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CHAPTER6:THEFOREIGNEXCHANGEMARKET1CHAPTER6THEFOREIGNEXCHANGEMARKETChapter6isbasicallyinstitutionalinnature,althoughitopensbydiscussingtherationaleforaforeignexchangemarket,namelytofacilitatethetransferofpurchasingpowerdenominatedinonecurrencytopurchasingpowerdenominatedinanothercurrency.Likeotherfinancialmarkets,theforeignexchangemarketfacilitatestradinginfinancialassetsbyloweringtransactioncosts.Thebalanceofthechapterprovidestheinstitutionalframeworkoftheforeignexchangemarket,bothspotandforwardtransactions.Itdiscussespricingconventions,costs,size,andparticipants,andgoesthroughsomeofthemechanicsofforeignexchangetrading.IalwaysillustratethissubjectmatterwithquotesfoundinTheWallStreetJournal.EveryissueoftheJournal(SectionC)containsastoryontheforeignexchangemarket,providingspotquotationsfortheCanadiandollar,poundsterling,Swissfrancs,euros,andJapaneseyen.Thefinancialsectionalsocarriesamoreextensivelistingofspotandforwardpricesforaboutfortycurrencies.SUGGESTEDANSWERSTO“ARBITRAGINGCURRENCYCROSSRATES”1.Doanytriangulararbitrageopportunitiesexistamongthesecurrencies?Assumethatanydeviationsfromthetheoreticalcrossratesof5pointsorlessareduetotransactioncosts.ANSWER.Unfortunately,therearenoshortcutshere.Itisnecessarytotryouteachpossibility.Herearethe4arbitrageopportunitiesthatIfound.Ifanyonefindsanyadditionalones,pleasecontactmeatmyemailaddress:[e-mail].1)ConvertdollarstoSFr,SFrtoDKr,andDKrbacktodollars.Theprofitperdollarequals$1*1.2250*4.5570/5.5485-$1=$0.0061.2)ConvertdollarstoDKr,DKrtopounds,andpoundsbacktodollars.Theprofitperdollarequals$1*5.5475*0.0910/.5012-1=$0.0072.3)ConvertdollarstoSFr,SFrtopounds,andpoundsbacktodollars.Theprofitperdollarequals$1*1.2250*0.4122/.5012-1=$0.0055.4)Convertdollarstoyen,yentopound,andpoundbacktodollars.Theprofitperdollarequals$1*121.33*0.0042/0.5012-1=$0.0167.2.Computetheprofitfroma$5milliontransactionassociatedwitheacharbitrageopportunity.ANSWER.Allanswersarebasedonroundingthearbitrageprofitperdollartothefourthdecimalplace.1)Theprofitforthe$/SFr/DKr/$arbitragewillbe$5,000,000*0.0061=$30,500.2)Theprofitfromthe$/DKr/£/$arbitragewillbe$5,000,000*0.0072=$36,000.3)Theprofitfromthe$/£/DKr/$arbitragewillbe$5,000,000*0.0055=$27,500.4)Theprofitfromthe$/¥/DKr/$arbitragewillbe$5,000,000*0.0167=$83,500.FOUNDATIONSOFMULTINATIONALFINANCIALMANAGEMENT,6THED.2SUGGESTEDANSWERSTOCHAPTER6QUESTIONS1.AnswerthefollowingquestionsbasedondatainExhibit6.5.1.a.HowmanySwissfrancscanyougetforonedollar?ANSWER.Theindirectquoteis$1=SFr1.2297.1.b.HowmanydollarscanyougetforoneSwissfranc?ANSWER.ThedirectquoteisSFr1=$0.8132.1.c.Whatisthethree-monthforwardratefortheSwissfranc?ANSWER.Thethree-monthforwardrateisSFr1=$0.8192.1.d.IstheSwissfrancsellingataforwardpremiumordiscount?ANSWER.Ataforwardpremium.1.e.Whatisthe90-dayforwarddiscountorpremiumontheSwissfranc?ANSWER.The90-dayforwardpremiumis60points(pips),whichtranslatesintoanannualizedforwardpremiumof2.95%(4*(0.8192–0.8132)/0.8132).2.Whatrisksconfrontdealersintheforeignexchangemarket?Howcantheycopewiththeserisks?ANSWER.Foreignexchangedealersmustcopewithexchangerisk,becauseoftheforeigncurrencypositionstheytake.Theyalsobearcreditrisksincethecounterpartiestothetradestheyenterintomaynothonortheirobligations.Theycancopewithcurrencyriskbyusingforwardcontractsandcurrencyoptions,wideningtheirbid-askquotes,andlimitingthepositiontheyarewillingtotakeinanyonecurrency.Theycanlimitcreditriskbyrestrictingthepositiontheyarewillingtotakewithanyonecustomerandbysettingmarginrequirementsthatvarywiththeriskinessoftheircustomers(bankswillgenerallynotdothis).3.Supposeacurrencyincreasesinvolatility.Whatislikelytohappentoitsbid-askspread?Why?ANSWER.Asacurrency’svolatilityincreases,itbecomesriskierfortraderstotakepositionsinthatcurrency.Tocompensatefortheaddedrisks,tradersquotewiderbid-askspreads.4.Whoaretheprincipalusersoftheforwardmarket?Whataretheirmotives?ANSWER.Theprincipalusersoftheforwardmarketarecurrencyarbitrageurs,hedgers,importersandexporters,andspeculators.Arbitrageurswishtoearnrisk-freeprofits;hedgers,importersandexporterswanttoprotectthehomecurrencyvaluesofvariousforeigncurrency-denominatedassetsandliabilities;andspeculatorsactivelyexposethemselvestoexchangerisktobenefitfromexpectedmovementsinexchangerates.CHAPTER6:THEFOREIGNEXCHANGEMARKET35.Howdoesacompanypayfortheforeignexchangeservicesofacommercialbank?ANSWER.Companiescompensatebanksforforeignexchangeservicesthroughthebid-askspread.Thebankwillbuyforeignexchangeatthebidrate(low)andsellattheaskrate(high).SUGGESTEDSOLUTIONSTOCHAPTER6PROBLEMS1.The$:€exchangerateis€1=$1.35,andthe€/SFrexchangerateisSFr1=€0.61.WhatistheSFr/$exchangerate?ANSWER.SFr1=€0.61*1.35=$0.8235so1/0.8235=SFR1.21/$.2.SupposethedirectquoteforsterlinginNewYorkis1.9880-5.2.a.Howmuchwould£500,000costinNewYork?ANSWER.Tobuy£500,000wouldcost£500,000*1.9885=$99,425.2.b.WhatisthedirectquotefordollarsinLondon?ANSWER.ThedirectquoteforthedollarinLondonisjustthereciprocalofthedirectquoteforthepoundinNewYorkor1/1.9880-1/1.9885=0.5029-0.5030.3.UsingthedatainExhib