Module 1.

Spot and Forward Exchange Rates

Chapter 5

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Outline
⚫ The structure of foreign exchange market
⚫ Spot rate quotations
⚫ Bid-ask spread
⚫ Cross exchange rates
⚫ Triangular arbitrage
⚫ Forward rate quotations
⚫ Payoffs to forward positions
The Structure of Foreign Exchange Market
FX market is a two-tiered market:
⚫ The interbank market (wholesale)
➢ International banks
➢ Nonbank dealers: stand ready to buy and sell.
➢ Brokers: match orders but do not carry inventory.
⚫ The client market (retail):
➢ Central banks, MNCs, money managers, private clients.

Interbank communication: Society for Worldwide

Interbank Financial Telecommunications (SWIFT).
Currency Symbols
In addition to currency symbols (e.g. $, £, ¥, €, kr),
there are three-letter codes for currencies.
For example:
AUD - Australian dollar GBP - British pound
CAD - Canadian dollar JPY - Japanese yen
CHF - Swiss francs SEK - Swedish krona
EUR - euro USD - US dollar

NZD - New Zealand dollar CNY - Chinese RMB

Correspondent Banking Relationships
Large commercial banks maintain demand deposit
accounts with one another to facilitate the efficient
functioning of the FX market.

Suppose Bank A is in London, Bank B is in New York. Each

maintains a correspondent balance sheet of assets and liabilities
with the other. The current exchange rate is £1.00 = $2.00.

Bank A Assets Liabilities Bank B Assets Liabilities

£ deposit at B £300m B’s Deposit $1,000m $ deposit at A $1000m A’s Deposit £300m
$ deposit at B $800m B’s Deposit £200m £ deposit at A £200m A’s Deposit $800m
Other Assets £600m Other L&E £600m Other Assets $800m Other L&E $800m
Total Assets £1,300m Total L&E £1,300m Total Assets $2,200m Total L&E $2,200m
 Example:
Suppose Bank A buys £100m from Bank B for $200m.
➢This trade is settled using the correspondent relationship.
$200
Bank A Bank B
London £100 N.Y.

Bank A Assets Liabilities Bank B Assets Liabilities

£ deposit at B £300m B’s Deposit $1,000m $ deposit at A$1000m A’s Deposit £300m
£400m $1,200m $1200m £400m
$ deposit at B $800m B’s Deposit £200m £ deposit at A £200m A’s Deposit $800m
$600m £100m £100m $600m
Other Assets £600m Other L&E £600m Other Assets $800m Other L&E $800m
Total Assets £1,300m Total L&E £1,300m Total Assets $2,200m Total L&E $2,200m
 Foreign Exchange Rate Quotations
⚫ Direct quotation (American term): the U.S. dollar
equivalent of one unit foreign currency.
❖ This is the market convention for quoting the euro, British
pound, Australian dollar and New Zealand dollar.
⚫ Indirect quotation (European term): the price of one
U.S. dollar in the foreign currency.

Country/currency in US$ per US$

UK pound 1.9717 .5072
1-month forward 1.9700 .5076
3-month forward 1.9663 .5086
Spot Rates
Country/currency in US$ per US$
UK pound 1.9717 .5072

The direct spot quote for the pound is: £1=$1.9717, or

$1.9717/£ .
The indirect spot quote for the pound is: £0.5072=$1, or
£0.5072/$.

➢ The direct quote is the reciprocal of the indirect

quote: $1.9717/£ = 1 / (£0.5072/$)
The Cross Rate
Suppose that S($/€) = 1.50 (i.e., $1.50 = €1.00)
and that S($/£) = 2.00 (i.e., $2.00 = £1.00).
What must the €/£ cross rate be?

€ €×$ $/£
= =
£ $×£ $/€

2.00($/£)
= =1.33(€/£)
1.50($/€)
The Bid-Ask Spread
⚫ The bid price is the price a dealer is willing to pay
you for something.
⚫ The ask price is the amount the dealer wants you
to pay for something.

➢ The bid-ask spread reflects the dealer’s expected

profit, which is (Ask price – Bid price).
⚫ Some dealers also charge a commission.
 The Convention of Quotation
Bank American Terms European Terms
Quotations Bid Ask Bid Ask
Pounds 1.9712 1.9717 .5072 .5073

⚫ A dealer pricing pounds in terms of dollars would

likely quote these prices as 12–17.

❖ The reciprocal of the S($/£) bid is the S(£/$) ask.

1
Sa(£/$) =
Sb($/£)
Foreign Exchange with Bid-Ask Spreads

A trader in New York wants to trade $10,000 for the

pound. What will be his position in the pound?

Bid Ask
S($/£) 1.9715 – 20

Since the dealer will charge $1.9720 for £1, the

trader will get:
$10,000
= £5,071
$1.9720/£1
The Effect of Bid-Ask Spread
If this trader wants to trade his £5,071 for the US$,
how much will he get in the US$?
Bid Ask
S($/£) 1.9715 – 20

Since the dealer will pay $1.9715 for £1, the trader
will get: £5,071× $1.9715/£1= $9,997

➢ $3 is “eaten” by the bid-ask spread!

Cross Rate with Bid-Ask Spread

Sb(£/€) = Sb(£/$) × Sb($/€)

Sa(£/€) = Sa(£/$) × Sa($/€)

Sb(£/€) = 1/ Sa(€/£)

Sa(£/€) = 1/ Sb(€/£)
 Cross Rates with Bid-Ask Spreads
Bank Quotations American Terms European Terms
Bid Ask Bid Ask
Bank A: Pounds 1.9712 1.9717 .5072 .5073
Bank B: Euros 1.4738 1.4742 .6783 .6785

Based on the above quotations, we can work out the

following bid and ask cross rates:

€/£ Cross Rates

Bid Ask
1.3371 1.3378
 Cross Bid Rate
How much € will a client get for selling £1?
⚫ Make two transactions:
1. Sell £1 for $ at $1.9712/£, get $1.9712;
2. Buy € using $1.9712 at €0.6783/$, get €1.3371/£.
➢ Therefore, a client will get €1.3371 for selling £1.
Alternatively,
⚫ Use the chain rule to find the cross bid rate of €/£:
Sb(€/£) = Sb(€/$) × Sb($/£)
= 0.6783 × 1.9712 = €1.3371/£
 Cross Ask Rate
How much € will a client pay for buying £1?

⚫ Make two transactions:

1. Buy £1 costs $1.9717 (at $1.9717/£).
2. It costs €1.3378 to get $1.9717 (at $1.4738/€).
➢ Therefore, it takes €1.3378 to buy £1.
➢ Alternatively, find the cross ask rate for £ priced in €
using the chain rule:
Sa(€/£) = Sa(€/$) × Sa($/£)
= 0.6785 × 1.9717 = €1.3378/£
Summary:
The cross rates between € and £ implied in the quotations
of Bank A and Bank B indicate a “no arbitrate” range.
Bank Quotations Bid Ask
Bank A $/£ $1.9712 $1.9717
Bank B $/€ $1.4738 $1.4742
“No Arbitrage” €/£ €1.3371 €1.3378

Suppose Bank C makes the market for €/£ and quotes:

Bank Quotations Bid Ask

Bank C €/£ €1.3310 €1.3317

Triangular Arbitrage with Bid-ask Spread
Bank Quotations Bid Ask
Bank A $/£ $1.9712 $1.9717
Bank B $/€ $1.4738 $1.4742
“No Arbitrage” €/£ €1.3371 €1.3378
Bank C €/£ €1.3310 €1.3317

Since SaC (€/£) < Sb implied A&B (€/£)

➢ Bank C is underpricing £ and/or overpricing €.
➢ A client can buy £ cheaply from Bank C and sell £ at a
higher price to Bank A to make a profit.
 Triangular Arbitrage strategy:
Bank Quotations Bid Ask
Bank A $/£ $1.9712 $1.9717
Bank B $/€ $1.4738 $1.4742
Bank C €/£ €1.3310 €1.3317

Suppose a trader has £1 million.

1. Sell £ to Bank A for $1,971,200.
2. Buy euro from Bank B and receive €1,337,132
= $1,971,200 / $1.4742/€
3. Buy £ from Bank C and receive £1,004,079.
= €1,337,132 / €1.3317/£
4. Make a profit of £4,079.
The Forward Market
The forward market for FX involves agreements to
buy and sell foreign currencies in the future at prices
agreed upon today.
⚫ Bank quotes for 1, 3, 6, 9, and 12 month maturities
are readily available for forward contracts.
Country/currency in US$ per US$
UK pound 1.9717 .5072
1-month forward 1.9700 .5076
3-month forward 1.9663 .5086
6-month forward 1.9593 .5104
Forward Cross Rates

Country/currency in US$ Find the 3-month forward

Euro area euro 1.4744 £/€ cross rate:
1-months forward 1.4747
3-months forward 1.4744
6-months forward 1.4726 F3 (£/€) = F3 (£/$) × F3 ($/€)
UK pound 1.9717 1
= × $1.4744/€
1-months forward 1.9700 $1.9663/£
3-months forward 1.9663
6-months forward 1.9593 = £0.7499/€
Forward Premium
The British pound is trading at a discount to the dollar in
this case – this reflects market participants’ expectation
that the pound will be worth less in dollars in 6 months.

The 180-day forward premium is given by:

F180($/£) – S($/£) 360
f180, £v$ = ×
S($/£) Days

Since S($/£) = 1.9717 to F180($/£) = 1.9593.

1.9593 – 1.9717 360
f180, £v$ = × = -1.26%
1.9717 180
The Implication of a Forward Premium
The forward premium (or discount) reflects the interest
rate differential of the two currencies.

In this case, the annualized holding period return (HPR)

of a dollar-based investor who buys £10,000 at the spot
exchange rate and sells them forward is -1.26%.
⚫ Why would anyone want to carry out this kind of
transaction?
Forward Positions: Long vs. Short
⚫ A forward swap transaction is covered by an
opposite position in the spot market.
⚫ An outright forward transaction is an uncovered
speculative position.

o You establish a “short” position if you have agreed

to sell something.
o You establish a “long” position by agreeing to buy
something.
Forward Positions: Example
Suppose a trader established a long position in $1,000 at
F180(¥/$) =105,
If in 180 days, S180(¥/$) = 120, what is his profit in yen?

At maturity,
• Long $ forward obliges the trader to buy $1,000 at
F180(¥/$) = 105, cost = $1,000 × ¥105/$ = ¥105,000;
• Then, he can sell $1,000 immediately on the spot market
at S180(¥/$) = 120, and get $1,000 × ¥120/$ = ¥120,000;
➢ Profit = ¥120,000 - ¥105,000 = ¥15,000.
 Payoffs at maturity to
a long position in forward
Profit
Payoff = ST − F
Long in the US$

0 S180(¥/$)
F180(¥/$)

-F180
Loss
Payoffs at maturity to
a short position in forward
Profit
-F180(¥/$) Payoff = F − ST

0 S180(¥/$)

F180(¥/$)

Loss Short in the US$

Profit/loss
Long in f
in h

0 S180(h/f)

F180(h/f)

Short in f

A zero sum game: the total sum of a short and a long in the
same contract = 0,
Note: S and F are quoted as h/f (home/foreign currency)
Homework:
Questions: 8, 9, 10;
Problems: 1-3, 8-13.

Next week:
Exchange rate parities and FX forecasts (chapter 6).