INTERNATIONAL FINANCE – MBA 926

1. Give a full definition of the market for foreign exchange.

Answer: Broadly defined, the foreign exchange (FX) market encompasses the conversion of

purchasing power from one 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.

2. What is the difference between the retail or client market and the wholesale or interbank

market for foreign exchange?

Answer: The market for foreign exchange can be viewed as a two-tier market. One tier is the

wholesale or interbank market and the other tier is the retail or client market. International banks

provide the core of the FX market. They stand willing to buy or sell foreign currency for their

own account. These international banks serve their retail clients, corporations or individuals, in

conducting foreign commerce or making international investment in financial assets that requires

foreign exchange. Retail transactions account for only about 14 percent of FX trades. The other

86 percent is interbank trades between international banks, or non-bank dealers large enough to

transact in the interbank market.

3. Who are the market participants in the foreign exchange market?

Answer: The market participants that comprise the FX market can be categorized into five

groups: international banks, bank customers, non-bank dealers, FX brokers, and central banks.

International banks provide the core of the FX market. Approximately 100 to 200 banks

worldwide make a market in foreign exchange, i.e., they stand willing to buy or sell foreign

currency for their own account.

Answer: The interbank market is a network of correspondent banking relationships, with

large commercial banks maintaining demand deposit accounts with one another, called

correspondent bank accounts. The correspondent bank account network allows for the

efficient functioning of the foreign exchange market. As an example of how the network

of correspondent bank accounts facilities international foreign exchange transactions,

consider a U.S. importer desiring to purchase merchandise invoiced in guilders from a

Dutch exporter. The U.S. importer will contact his bank and inquire about the exchange

rate. If the U.S. importer accepts the offered exchange rate, the bank will debit the U.S.

importer’s account for the purchase of the Dutch guilders. The bank will instruct its

correspondent bank in the Netherlands to debit its correspondent bank account the

appropriate amount of guilders and to credit the Dutch exporter’s bank account. The

importer’s bank will then debit its books to offset the debit of U.S. importer’s account,

reflecting the decrease in its correspondent bank account balance.

5.What is meant by a currency trading at a discount or at a premium in the forward market?

Answer: The forward market involves contracting today for the future purchase or sale of foreign

exchange. The forward price may be the same as the spot price, but usually it is higher (at a

premium) or lower (at a discount) than the spot price.

6. Why does most interbank currency trading worldwide involve the U.S. dollar?

Answer: Trading in currencies worldwide is against a common currency that has international

appeal. That currency has been the U.S. dollar since the end of World War II. However, the euro

and Japanese yen have started to be used much more as international currencies in recent years.
More importantly, trading would be exceedingly cumbersome and difficult to manage if each

trader made a market against all other currencies.

7. Banks find it necessary to accommodate their clients’ needs to buy or sell FX forward, in

many instances for hedging purposes. How can the bank eliminate the currency exposure it has

created for itself by accommodating a client’s forward transaction?

Answer: Swap transactions provide a means for the bank to mitigate the currency exposure in a

forward trade. A swap transaction is the simultaneous sale (or purchase) of spot foreign

exchange against a forward purchase (or sale) of an approximately equal amount of the foreign

currency. To illustrate, suppose a bank customer wants to buy dollars three months forward

against British pound sterling. The bank can handle this trade for its customer and

simultaneously neutralize the exchange rate risk in the trade by selling (borrowed) British pound

sterling spot against dollars. The bank will lend the dollars for three months until they are needed

to deliver against the dollars it has sold forward. The British pounds received will be used to

liquidate the sterling loan.

8. A CD/$ bank trader is currently quoting a small figure bid-ask of 35-40, when the rest of the

market is trading at CD1.3436-CD1.3441. What is implied about the trader’s beliefs by his

prices?

Answer: The trader must think the Canadian dollar is going to appreciate against the U.S. dollar

and therefore he is trying to increase his inventory of Canadian dollars by discouraging

purchases of U.S. dollars by standing willing to buy $ at only CD1.3435/$1.00 and offering to

sell from inventory at the slightly lower than market price of CD1.3440/$1.00.

9. What is triangular arbitrage? What is a condition that will give rise to a triangular arbitrage

opportunity?
Answer: Triangular arbitrage is the process of trading out of the U.S. dollar into a second

currency, then trading it for a third currency, which is in turn traded for U.S. dollars. The purpose

is to earn an arbitrage profit via trading from the second to the third currency when the direct

exchange between the two is not in alignment with the cross exchange rate.

Most, but not all, currency transactions go through the dollar. Certain banks specialize in

making a direct market between non-dollar currencies, pricing at a narrower bid-ask spread than

the cross-rate spread. Nevertheless, the implied cross-rate bid-ask quotations impose a discipline

on the non-dollar market makers. If their direct quotes are not consistent with the cross exchange

rates, a triangular arbitrage profit is possible.

10. Over the past six years, the exchange rate between Swiss franc and U.S. dollar, SFr/$, has

changed from about 1.30 to about 1.60. Would you agree that over this six-year period, the Swiss

goods have become cheaper for buyers in the United States? (UPDATE? SF has gone from

SF1.67/$ to SF1.04/$ over the last six years.)

Answer:

The value of the dollar in Swiss francs has gone up from about 1.30 to about 1.60. Therefore, the

dollar has appreciated relative to the Swiss franc, and the dollars needed by Americans to

purchase Swiss goods have decreased. Thus, the statement is correct.

1. Using Exhibit 5.4, calculate a cross-rate matrix for the euro, Swiss franc, Japanese yen, and

the British pound. Use the most current American term quotes to calculate the cross-rates so that

the triangular matrix resulting is similar to the portion above the diagonal in Exhibit 5.6.
Solution: The cross-rate formula we want to use is:

S(j/k) = S($/k)/S($/j).

The triangular matrix will contain 4 x (4 + 1)/2 = 10 elements.

¥ SF £ $

Euro 159.91 1.6317 .7478 1.4744

Japan (100) 1.0204 .4676 .9220

Switzerland .4583 .9036

U.K 1.9717

11.Using Exhibit 5.4, calculate the one-, three-, and six-month forward cross-exchange rates

between the Canadian dollar and the Swiss franc using the most current quotations. State the

forward cross-rates in “Canadian” terms.

Solution: The formulas we want to use are:

FN(CD/SF) = FN($/SF)/FN($/CD)

or
 FN(CD/SF) = FN(CD/$)/FN(SF/$).

We will use the top formula that uses American term forward exchange rates.

F1(CD/SF) = .9052/.9986 = .9065

F3(CD/SF) = .9077/.9988 = .9088

F6(CD/SF) = .9104/.9979 = .9123

12.A foreign exchange trader with a U.S. bank took a short position of £5,000,000 when the $/£

exchange rate was 1.55. Subsequently, the exchange rate has changed to 1.61. Is this movement

in the exchange rate good from the point of view of the position taken by the trader? By how

much has the bank’s liability changed because of the change in the exchange rate? UPDATE TO

CURRENT EX-RATES?

Answer:

The increase in the $/£ exchange rate implies that the pound has appreciated with respect to the

dollar.

This is unfavorable to the trader since the trader has a short position in pounds.
Bank’s liability in dollars initially was 5,000,000 x 1.55 =

$7,750,000 Bank’s liability in dollars now is 5,000,000 x 1.61 =

$8,050,000

13.Restate the following one-, three-, and six-month outright forward European term bid-ask

quotes in forward points.

Spot1.3431-1.3436

One-Month1.3432-1.3442

Three-Month1.3448-1.3463

Six-Month 1.3488-1.3508

Solution:

One-Month01-06

Three-Month 17-27

Six-Month 57-72

14.Using the spot and outright forward quotes in problem 3, determine the corresponding bid-ask

spreads in points.
Solution:

Spot 5

One-Month 10

Three-Month 15

Six-Month 20

15.Using Exhibit 5.4, calculate the one-, three-, and six-month forward premium or discount for

the Canadian dollar versus the U.S. dollar using American term quotations. For simplicity,

assume each month has 30 days. What is the interpretation of your results?

Solution: The formula we want to use is:

fN,CD = [(FN($/CD) - S($/CD/$)/S($/CD)] x 360/N

f1,CD = [(.9986 - .9984)/.9984] x 360/30 = .0024

f3,CD = [(.9988 - .9984)/.9984] x 360/90 = .0048

f6,CD = [(.9979 - .9984)/.9984] x 360/180 = -.0060

versus the U.S. dollar for maturities up to three months into the future and then it trades at a

discount.

16.Using Exhibit 5.4, calculate the one-, three-, and six-month forward premium or discount for

the U.S. dollar versus the British pound using European term quotations. For simplicity, assume

each month has

30 days. What is the interpretation of your results?

Solution: The formula we want to use is:

fN,$ = [(FN (£/$) - S(£/$))/S(£/$)] x 360/N

f1,$ = [(.5076 - .5072)/.5072] x 360/30 = .0095

f3,$ = [(.5086 - .5072)/.5072] x 360/90 = .0331

f6,$ = [(.5104 - .5072)/.5072] x 360/180 = .0757

British pound. That is, it becomes more expensive to buy a U.S. dollar forward for British

pounds (in absolute and percentage terms) the further into the future one contracts.

BOOKS:

 P. G. Apte, International Financial Management, Tata McGraw-Hill, New Delhi.