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The Spot Market

The Spot Market. Spot Rate Quotations The Bid-Ask Spread Spot FX trading Cross Rates. Spot Rate Quotations. The direct quote for British pound is: £1 = $1.688. Spot Rate Quotations. The indirect quote for British pound is: £.5924 = $1. Spot Rate Quotations.

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The Spot Market

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  1. The Spot Market • Spot Rate Quotations • The Bid-Ask Spread • Spot FX trading • Cross Rates

  2. Spot Rate Quotations The direct quote for British pound is: £1 = $1.688

  3. Spot Rate Quotations The indirect quote for British pound is: £.5924 = $1

  4. Spot Rate Quotations Note that the direct quote is the reciprocal of the indirect quote:

  5. Triangular Arbitrage Suppose we observe these banks posting these exchange rates. $ Barclays S(¥/$)=120 Credit Lyonnais S(£/$)=1.50 ¥ £ First calculate the implied cross rates to see if an arbitrage exists. Credit Agricole S(¥/£)=85

  6. Triangular Arbitrage $ The implied S(¥/£) cross rate is S(¥/£) = 80 Barclays S(¥/$)=120 Credit Lyonnais S(£/$)=1.50 Credit Agricole has posted a quote of S(¥/£)=85 so there is an arbitrage opportunity. ¥ £ Credit Agricole S(¥/£)=85 So, how can we make money?

  7. Triangular Arbitrage As easy as 1 – 2 – 3: $ 1. Sell our $ for £, 2. Sell our £ for ¥, 3. Sell those ¥ for $. Barclays S(¥/$)=120 Credit Lyonnais S(£/$)=1.50 ¥ £ Credit Agricole S(¥/£)=85

  8. Triangular Arbitrage Sell $100,000 for £ at S(£/$) = 1.50 receive £150,000 Sell our £ 150,000 for ¥ at S(¥/£) = 85 receive ¥12,750,000 Sell ¥ 12,750,000 for $ at S(¥/$) = 120 receive $106,250 profit per round trip = $ 106,250- $100,000 = $6,250

  9. Spot Foreign Exchange Microstructure • Market Microstructure refers to the mechanics of how a marketplace operates. • Bid-Ask spreads in the spot FX market: • increase with FX exchange rate volatility and • decrease with dealer competition. • Private information is an important determinant of spot exchange rates.

  10. The Forward Market • Forward Rate Quotations • Long and Short Forward Positions • Forward Cross Exchange Rates • Swap Transactions • Forward Premium

  11. The Forward Market • A forward contract is an agreement to buy or sell an asset in the future at prices agreed upon today. • If you have ever had to order an out-of-stock textbook, then you have entered into a forward contract.

  12. Forward Rate Quotations • The forward market for FOREX involves agreements to buy and sell foreign currencies in the future at prices agreed upon today. • Bank quotes for 1, 3, 6, 9, and 12 month maturities are readily available for forward contracts. • Longer-term swaps are available.

  13. Forward Rate Quotations • Consider the example from above: for Japanese yen, the spot rate is ¥115.75 = $1.00 While the 180-day forward rate is Y112.80 = $1.00 • What’s up with that?

  14. Spot Rate Quotations Clearly the market participants expect that the yen will be worth MORE in dollars in six months.

  15. Long and Short Forward Positions • If you have agreed to sell anything (spot or forward), you are “short”. • If you have agreed to buy anything (forward or spot), you are “long”. • If you have agreed to sell forex forward, you are short. • If you have agreed to buy forex forward, you are long.

  16. Payoff Profiles profit If you agree to sell anything in the future at a set price and the spot price later falls then you gain. S180($/¥) 0 F180($/¥) = .009524 If you agree to sell anything in the future at a set price and the spot price later rises then you lose. loss Short position

  17. Payoff Profiles profit short position Whether the payoff profile slopes up or down depends upon whether you use the direct or indirect quote: F180(¥/$) = 105 or F180($/¥) = .009524. S180(¥/$) 0 F180(¥/$) = 105 -F180(¥/$) loss

  18. Payoff Profiles profit short position S180(¥/$) 0 F180(¥/$) = 105 When the short entered into this forward contract, he agreed to sell ¥ in 180 days at F180(¥/$) = 105 -F180(¥/$) loss

  19. Payoff Profiles profit short position 15¥ S180(¥/$) 0 120 F180(¥/$) = 105 If, in 180 days, S180(¥/$) = 120, the short will make a profit by buying ¥ at S180(¥/$) = 120 and delivering ¥ at F180(¥/$) = 105. -F180(¥/$) loss

  20. Payoff Profiles profit Since this is a zero-sum game, the long position payoff is the opposite of the short. short position F180(¥/$) S180(¥/$) 0 F180(¥/$) = 105 -F180(¥/$) Long position loss

  21. Payoff Profiles profit The long in this forward contract agreed to BUY ¥ in 180 days at F180(¥/$) = 105 -F180(¥/$) If, in 180 days, S180(¥/$) = 120, the long will lose by having to buy ¥ at S180(¥/$) = 120 and delivering ¥ at F180(¥/$) = 105. S180(¥/$) 0 120 F180(¥/$) = 105 –15¥ Long position loss

  22. SWAPS • A swap is an agreement to provide a counterparty with something he wants in exchange for something that you want. • Swap transactions account for approximately 51 percent of interbank FX trading, whereas outright trades are less than 9 percent.

  23. Comparative Advantage as the Basis for Swaps Consider two firms A and B: firm A is a U.S.–based multinational and firm B is a U.K.–based multinational. Both firms wish to finance a project in each other’s country of the same size. Their borrowing opportunities are given in the table below.

  24. Comparative Advantage as the Basis for Swaps A is the more credit-worthy of the two firms. A pays 2% less to borrow in dollars than B and A pays .4% less to borrow in pounds than B: A has a comparative advantage in borrowing in dollars B has a comparative advantage in borrowing in pounds.

  25. One Feasible Swap: Swap Bank $9.4% $8% £12% $8% Company A Company B £12% £11%

  26. One Feasible Swap: Swap Bank $9.4% $8% £12% $8% Company A Company B £12% £11% A’s net position is to borrow at £11%

  27. One Feasible Swap: Swap Bank $9.4% $8% £12% $8% Company A Company B £12% £11% B’s net position is to borrow at $9.4%

  28. One Feasible Swap: Swap Bank $9.4% $8% £12% $8% Company A Company B £12% £11% A saves £.6%

  29. One Feasible Swap: Swap Bank $9.4% $8% £12% $8% Company A Company B £12% £11% A saves £.6% B saves $.6%

  30. One Feasible Swap: The swap bank makes money too. Swap Bank $9.4% $8% £12% $8% Company A Company B £12% £11% A saves £.6% B saves $.6%

  31. SWAPS • A swap can be viewed as a portfolio of spot and forward positions. • In the above example, firm A would borrow in dollars and then swap for pounds with the bank and simultaneously enter into a series of forward contracts with the bank to exchange dollars for pounds.

  32. Forward Premium • It’s just the interest rate differential implied by forward premium or discount. • For example, • appreciating from S($/DM) = .5235 to F180($/DM) = .5307 • The forward premium is given by:

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