The Foreign Exchange Market

I Conceptual Questions

1. Value Date: The settlement of a transaction takes place by transfers of deposits

between two parties. The day on which these transfers are effected is called the
Settlement Date or the Value Date.

2. Spot Rate: When the exchange of currencies takes place on the second working day
after the date of the deal, it is called spot rate.

3. Forward Transactions: If the exchange of currencies takes place after a certain period
from the date of the deal (more than 2 working days), it is called a forward rate. A
trader may quote a forward transaction for any future date. It is a binding contract
between a customer and dealer for the purchase or sale of a specific quantity of a
stated foreign currency at the rate of exchange fixed at the time of making the
contract.

4. Swap Transaction: A swap transaction in the foreign exchange market is combination

of a spot and a forward in the opposite direction. Thus a bank will buy DEM spot
against USD and simultaneously enter into a forward transaction with the same
counter party to sell DEM against USD against the mark coupled with a 60- day
forward sale of USD against the mark. As the term ‘swap’ implies, it is a temporary
exchange of one currency for another with an obligation to reverse it at a specific
future date.

5. Bid Rate: The bid rate denotes the number of units of a currency a bank is willing to
pay when it buys another currency.

6. Offer Rate: The offer rate denotes the number of units of a currency a bank will want
to be paid when it sells a currency.

7. Bid - Offer Rate: The bid offer Rate is the rate which states both, the price which is
the bank is willing to pay to buy other currencies and the price the bank expects when
it sells the same currency. Bid and Ask will always be from a bank’s point of view.
Thus (A/B)bid will denote the number of units of A the bank will pay when it buys
one unit of B and (A/B)ask will mean the number of units of A the bank will want to
be paid in order to sell one unit of B.

8. European Quote: The quotes are given as number of units of a currency per USD.
Thus DEM1.5675/USD is a European quote.

9. American Quotes: American quotes are given as number of dollars per unit of a
currency. Thus USD0.4575/DEM is an American quote.

10.Direct Quotes: in a country, direct quotes are those that give unit of the currency of
that country per unit of a foreign currency. Thus INR 35.00/USD is a direct quote in
India.

1
 11.Indirect Quote: Indirect or Reciprocal Quotes are stated as number of units of a
foreign currency per unit of the home currency. Thus USD 3.9560/INR 100 is an
indirect quote in India.

12.Arbitrage: Arbitrage may be defined a san operation that consists in deriving a profit
without risk from a differential existing between different quoted rates. It may result
from 2 currencies, also known as, geographical arbitrage or from 3 currencies, also
known as, triangular currencies.

II Descriptive questions

1. What is foreign exchange?

In a business setting, there is a fundamental difference between making payment in
the domestic market and making payment abroad. In a domestic transaction, only one
currency is used while in a foreign transaction, two or more currencies maybe used.
Suppose an U.S importer has agreed to purchase a certain quantity of Indian spices
and to pay the Indian exporter Rs. 1000000 for it. How would he go about doing this? He
would have to pay the amount in dollars, which will be equivalent to its existing rate in
rupees at a decided date. That is why the foreign exchange market comes into existence so
that such transactions become possible and easier.

The special checks and other instruments for making payment abroad are referred to
collectively as foreign exchange. In other words, Foreign exchange includes currencies and
other instruments of payment denominated in currencies.

2. Elaborate the structure of the foreign exchange market and compare it with the
foreign exchange of India

The major participants in the foreign exchange markets are commercial banks; foreign
exchange brokers and other authorized dealers, and the monetary authorities. It is necessary
to understand that the commercial banks operate at retail level for individual exporters and
corporations as well as at wholesale levels in the inter – bank market. The foreign exchange
brokers involve either individual brokers or corporations. Bank dealers often use brokers to
stay anonymous since the identity of banks can influence short – term quotes. The monetary
authorities mainly involve the central banks of various countries, which intervene in order to
maintain or influence the exchange rate of their currencies within a certain range and also to
execute the orders of the government.
It is important to recognize that, although the participants themselves may be based
within the individual countries, and countries may have their own trading centers, the market
itself is world – wide. The trading centers are in close and continuous contact with one
another, and participants will deal in more than one market.
Primarily, exchange markets function through telephone and telex. Also, it is
important to note that currencies with limited convertibility play a minor role in the exchange
market. Besides this, only a small number of countries have established their full
convertibility of their currencies for full transactions.

2
 The foreign exchange market in India consists of 3 segments or tires. The first
consists of transactions between the RBI and the authorized dealers. The latter are mostly
commercial banks. The second segment is the interbank market in which the AD’s deal with
each other. And the third segment consists of transactions between AD’s and their corporate
customers.
The retail market in currency notes and travelers cheques caters to tourists. In the
retail segment in addition to the AD’s there are moneychangers, who are allowed to deal in
foreign currencies. The Indian market started acquiring some depth and features of well
functioning market e.g. active market makers prepared to quote two-way rates only around
1985. Even then 2 - way forward quotes were generally not available. In the interbank
market, forward quotes were even in the form of near – term swaps mainly for AD’s to adjust
their positions in various currencies.
Apart from the AD’s currency brokers engage in the business of matching sellers with
buyers. In the interbank market collecting a commission from both. FEDAI rules required
that deals between AD’s in the same market centers must be effected through accredited
brokers.

3. Write a note on Inter bank dealing

Primary dealers quote two – way prices and are willing to deal either side, i.e. they
buy and sell the base currency up to conventional amounts at those prices. However, in
interbank markets this is a matter of mutual accommodation. A dealer will be shown a two-
way quote only if he / she extends the privilege to fellow dealers when they call for a quote.
Communications between dealers tend to be very terse. A typical spot transaction
would be dealt as follows:
BANK A : “ Bank A calling. Your price on mark – dollar please.”
BANK B : “ Forty forty eight.”
BANK A : “ Ten dollars mine at forty eight.”

Bank A dealer identifies and asks himself for B’s DEM/USD. Bank A is dealing at
1.4540/1.4548. The first of these, 1.4540, is bank B’s price for buying USD against DEM or
its bid for USD; it will pay DEM 1.4540 for every USD it buys. The second 1.4548, is its
selling or offer price for USD, also called ask price; it will charge DEM 1.4548 for very USD
it sells. The difference between the two, 0.0008 or 8 points is bank B’s bid – offer or bid – ask
spread. It compensates the bank for costs of performing the market making function including
some profit. Between dealers it is assumed that the caller knows the big figure, viz. 1.45.
Bank B dealer therefore quotes the last two digits (points) in her bid offer quote viz. 40 – 48.
Bank A dealer whishes to buy dollars against marks and he conveys this in the third
line which really means “ I buy ten million dollars at your offer price of DEM 1.4548per US
dollar.”
Bank B is said to have been “hit” on its offer side. If the bank A dealer wanted to sell
say 5 million dollars, he would instead said “Five dollars yours at forty”. Bank B would have
been “hit” on its bid side.
When a dealer A calls another dealer B and asks for a quote between a pair of
currencies, dealer B may or may not wish to take on the resulting position on his books. If he
does, he will quote a price based on his information about the current market and the
anticipated trends and take the deal on his books. This is known as “warehousing the deal”. If
he does not wish to warehouse the deal, he will immediately call a dealer C, get his quote and

3
show that quote to A. If A does a deal, B will immediately offset it with C. This is known as
“back-to-back” dealing. Normally, back-to-back deals are done when the client asks for a
quote on a currency, which a dealer does not actively trade.
In the interbank market deals are done on the telephone. Suppose bank A wishes to
buy the British pound sterling against the USD. A trader in bank A might call his counterpart
in bank B and asks for a price quotation. If the price is acceptable they will agree to do the
deal and both will enter the details- the amount bought/sold, the price, the identity of the
counter party, etc.-in their respective banks’ computerized record systems and go to the next
transaction. Subsequently, written confirmations will be sent containing all the details. On the
day of the settlement, bank A will turn over a US dollar deposit to bank B and B will turn
over a sterling deposit to A. The traders are out of the picture once the deal is agreed upon
and entered in the record systems. This enables them to do deals very rapidly.
In a normal two-way market, a trader expects “to be hit” on both sides of his quote
amounts. That is in the pound – dollar case above. On a normal business day the trader
expects to buy and sell roughly equal amounts of pounds / dollars. The bank margin would
then be the bid – ask spread.
But suppose in the course of trading the trader finds that he is being hit on one side
of hiss quote much more often than the other side. In the pound – dollar example this means
that he is buying many more pounds that he selling or vie versa. This leads to a trader
building up a position. If he has sold / bough t more pounds than he has bought/ sold he is
said to have a net short position / long position in pounds. Given the variability of exchange
rates, maintaining a large net short or long position in pounds of 1000000. The pound
suddenly appreciates from say $1.7500 to $1.7520. This implies that the banks liability
increases by $2000 ($0.0020 per pound for 1 million pounds. Of course pound depreciation
would have resulted in a gain. Similarly a net long position leads to a loss if it has to be
covered at a lower price and a gain if at a higher price. (By covering a position we mean
undertaking transactions that will reduce the net position to zero. A trader net long in pounds
must sell pounds to cover a net short must buy pounds. A potential gain or loss from a
position depends upon the size of the position and the variability of exchange rates. Building
and carrying such net positions for a long duration would be equivalent to speculation and
banks exercise tight control over their traders to prevent such activity. This is done by
prescribing the maximum size of net positions a trader can build up during a trading day and
how much can be carried overnight.
When a trader realizes that he is building up an undesirable net position he will adjust
his bid ask quotes in a manner designed to discourage on type of deal and encourage the
opposite deal. For instance a trader who has overbought say DEM against USD, will want to
discourage further sellers of marks and encourage buyers. If his initial quote was say
DEM/USD 1.7500 – 1.7510 he might move it to 1.7508 – 1.7518 i.e offer more marks per
USD sold to the bank and charge more marks per dollar bought from the bank.

Since most of the trading takes place between market making banks, it is a zero – sum
game, i.e. gains made by one trader are reflected in losses made by another. However when
central banks intervene, it is possible for banks as a group to gain or lose at the expense of the
central bank.
Bulk of the trading of the convertible currencies. Takes place against the US dollar. Thus
quotations for Deutschemarks, Swiss Francs, yen, pound sterling etc will be commonly given
against the US dollar. If a corporate customer wants to buy or sell yen against the DEM, a
cross rate will be worked out from the DEM/USD and JPY/USD quotation. One reason for
using a common currency (called the vehicle currency) for all quotations is to economize on
the number of exchange rates. With 10 currencies 54 two-way quotes will be needed. By

4
using a common currency to quote against, the number is reduced to 9 or in general n – 1ss.
Also by this means the possibility of triangular arbitrage is minimized. However some banks
specialize in giving these so called cross rates.

4. Define the value date and classify the transactions into spot and forward
transactions based on value date
A settlement of any transaction takes place by transfers of deposits between the two
parties. The day on which these transactions are effected is called the settlement date or the
value date. To effect the transfers, the banks in the countries of the two currencies involved
must be open for business. The relevant countries are called settlement locations. The
location of the two banks involved in the trade is dealing locations, which need not be the
same as the settlement locations. When we talk about settlements, they are usually of the
following types:

Cash – T + 0
Tom – T+1
Spot – T+2
Forward – T + n

Where T represents the current day when trading takes place and n represents number of
days, usually after two business days but mostly at least after one month.

• Cash – Cash rate or Ready rate is the rate when the exchange of currencies takes place
on the date of the deal itself. There is no delay in payment at all, therefore represented
by T + 0. When the delivery is made on the day of the contract is booked, it is called a
Telegraphic Transfer or cash or value – day deal.

• Tom – It stands for tomorrow rate, which indicates that the exchange of currencies
takes place on the next working day after the date of the deal, and therefore
represented by T+ 1.

• Spot – When the exchange of currencies takes place on the second day after the date
of the deal (T+2), it is called as spot rate. The spot rate is the rate quoted for current
foreign – currency transactions. It applies to interbank transactions that require
delivery on the purchased currency within two business days in exchange for
immediate cash payment for that currency.

• Forward – If the exchange of currencies takes place after a certain period after the
date of the deal (more than two working days), it is called forward rate. The forward
rate is a contractual rate between a foreign – exchange trader and the trader’s client
for delivery of foreign currency sometime in the future, after at least two business
days but usually after at least one month. Standard forward contract maturities are
1,2,3,6, 9, and 12 months.

5. Define arbitrage and explain the different types of arbitrage.

Sometimes companies deal in foreign exchange to make a profit, even though the
transaction is not connected to any other business purpose, such as trade flows or investment
flows. Usually, however, this type of foreign – exchange activities is more likely to be
persuaded by foreign – exchange traders and investors. One type of profit – seeking activity

5
is arbitrage, which is the purchase of foreign currency on one market for immediate resale on
another market (in a different country) in order to profit from a price discrepancy. Hence,
arbitrage may be defined as an operation that consists in deriving a profit without risk from a
differential existing between different quoted rates. It may result from two currencies (also
known as geographical arbitrage) or from three currencies (also known as triangular
arbitrage).

Interest arbitrage involves investing in foreign – bearing instruments in foreign

exchange in an effort to earn a profit due to interest – rates differentials. For example, a trader
may invest $ 1000 in the United States for ninety days or convert $1000 into British pounds,
invest the money in the United Kingdom for ninety days and then convert the pounds back
into dollars. The investor would try to pick the alternative that would be the highest yielding
at the end of ninety days.

But Speculation is the buying or the selling of the commodity i.e. foreign
currency, where the activity contains both the element of risk and the chances of a greater
profit. Speculators are important in the foreign – exchange market because they spot trends
and try to take advantage of them. Thus they can be a valuable source of both supply and
demand for a currency. As a protection against risk, foreign – exchange transactions can be
used to hedge against a potential loss due to an exchange – rate change.

 Spot Quotations:

• Arbitraging between Banks: Though one hears the term “market rate”, it is not
true that all banks will have identical quotes for a given pair of currencies at a given
point of time. The rates will be close to each other but it may be possible for a
corporate customer to save some money by shopping around.

• Inverse quotes and 2 – point arbitrage: The arbitrage transaction that involve
buying a currency in one market and selling it at a higher price in another market is
called Two – point Arbitrage. Foreign exchange markets quickly eliminate two –
point arbitrage opportunities if and when they arise.

• Cross rates and 3 – point arbitrage: The term three – point arbitrage refers to the
kind of transaction where one starts with currency A, sell it for B, sell B for C and
finally sell C back for A ending up with more A than one began with. Efficient
foreign exchange markets do not permit risk - less arbitrage profit of this kind.

Numerical Examples

1. An Arbitrage between two Currencies.

Suppose two traders A and B are quoting the following rates:

Trader A (Paris) Trader B (New York)

FFr 5.5012/US$ US $ 0.1817/FFr

6
 We assume that the buying and selling rates for these traders are the same. We find
out the reciprocal rate of the quote given by the trader B, which is FFr 5.5036 / US $ (=
1/0.1817) .A combiste buys, say, US $ 10,000 from the trader A by paying FFr 55,012. Then
he sells these US $ to trader B and receives FFr 55,036. in the process he gains FFr 24
(=55,036 - 55,012).

Since, in practice buying and selling rates are likely to be different, so the quotation is
likely to be as follows:

Trader A Trader B

FFr 5.4500/US $ - FFr 5.5012 US $ US $ 0.1785/FFr - US $ 0.1817/ FFr

These rates mean that trader A would be willing to buy one unit of US dollar by
paying FFr 5.45 while he would sell one US dollar for FFr 5.501. The same holds true for the
corresponding figures of trader B.

But this process would tend to increase the selling rate at the trader A because of the
increase in demand of US dollars and the reverse would happen at the trader B because of
increased supply of US dollars. This would lead to an equilibrium after some time.

2.An Arbitrage between three currencies

Suppose two traders, both located at New York are quoting as follows:

Trader A Trader B

$ 0.60/SF $ 0.60/SFr

$ 0.51 DM $ 0.52 DM

Since three currencies are involved here, we find the cross rates between SFr and DM
as well. These are:

SFr 0.85/DM (= 0.51/0.60) at the trader A and SFr 0.867/DM (= 0.52/0.60) at the
trader B. Thus, the situation looks like as follows:

Trader A Trader B

$ 0.60/SFr $ 0.60/SFr

$ 0.51/DM $ 0.52/DM

SFr 0.85/DM SFr 0.867/ DM

Hence what are the arbitrage possibilities?

There is no arbitrage gain possible between the US $ and the Swiss franc.

The following two arbitrages are, however possible.

7
  Deutschmarks against the US $ is being quoted at the trader B. So buy DM’s
from the trader A and sell them to trader B.
 Buy DM’s against SFr’s from the trader A and sell them to the trader B.

6. Examine clearly the different types of forward transactions and describe

discount and premium evaluation in forward quotations.

 Outright forward quotation:

Some of the major currencies quoted in the forward market are Deutschmarks, Pound
sterling, Japanese yen, Swiss franc, Canadian dollar etc. they are generally quoted in terms of
US dollars. Currencies may be quoted in terms of one, three, six months and one year
forward. But enterprises may obtain form banks quotations for different periods.

As mentioned earlier, the spot market is for foreign – exchange transactions within
two business days. However, some transactions maybe entered into on one day but not
completed until after two business days. For example, a French exporter of perfume might
sell perfume to an US importer with immediate delivery but payment not required for thirty
days. The US importer is obligated to pay in francs in thirty days and may enter into a
contract with a trader to deliver francs in thirty days at a forward rate, a rate today for future
delivery.

Thus the forward rate is the rate quoted by foreign – exchange traders for the purchase
or sale of foreign exchange in the future. The difference between the spot and the forward
rates is known as either the forward discount or the forward premium on the contract. If the
domestic currency is quoted on a direct basis and the forward rate is greater than the spot rate,
the foreign currency is selling at a premium. It is calculated as follows:

Forward discount/ premium = Forward mid – Spot mid * 12/n * 100

Spot mid

Where n indicates the number of months forward.

When Fwd rate > Spot rate, it implies premium.
Fwd rate < Spot rate, it implies discount.

In the case of forward market, the arbitrage operates in the differential of interest rates and
the premium or discount on exchange rates.

Numerical problems

1. Spot 1-month 3-months 6-months

(FFr/US$) 5.2321/2340 25/20 40/32 20/26

In outright terms these quotes would be expressed as below:

Maturity Bid/Buy Sell/Offer/Ask Spread

8
 Spot FFr 5.2321 per US $ FFr 5.2340 per US $ 0.0019

1-month FFr 5.2296 per US $ FFr 5.2320 per US $ 0.0024

3-months FFr 5.2281 per US $ FFr 5.2308 per US $ 0.0027

6-months FFr 5.2341 per US $ FFr 5.2366 per US $ 0.0025

It may be noted that in the forward deals of one month and 3 months, US $ is at
discount against the French franc while 6 months forward is at a premium. The first figure is
greater than the second both in one month and three months forward quotes. Therefore, these
quotes are at a discount and accordingly these points have been subtracted from the spot rates
to arrive at outright rates. The reverse is the case for 6 months forward.

2. We take an example of a quotation for the US $ against Rupees, given by a trader in

New Delhi.

Spot 1-month 3-months 6-months

Rs 32.1010-Rs32.1100 225/275 300/350 375/455

Spread 0.0090 0.0050 0.0050 0.0080

The outright rates from these quotations will be as follows:

Maturity Bid/Buy Sell/Offer/Ask Spread

Spot Rs 32.1010 per US $ Rs 32.1100 per US $ 0.0090

1-month Rs 32.1235 per US $ Rs 32.1375 per US$ 0.0140

3-months Rs 32.1310 per US $ Rs 32.1450 per US $ 0.0140

6-months Rs 32.1385 per US $ Rs 32.1555 per US $ 0.0170

Here we notice that the US $ is at a premium for all three forward periods.

Also, it should be noted that the spreads in forward rates are always equal to the sum
of the spread of the spot rate and that of the corresponding forward points.

Numerical problems and solutions

1. On a particular date the following DEM/$ spot quote is obtained from a bank: -1.6225/35
a) Explain this quotation.
Ans. The above quotation shows the bid rate and the ask rate of the currencies in question,
the initial figure i.e. 1.6225 being the bid rate and the latter being the ask rate. Also

9
 it shows the number of DEM used to buy or sell one US dollar i.e. the bank will
pay 1.6225 DEM for each US dollar it buys and will want to be paid 1.6235 DEM
for each US dollar it sells.

b) Compute implied inverse quote.

Ans. When DEM/$ is 1.6225/35, the implied inverse quote is:
$/DEM becomes 0.6159/63
(1/1.6235 = 0.6159 and 1/ 1.6225 = 0.6163)

c) Another bank quoted $/DEM 0.6154/59. Is there an arbitrage? If so how would

it work?
Ans. Suppose Bank A quotes $/DEM 0.6154/59 and Bank B quotes $/DEM 0.6159/63.
There is no arbitrage opportunity since the main purpose of doing an arbitrage is
making a profit without any risk or commitment of capital. This doesn’t exist in the
given case as a potential buyer would end up buying a DEM at 0.6159 $ from Bank
A and would have to sell it to Bank B at the same price since that would be the only
way of not making any losses. It is clear form the diagram shows that shows no
arbitrage is possible:

$/DEM 0.6154 59 63

Bank A Bank B

2. The following quotes are obtained from the banks:

Bank A Bank B
FFr/$ spot 4.9570/80 4.9578/90

a) Is there an arbitrage opportunities

Ans. There is no arbitrage opportunity in this case. This can be represented
diagrammatically as:

FFr/$ 4.9570 78 80 90

Bank A
Bank B

The quotes are overlapping each other hence preventing an arbitrage. The
buyer will go into a loss if he buys from bank A at 4.9580 FFr since he would have to sell it
to bank B for 4.9578 FFr undergoing a loss of 0.0002 FFr.

b) What kind of market will it result into?

Ans. This will result into a one – way market.

10
 c) What might be the reason for this?
Ans. A one – way market may be created when a bank wants to either encourage the
seller of dollars and discourage buyers or vice – versa. In this case, Bank A wants to
encourage buyers of dollars and discourage sellers of the same thus creating a net long
positioning dollars. At the same time Bank B wants to encourage the sellers of dollars
and discourage buyers thus creating a net short position in dollars. Hence the outcome
would be that Bank A will be confronted largely with buyers of US dollars and few
sellers while for Bank B the reverse case will hold true. Eventually, it would mean
that regular clients of Bank B wanting to buy dollars can save some money by going
to Bank A and vice – versa.

3. In London a dealer quotes: DEM/ GPB spot 3.5250/55

JPY/ GPB spot 180.0080/181.0030
a) What do you expect the JPY/ DEM rate to be in Frankfurt?
Ans. In London: DEM/ GPB spot 3.5250/55
JPY/ GPB spot 180.0080/181.0030
Therefore, JPY/ DEM = B1 A1 [where B1 - 180.0080
A2 B2 A1 – 181.0030
B2 - 3.5250
A2 – 3.5255]
= 180.0080 181.0030
3.5255 3.5250

= 51.0588 / 51.3483 JPY/ DEM

It is assumed that the JPY/ DEM rate in Frankfurt will also approximately be the same
as in London. Therefore, the JPY/ DEM rate in Frankfurt is 51.0588 / 51.3483.

b) Suppose that in Frankfurt you get a quote: JPY/ DEM spot 51.1530/ 51.2250.
Is there an arbitrage opportunity?
Ans. When in London: JPY/ DEM 51.0588 / 51.3483 and
In Frankfurt: JPY/ DEM 51.1530/ 51.2250
There is no arbitrage opportunity as the quotes overlap each other and the buyer will
stand to make a loss. If he buys in Frankfurt where 1 DEM is 51.2250 JPY and sells
it in London for 51.0588 JPY, he makes a loss of 0.1662JPY. Diagrammatically it
can be represented as:

JPY/ DEM 51.0588 .1530 .2250 .3483

Frankfurt

London

11
 4. The following quotes are obtained in New York: DEM/$ spot 1.5880/ 90
1- month forward 10/ 5
2- month forward 20/ 10
3- month forward 30/ 15
Calculate the outright forward rates.
Ans. While observing the forward quotations, it is clear that the US dollar is at discount in
the forward market since the points corresponding to the bid price are higher than
those corresponding to the ask price. Therefore, the forward points will be
subtracted form the spot rate figure. Thus, the outright rates are:

DEM/$ spot - 1.5880/ 90

1 – month forward - 1.5870/ 85
2 – month forward - 1.5860/ 80
3 – month forward - 1.5850/ 75

Text Book Questions

The Foreign Exchange Market

I. Explain the following terms:

1. Bid rate: The bid rate denotes the number of units of a currency a bank is willing to
pay when it buys another currency.

2. Offer rate: The offer rate denotes the number of units of a currency a bank will want
to be paid when it sells a currency

3. Bid offer spread: The difference between the ask and bid rates. E.g. [(DEM/USD)ask
– (DEM/USD)bid]

4. Value date: The settlement of a transaction takes place by transfers of deposits

between two parties. The day on which these transfers are effected is called the
Settlement Date or the Value Date.

5. Swap transaction: A swap transaction in the foreign exchange market is combination

of a spot and a forward in the opposite direction. Thus a bank will buy DEM spot
against USD and simultaneously enter into a forward transaction with the same
counter party to sell DEM against USD against the mark coupled with a 60- day
forward sale of USD against the mark. As the term ‘swap’ implies, it is a temporary
exchange of one currency for another with an obligation to reverse it at a specific
future date.

II Explain the terms:

a) European quotes: The quotes are given as number of units of a currency per USD. Thus
DEM1.5675/USD is a European quote.

b) American quotes: American quotes are given as number of dollars per unit of a currency.
Thus USD0.4575/DEM is an American quote

12
c) Direct quotes: In a country, direct quotes are those that give unit of the currency of that
country per unit of a foreign currency. Thus INR 35.00/USD is a direct quote in India.

d) Indirect quotes: Indirect or Reciprocal Quotes are stated as number of units of a foreign
currency per unit of the home currency. Thus USD 3.9560/INR 100 is an indirect quote in
India.

e) On a particular day at 11.00 am, the following DEM/$ spot quote is obtained from a bank
1.6225/35.
a). Explain this quotation.
Ans. The above quotation shows the bid rate and the ask rate of the currencies in question,
the initial figure i.e. 1.6225 being the bid rate and the latter being the ask rate. Also it shows
the number of DEM used to buy or sell one US dollar i.e. the bank will pay 1.6225 DEM for
each US dollar it buys and will want to be paid 1.6235 DEM for each US dollar it sells.

b) Compute implied inverse quote.

Ans. When DEM/$ is 1.6225/35, the implied inverse quote is:
$/DEM becomes 0.6159/63
(1/1.6235 = 0.6159 and 1/ 1.6225 = 0.6163)

c). Another bank quoted $/DEM 0.6154/59. Is there an arbitrage? If so how would it work?
Ans. Suppose Bank A quotes $/DEM 0.6154/59 and Bank B quotes $/DEM 0.6159/63. There
is no arbitrage opportunity since the main purpose of doing an arbitrage is making a profit
without any risk or commitment of capital. This doesn’t exist in the given case as a potential
buyer would end up buying a DEM at 0.6159 $ from Bank A and would have to sell it to
Bank B at the same price since that would be the only way of not making any losses. It is
clear form the diagram shown below that shows no arbitrage is possible:

$/DEM 0.6154 59 63
Bank A Bank B

III. The following quotes are obtained from the banks:

Bank A Bank B
FFr/$ spot 4.9570/80 4.9578/90

a) Is there an arbitrage opportunities

Ans. There is no arbitrage opportunity in this case. This can be represented
diagrammatically as:

FFr/$ 4.9570 78 80 90

Bank A
Bank B
The quotes are overlapping each other hence preventing an arbitrage. The buyer will go into a
loss if he buys from bank A at 4.9580 FFr since he would have to sell it to bank B for 4.9578
FFr undergoing a loss of 0.0002 FFr.

13
 b) What kind of market will it result into?
Ans. This will result into a one – way market.

c) What might be the reason for this?

Ans. A one – way market may be created when a bank wants to either encourage the seller
of dollars and discourage buyers or vice – versa. In this case, Bank A wants to encourage
buyers of dollars and discourage sellers of the same thus creating a net long positioning
dollars. At the same time Bank B wants to encourage the sellers of dollars and discourage
buyers thus creating a net short position in dollars. Hence the outcome would be that
Bank A will be confronted largely with buyers of US dollars and few sellers while for
Bank B the reverse case will hold true. Eventually, it would mean that regular clients of
Bank B wanting to buy dollars can save some money by going to Bank A and vice –
versa.

IV. The buyer rate for SFr spot in New York is $ 0.5910. A corporate treasurer is going to buy
SFr in Zurich at SFr/$ 1.6650 and sell them in New York. Will he make a profit? If yes, then
how much?
Ans. The steps involved in this process are as follows:
i. Buys 1.6650SFr at Zurich by paying 1$
ii. Sells 1.6650 SFr at New York and gets 0.9840$ [0.5910*1.6650]
Thus, gives 1$ and gets 0.9840$.
Therefore loss inculcated is $0.016.

V. In London a dealer quotes: DEM/ GPB spot 3.5250/55 JPY/ GPB spot 180.80/181. 30
a) What do you expect the JPY/ DEM rate to be in Frankfurt?
Ans. In London: DEM/ GPB spot 3.5250/55
JPY/ GPB spot 180.80/181.30
Therefore, JPY/ DEM = B1 A1 [where B1 - 180.80
A2 B2 A1 – 181.30
B2 - 3.5250
A2 – 3.5255]
= 180.80 181.30
3.5255 3.5250
= 51.2835/ 51.4326 JPY/ DEM
It is assumed that the JPY/ DEM rate in Frankfurt will also approximately be the same as in
London. Therefore, the JPY/ DEM rate in Frankfurt is 51.2835/ 51.4326

b) Suppose that in Frankfurt you get a quote: JPY/ DEM spot 51.1530/ 51.2250.
Is there an arbitrage opportunity?
Ans. When in London A: JPY/ DEM 51. 2835/ 51.4326 and
In Frankfurt B: JPY/ DEM 51.1530/ 51.2250
There exist an arbitrage opportunity, buy from the dealer from Frankfurt at
51.2550JPY and sell it to the dealer in London at 51.2835JPY making a profit of
0.0285JPY/DEM without any risk of commitment of capital. It can be shown as :
At B + DEM -51.2550 JPY
At A -DEM +51.2835 JPY
i. +0.0285JPY

Another arbitrage that is possible is shown as under:

14
 At A buy DEM i.e. –DEM +51.2835 JPY
At B +x -51.2550 JPY
X = 51.2835/51.2550 = 1.0006 DEM
Therefore, arbitrage of 0.0006 DEM is possible.

VI. The following quotes are obtained in New York: $/GPB = 1.5275/85
SFr/ $ = 1.5530/35
a. what rates do you expect for SFr/ GPB spot in London?
Ans. In New York $/GPB = 1.5275/85
And SFr/$ =1.5530/35
Therefore GPB/$ =0.6542/0.6547
Also in New York:
SFr/GPB =B1 B2
A2 A1
=1.5275 1.5285
0.6547 0.6542

1. Therefore SFr/GPB = 2.3720/2.3746

It is assumed that the spot rate in London will approximately same as that in New York.
Therefore, in London SFr/GPB spot is assumed to be 2.3720/2.3746.

b. If a London bank quotes 2.3730/40, can you make arbitrage profits? If so, then how?

Ans. In London SFr/GPB 2.3730/40

In New York SFr/GPB 2.3720/2.3746
In this case, an arbitrage opportunity does not exist. It is clearly seen below in
the diagram:

SFr/GPB 2.3720 3730 3740 3746

London
New York

VII. The following quotes are obtained in New York: DEM/$ spot 1.5880/ 90
1- month forward 10/ 5
2- month forward 20/ 10
3- month forward 30/ 15
Calculate the outright forward rates.
Ans. While observing the forward quotations, it is clear that the US dollar is
at discount in the forward market since the points corresponding to the bid price
are higher than

VIII The following quotes are available in Amsterdam:

$/DG spot :0.5875/85
1- month fwd :12/18
2-month fwd :15/25
3- month fwd :20/30
Calculate the outright forward.

15
 Ans. An observation of the figures indicates that the first figure is lower than the
second in all the three forward quotes, implying DG is quoted at premium in the
forward market.
Thus, the points will be added to the corresponding spot rates. The
rates are calculated as shown:
$/DG spot :0.5875/58
1-month fwd :0.5887/0.5903
2-month fwd :0.5890/0.5910
3-month fwd :0.5895/0.5915
those corresponding to the ask price. Therefore, the forward points will be subtracted form
the spot rate figure. Thus, the outright rates are:

DEM/$ spot - 1.5880/ 90

1 – month forward - 1.5870/ 85
2 – month forward - 1.5860/ 80
3 – month forward - 1.5850/ 75

16