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It includes trading currencies spot and forward; bank deposits of ... FOREX market is a global over-the-counter market. Market participants include international banks, their ...

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Slide 1: The Market for Foreign Exchange (chapter 4 Eun and Resnick))

Slide 2:FOREX Market Participants

FX market involves participants buying and selling currencies all over the world It includes trading currencies spot and forward; bank deposits of foreign currencies; foreign trade financing; trading in currency options, futures and swaps FOREX market is a global over-the-counter market Market participants include international banks, their customers, nonbank dealers, FOREX brokers, and central banks

Slide 7:The Spot Market

The spot market involves immediate purchase or sale of foreign exchange Direct quotation from US perspective the U.S. dollar equivalent the price of one unit of the foreign currency in US Dollars Indirect Quotation from US perspective the price of a U.S. dollar in the foreign currency e.g. “you get 100 yen to the dollar” The direct quote is the reciprocal of the indirect quote

Slide 8:Cross Rates

The cross rate is the rate of exchange between two non-US currencies Suppose that S(\$/Euro) = 1.25 and that S(Yen/\$) = 110 Yen What must the Yen/Euro cross rate be? Yen/Euro= (Yen/\$)x(\$/Euro) = 110x1.25= 137.5 Suppose that S(\$/Euro) = 1.25 and that S(\$/AUD) = 0.5 What must the AUD/Euro cross rate be?

Triangular Arbitrage \$ £ ¥ Credit Lyonnais S(\$/£)=1.50 Credit Agricole S(¥/£)=185 Barclays S(¥/\$)=120 Suppose we observe these banks posting these exchange rates. First calculate the implied cross rates to see if an arbitrage exists.

Slide 10:Triangular Arbitrage

Sell \$150,000 for £ at S(\$/£) = 1.50 receive £100,000 Sell our £ 100,000 for ¥ at S(¥/£) = 185 receive ¥18,500,000 Sell ¥ 18,500,000 for \$ at S(¥/\$) = 120 receive \$154,167 profit per round trip = \$ 154,167- \$150,000 = \$4,167 When cross rates differ from one financial center to another, profit opportunities exist. Currency arbitrage involves buying a currency in one market while simultaneously selling it at a higher price in a second market The implied ¥/£ is 180. Credit Agricole has posted a quote of S(¥/£)=185 so there is an arbitrage opportunity. So, how can we make money here?

Triangular Arbitrage: exam type problem The Singapore dollar spot rate is 1.7 SGD/\$, the Swiss franc spot rate is 1.35 SF/\$ and the market cross-rate is 1.15SGD/SF . Calculate the implied cross-rate (SGD/SF). Calculate the triangular arbitrage profit that is possible if you start with \$1 million. Show all your calculations. Cross rate: SGD/SF = (1.7 SGD/\$)/(1.35SF/\$)= 1.26SGD/SF Arbitrage Direction: exchange (sell) SGD for SF Triangular arbitrage: Sell \$1,000,000 for SGD at S(SGD/\$) = 1.7 receive SGD 1,700,000 Sell our SGD 1,700,000 for SF at S(SGD/SF) = 1.15 receive SF1,478,261 Sell SF1,478,261 for \$ at S(SF/\$) = 1.35 receive \$1,095,008 profit per round trip = \$ 1,095,008- \$1,000,000 = \$95,008 The following sections in chapter 4 are not required for the exam: Spot Foreign Exchange Microstructure Swap transactions Forward Market Learning outcomes Know the structure of the FX market Know the difference between wholesale (interbank) market and retail market Who are the participants in the FX market? Know how to read/use spot and forward quotes; direct and indirect method Calculate currency cross-rates, without bid-ask quotes, when given two spot or forward FX quotations involving three currencies Calculate the profit/loss on a triangular arbitrage opportunity given three currency quotations, without bid-ask spread Recommended end-of-chapter questions: 2,3,4 Recommended end-of-chapter problems: 1, 8