at maturity at the forward price

Meets the needs of investorCommonly madeFor large financial institutions, business firms and wholesale banking activities

1)Futures:Daily ResettlementSuppose you want to speculate on a rise in the $/ exchange rate (specifically you think that the dollar will appreciate).

Currently $1 = 140. The 3-month forward price is $1=150.

Sheet1

Currency per

U.S. $ equivalentU.S. $

WedTueWedTue

Japan (yen)0.00714285710.0071942446140139

1-month forward0.0069930070.0070422535143142

3-months forward0.00666666670.0067114094150149

6-months forward0.006250.0062893082160159

Sheet2

Sheet3

1)Futures: Daily ResettlementCurrently $1 = 140 and it appears that the dollar is strengthening. If you enter into a 3-month futures contract to sell at the rate of $1 = 150 you will make money if the yen depreciates. The contract size is 12,500,000To trade futures market, a trader must deposit money with a broker(margin).Your initial margin is 4% of the contract value:

1)Futures: Daily ResettlementIf tomorrow, the futures rate closes at $1 = 149, then your positions value drops.Your original agreement was to sell 12,500,000 and receive $83,333.33But now 12,500,000 is worth $83,892.62

You have lost $559.28 overnight.

1)Futures: Daily ResettlementThe $559.28 comes out of your $3,333.33 margin account, leaving $2,774.05This is short of the $3,355.70 required for a new position.

Your broker will let you slide until you run through your maintenance margin. Then you must post additional funds or your position will be closed out. This is usually done with a reversing trade.

1)Futures: Daily ResettlementSuppose the March pound contract requires an initial margin of $2,000.if the price fell $0.0175 on one day, then the fall in the settlement price of $0.0175 represents a loss of $1,093.75=0.0175 62,500, and deducting this daily loss from the margin deposit. So in a single day the margin account reduces to $906.25

1)Futures:reversing tradeIf in March the pound will sell for $1.45,and March futures contract is currently priced at $1.5 , we would sell a March contract.then at maturity ,we will receive $1.5 per pound,or $93,750. If the actual price of the pound falls below $1.5, we realize a profit. Suppose the actual price in March is $1.45, we could then buy pound for $90,625. The difference of $93,750-$90,625=$3,125,will be the profit.

2)Foreign Exchange OptionsA foreign currency option is a contract that provides the right, but not the obligation, to buy (Call options )or sell (put options )a given amount of an asset at a specified price at some time in the future.American options can be exercised at any time during their life, European options can only be exercised at maturity.Exercised price or striking price:the price at which currency can be bought or sold.

2)Foreign Exchange OptionsExchange-traded options with standardized features are traded on two exchanges. Options on the spot foreign exchange are traded at the Philadelphia Stock Exchange, option on currency futures at the Chicago Mercantile Exchange. OTC volume is much bigger than exchange volume.Trading is in seven major currencies plus the euro against the U.S. dollar.

2)Foreign Exchange OptionsProfit

lossLong callShort callStEE

2)Foreign Exchange OptionsProfit

LossLong putShort putEE

2)Foreign Exchange OptionsSuppose a U.S importer is buying equipment from a German manufacturer with a 1 million due in three months. The importer can hedge against a euro appreciation by buying a call option that confers the right to purchase euros over the next three months at a specified price. The current $1.2/ , if $1.25/ over the next three months. The importer exercises the option. Basic option-pricing relationships at expiration (see case study14-4 p.470-471)

2)options: example1Example1: expiration value of an American call optionConsider the PHLX 75 Mar. CD American call option, the exercise price 75 cents per CD, current premium Ca=0.84 cents per CD. Suppose at expiration the spot rate is $0.7564/CDThe call option, exercise value: 75.64-75=0.64 cents per each of the CD50,000 of the contract, or $320. That is, the call owner can buy CD50,000, worth $37,820=CD50,000$0.7564 in the spot market, for $37,500=CD50,000$0.7500.

2)options: example1Call optionExercise price: $0.7500/CDCurrent premium: c0.84/CDSpot rate: $0.7564/CDCD50,000Exercise value: $320

2)options: example1 profit

0 E=75 ST

-0.84 ST=E+Ca =75+0.84 =75.84 Call option : Buyers perspective

Call option: Writers perspective profit

0.84

STST=E+Ca

2)options: example1

2)options: example1At ST=E+Ca both the call buyer and writer break even . The speculative possibilities of a long position in a call: Anytime the speculator believes ST will be in excess of the breakeven point, establish a long position in the call. If correct ,profit. If incorrect, the loss limited to the premium paid.If the speculator believes ST will be less than the breakeven point, a short position in the call will yield a profit, the largest amount being the call premium. If incorrect, very large losses.

Example 2expiration value of an American put option Consider the 104 Sep EUR American put, a current premium pa, of 2.47 cents per EUR. If ST=$1.0307/EUR, the put contracts exercise value: 104-103.07=0.93 cents per EUR for each of the EUR62,500, worth$64,618.75=EUR62,500$1.0307 in the spot market, for $65,000=EUR62,500 $1.04. If $1.0425/EUR,the exercise value is 104-104.25=-0.25 cents per EUR.the put buyer will not exercise.

2)options: example2Put optionExercise price: $1.04/EURCurrent premium: c2.47/EURSpot rate: $1.0307/EUREUR62,500Exercise 1.04-1.0307= 0.93If spot rate: $1.0425/EURNot exercise: 1.04-1.0425=-0.0025

2)options: example2Put option: buyerperspectiveProfit E-Pa=104- 2.47 =101.53 E=104

-2.47 104-2.47=101.53

Put option: writers perspectiveProfit

2.47ST

4.Foreign Exchange Risks ,Hedging, and Speculation

(1)Foreign exchange risks(2)Hedging(3)Speculation

(1)Foreign exchange risksExchange rate changes can systematically affect the value of the firm by influencing the firms operating cash flows as well as the domestic currency values of its assets and liabilities. Open position. exposure classify foreign currency exposure into three classes:

(1)Foreign exchange risks1)Economic ExposureExchange rate risk as applied to the firms competitive position.2)Transaction ExposureExchange rate risk as applied to the firms home currency cash flows.3)Translation ExposureExchange rate risk as applied to the firms consolidated financial statements.

Cash SAR1,000,000 Debit SAR5,000,000Accounts receivable 3,000,000 Equity 6,000,000Plant and equipment 5,000,000Inventory 2,000,000 SAR11,000,000 SAR11,000,000Dollar translation on May 31, SAR4=$1Cash $250,000 Debt $1,250,000Accounts receivable 750,000 Equity 1,500,000Plant and equipment 1,250,000Inventory 500,000 $2,750,000 $2,750,000Dollar translation on June 31, SAR5=$1Cash $200,000 Debt $1,000,000Accounts receivable 600,000 Equity 1,200,000Plant and equipment 1,000,000Inventory 400,000 $2,200,000 $2,200,000

Balance sheet of one-Saudi Arabia May 31

(2)HedgingHedging refers to the avoidance of a foreign exchange risk,or the covering of an open position. An activity to offset risk.Money Market HedgeForward Market HedgeOptions Market HedgeFutures Market HedgeCross-Hedging Minor Currency ExposureHedging Contingent ExposureHedging Recurrent Exposure with Swap Contracts

(2)HedgingHedging Through Invoice CurrencyHedging via Lead and LagExposure NettingShould the Firm Hedge?What Risk Management Products do Firms Use?

Money Market HedgeThis is the same idea as covered interest arbitrageExample: The importer of British woolens can hedge his 100 million payable with a money market hedge:Lend $112.05 million in the U.S.Translate $112.05 million into pounds at the spot rate S($/) = $1.25/Invest 89.64 million in the UK at i = 11.56% for one year.In one year your investment will have grown to 100 million.

Spot exchange rateS($/)=$1.25/360-day forward rateF360($/)=$1.20/U.S. discount ratei$=7.10%British discount rate i =11.56%

Where do the numbers come from?We owe our supplier 100 million in one yearso we know that we need to have an investment with a future value of 100 million. Since i = 11.56% we need to invest 89.64 million at the start of the year.

How many dollars will it take to acquire 89.64 million at the start of the year if the spot rate S($/) = $1.25/?Money Market Hedge

Forward Market Hedge

The most direct and popular way of hedgingIf you are going to owe foreign currency in the future, agree to buy the foreign currency now by entering into long position in a forward contract.(Long position:buying currency for future delivery.)If you are going to receive foreign currency in the future, agree to sell the foreign currency now by entering into short position in a forward contract.(Short position: selling currency for future delivery)

Options Market HedgeOptions provide a flexible hedge against the downside, while preserving the upside potential.To hedge a foreign currency payable buy calls on the currency.If the currency appreciates, your call option lets you buy the currency at the exercise price of the call.To hedge a foreign currency receivable buy puts on the currency.If the currency depreciates, your put option lets you sell the currency for the exercise price.

ExampleSuppose that Boeing Corporation exported a Boeing 747 to British Airways and billed 10million payable in one year. the money market interest rates and foreign exchange rates are given as follows:The U.S. interest rate:6.10%The U.K. interest rate:9.00%The spot exchange rate:$1.50/ The forward exchange rate:$1.46/ Give the various techniques for managing this transaction exposure

ExampleForward market hedgeGain=(F-ST)10 millionMoney market hedgeThe firm may borrow (lend) in foreign currency to hedge its foreign currency receivables (payables), thereby matching its assets and liabilities in the same currency.

ExampleMoney market hedgeBorrow 9,174,312= 10/1.09 in the U.K.Convert 9,174,312 into $13,761,468 at the spot rate of $1.5/ Invest $13,761,468 in the U.S.Collect 10million receivable and use it to repay the pound loanReceive the maturity value of dollar investment, $14,800,918= $13,761,468 1.061

ExampleOption market hedge buy a put option with an exercise price of $1.46Assume premium was $0.02 per pound, $200,000Under the options hedge, the net dollar proceeds from the British sale become:$14,387,800=$14,600,000-$200,0001.061

Cross-Hedging Minor Currency Exposure

The major currencies are the: U.S. dollar, Canadian dollar, British pound, French franc, Swiss franc, Japanese yen, and now the euro. Easy to use forward ,money market, or options to hedge.In contrast, if minor currencies, such as Korean won, Czech koruna. It is difficult, expensive, or impossible to use financial contracts to hedge exposure to minor currencies.

Cross-Hedging involves hedging a position in one asset by taking a position in another asset.The effectiveness of cross-hedging depends upon how well the assets are correlated.An example would be a U.S. importer with liabilities in Czech koruna hedging with long or short forward contracts on the euro. If the koruna is expensive when the euro is expensive, or even if the koruna is cheap when the euro is cheap it can be a good hedge. But they need to co-vary in a predictable way.

Cross-Hedging Minor Currency Exposure

Hedging Contingent ExposureContingent exposure refers to a situation in which the firm may or may not be subject to exchange exposure.If only certain contingencies give rise to exposure, then options can be effective insurance.For example, if your firm is bidding on a hydroelectric dam project in Canada, you will need to hedge the Canadian-U.S. dollar exchange rate only if your bid wins the contract. Your firm can hedge this contingent risk with options.

Hedging Recurrent Exposure with Swaps

Recurrent exposure: Recurrent cash flows in a foreign currency, hedged using a currency swap contract which can be viewed as a portfolio of forward contracts. It is an arrangement to exchange one currency for another at a predetermined exchange rate, the swap rate , on a sequence of future dates. Swaps are very flexible in terms of amount and maturity which can range from a few months to 20 years.

Hedging Recurrent Exposure with Swaps

Firms that have recurrent exposure can very likely hedge their exchange risk at a lower cost with swaps than with a program of hedging each exposure as it comes along.It is also the case that swaps are available in longer-terms than futures and forwards.

(2)Hedging : Operation techniques

Hedging Through Invoice CurrencyHedging via Lead and LagExposure Netting

The firm can shift, share, or diversify:shift exchange rate risk by invoicing foreign sales in home currencyshare exchange rate riskby pro-rating the currency of the invoice between foreign and home currenciesdiversify exchange rate riskby using a market basket index

Hedging Through Invoice Currency

Hedging via Leads and Lags

If a currency is appreciating, pay those bills denominated in that currency early; let customers in that country pay late as long as they are paying in that currency.If a currency is depreciating, give incentives to customers who owe you in that currency to pay early; pay your obligations denominated in that currency as late as your contracts will allow.

Exposure Netting

A multinational firm should not consider deals in isolation, but should focus on hedging the firm as a portfolio of currency positions.As an example, consider a U.S.-based multinational with Korean won receivables and Japanese yen payables. Since the won and the yen tend to move in similar directions against the U.S. dollar, the firm can just wait until these accounts come due and just buy yen with won.

Exposure NettingEven if its not a perfect hedge, it may be too expensive or impractical to hedge each currency separately.Many multinational firms use a reinvoice center. Which is a financial subsidiary that nets out the intrafirm transactions.Once the residual exposure is determined, then the firm implements hedging.

Exposure Netting: an ExampleConsider a U.S. MNC with three subsidiaries and the following foreign exchange transactions:

$10$20$20$35$10$30$30$30$40$25$60$30$40

Exposure Netting: an Example

$15 Clearly, multilateral netting can simplify things greatly. $40

Should the Firm Hedge?

Not everyone agrees that a firm should hedge:Hedging by the firm may not add to shareholder wealth if the shareholders can manage exposure themselves.Hedging may not reduce the non-diversifiable risk of the firm. Therefore shareholders who hold a diversified portfolio are not helped when management hedges.

Should the Firm Hedge?

In the presence of market imperfections, the firm should hedge.Information AsymmetryThe managers may have better information than the shareholders.Differential Transactions CostsThe firm may be able to hedge at better prices than the shareholders.Default CostsHedging may reduce the firms cost of capital if it reduces the probability of default.

Should the Firm Hedge?

Taxes can be a large market imperfection.Corporations that face progressive tax rates may find that they pay less in taxes if they can manage earnings by hedging than if they have boom and bust cycles in their earnings stream.

What Risk Management Products do Firms Use?

Most U.S. firms meet their exchange risk management needs with forward, swap, and options contracts.The greater the degree of international involvement, the greater the firms use of foreign exchange risk management.

A survey of knowledge and use of foreign exchange risk management productsType of product heard of usedForward 100% 93%Foreign currency swaps 98.8 52.6Foreign currency futures 98.8 20.1Exchange-trade currency options 96.4 17.3Exchange-trade futures options 95.8 8.9OTC currency options 93.5 48.8 Columbia Journal of World Business(1995)

(3)SpeculationThe opposite of hedging. A speculator accepts and seeks out a foreign exchange risk, or an open position, to make a profit.In general, speculation believed to be stabilizing. Long and short position long position: buying currency for future delivery. short position: selling currency for future delivery.

(3)SpeculationSpeculative forward positionIt is July 6,1999. Suppose the $/SF trader has heard the dollar will likely appreciate in value against Swiss franc to level less than the forecast rate over the next three months. He will short the 90-day $/SF contract. If the trader sells SF5,000,000 forward, suppose the forward has proven correct, on Oct.6, 1999, spot $/SF is trade at $0.6400.

(3)SpeculationAnd the trader can buy Swiss franc at $0.6400 and deliver it under the forward contract at $0.6453. Speculative profit: $0.6453- $0.6400= $0.0053 per unit, total:SF5000000 $0.0053= $26500If the dollar depreciated at $0.6500 loss: $0.6453- $0.6500= -$0.0047, per unitTotal loss:SF5000000- $0.0047=-$23500

(3)SpeculationP/L(profit/loss) long position

0.6453

S90 ($/SF)

short position

0.65000.6400-0.00470.0053Short position

5.Interest Arbitrage1)uncovered interest arbitrage2)covered interest arbitrage3)covered interest arbitrage parity4)covered interest arbitrage margin5)efficiency of FOREX market

5.Interest ArbitrageArbitrage: the act of simultaneously buying and selling the same or equivalent assets or commodities for making certain profits.Interest arbitrage: refers to the international flow of short-term liquid capital to earn higher returns abroad.

1)Uncovered Interest arbitrageTo earn higher return abroad, a foreign exchange risk involved due to the possible depreciation of the foreign currency during the period of the investment. If such risk uncovered, then uncovered interest arbitrage.Consider the following set of foreign and domestic interest rates and spot and forward exchange rates.

Spot exchange rateS($/)=$1.25/360-day forward rateF360($/)=$1.20/U.S. discount ratei$=7.10%British discount rate i =11.56%

1)Uncovered Interest arbitrageA trader with $1,000 to invest could invest in the U.S., in one year his investment will be worth $1,071 = $1,000(1+ i$) = $1,000(1.071)Alternatively, this trader could exchange $1,000 for 800 at the prevailing spot rate, (note that 800 = $1,000$1.25/) invest 800 at i = 11.56% for one year to achieve 892.48. Translate 892.48 back into dollars at F360($/) = $1.20/, the 892.48 will be exactly $1,071.

2)Covered Interest ArbitrageRefers to the spot purchase of the foreign currency to make the investment and the offsetting simultaneous forward sale of the foreign currency to cover the foreign exchange risk. If F360($/) $1.20/, an astute trader could make money with a forward contract.The result of covered interest arbitrage

3)Covered Interest Arbitrage ParityThe net return from covered interest arbitrage is usually equal to the interest differential in favor of the foreign monetary center minus the forward discount on the foreign currency.as covered interest arbitrage continues the net gain is reduced and finally eliminated.when the net gain is zero,the currency is said to be at interest parity.

4)Covered Interest Arbitrage MarginSuppose you have $1 to invest for one year. You can either invest in the U.S. at i$. Future value = $1 (1 + i$) trade your dollars for GBP at the spot rate, invest in London at i and hedge your exchange rate risk by selling the future value of the Britain investment forward. The future value = $1 (F/S)(1 + i ) Since both of these investments have the same risk, they must have the same future valueotherwise an arbitrage would exist.(F/S)(1 + i ) = (1 + i$)

4)Covered Interest Arbitrage MarginFormally, (F/S)(1 + i ) = (1 + i$) or if you prefer,

IRP is sometimes approximated as

4)Covered Interest Arbitrage Margind>0,GBP premium, if d

4)Covered Interest Arbitrage MarginTransactions CostsThe interest rate available to an arbitrageur for borrowing, ib,may exceed the rate he can lend at, il.There may be bid-ask spreads to overcome, Fb/Sa < F/S Thus(Fb/Sa)(1 + il) (1 + i b) 0Capital ControlsGovernments sometimes restrict import and export of money through taxes or outright bans.

4)Covered Interest Arbitrage Margini-i*(F-S)/SIRP lineADB

5)Efficiency of FOREX MarketsFinancial Markets are efficient if prices reflect all available and relevant information.If this is so, exchange rates will only change when new information arrives, thus:St = E[St+1] andFt = E[St+1| It]Predicting exchange rates using the efficient markets approach is affordable and is hard to beat.

If forward rates accurately predict future spot rates

6.Offshore Financial Markets1)Eurocurrency MarketWhats the Eurocurrency?Offshore market2)Reasons for its Development PoliticalCredit and deposit rate3)Eurobonds and Euronotes

6.Offshore Financial MarketsProducts 82 88 94Eurobonds 71.7 225.5 422.1 FRNs 12.6 23.1 92.7Euronotes 2.3 76.4 193.3amongCP 0 58.25 36.4EMTNs 0 19.196 157NIFs 2.3 3.7 0.5Syndicated Euro-loans 100.5 102 248.6

Key WordsForeign exchange marketExchange rateSpot rateForward rateCross exchange rateSwap AppreciationDepreciation Devaluation Arbitrage Currency swapFutures and optionsHedgingPositionLong and short positionForeign exchange riskCovered and uncovered interest arbitrageEurocurrency

Discussion and Problems1.Assume you are a trader with Deutsche Bank.from the quote screen on your computer terminal, you notice Dresdner Bank is quoting 1.6230/$1.00 and Credit Suisse is offering SF1.4260/$1.00. You learn that UBS is making a direct market between the Swiss franc and the euro, with a current /SF quote of 1.1250. Show how you can make a triangular arbitrage profit by trading at these prices.(ignore bid-ask spreads for this problem.) Assume you have $5,000,000 with which to conduct the arbitrage. What happens if you initially sell dollars for Swiss francs? What /SF price will eliminate triangular arbitrage?