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1、CHAPTER 5 THE MARKET FOR FOREIGN EXCHANGESUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTER QUESTIONS AND PROBLEMSQUESTIONS1. 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 cur
2、rency 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
3、 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
4、 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 oth
5、er 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: inter
6、national 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. These in
7、ternational banks serve their retail clients, the bank customers, in conducting foreign commerce or making international investment in financial assets that requires foreign exchange. Non-bank dealers are large non-bank financial institutions, such as investment banks, mutual funds, pension funds, a
8、nd hedge funds, whose size and frequency of trades make it cost- effective to establish their own dealing rooms to trade directly in the interbank market for their foreign exchange needs.Most interbank trades are speculative or arbitrage transactions where market participants attempt to correctly ju
9、dge the future direction of price movements in one currency versus another or attempt to profit from temporary price discrepancies in currencies between competing dealers.FX brokers match dealer orders to buy and sell currencies for a fee, but do not take a position themselves. Interbank traders use
10、 a broker primarily to disseminate as quickly as possible a currency quote to many other dealers.Central banks sometimes intervene in the foreign exchange market in an attempt to influence the price of its currency against that of a major trading partner, or a country that it “fixes” or “pegs” its c
11、urrency against. Intervention is the process of using foreign currency reserves to buy ones own currency in order to decrease its supply and thus increase its value in the foreign exchange market, or alternatively, selling ones own currency for foreign currency in order to increase its supply and lo
12、wer its price.4. How are foreign exchange transactions between international banks settled?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 corre
13、spondent 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 fr
14、om 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. importers account for the purchase of the Dutch guilders. The bank will instruct its correspondent bank in the Nether
15、lands to debit its correspondent bank account the appropriate amount of guilders and to credit the Dutch exporters bank account. The importers bank will then debit its books to offset the debit of U.S. importers account, reflecting the decrease in its correspondent bank account balance.5. What is me
16、ant 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 discoun
17、t) 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 Japanes
18、e 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 sel
19、l FX forward, in many instances for hedging purposes. How can the bank eliminate the currency exposure it has created for itself by accommodating a clients forward transaction?Answer: Swap transactions provide a means for the bank to mitigate the currency exposure in a forward trade. A swap transact
20、ion 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
21、 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 re
22、ceived 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 traders beliefs by his prices?Answer: The trader must think the Canadian dollar is goi
23、ng 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/$1.0
24、0.9. What is triangular arbitrage? What is a condition that will give rise to a triangular arbitrage opportunity?Answer: Triangular arbitrage is the process of trading out of the U.S. dollar into a second currency, then trading it for a third currency, which is in turn traded for U.S. dollars. The p
25、urpose is to earn an arbitrage profit via trading from the second to the third currency when the direct exchange between the two is not in alignment with the cross exchange rate.Most, but not all, currency transactions go through the dollar. Certain banks specialize in making a direct market between
26、 non-dollar currencies, pricing at a narrower bid-ask spread than the cross-rate spread. Nevertheless, the implied cross-rate bid-ask quotations impose a discipline on the non-dollar market makers. If their direct quotes are not consistent with the cross exchange rates, a triangular arbitrage profit
27、 is possible.PROBLEMS1. Using Exhibit 5.4, calculate a cross-rate matrix for the euro, Swiss franc, Japanese yen, and the British pound. Use the most current American term quotes to calculate the cross-rates so that the triangular matrix resulting is similar to the portion above the diagonal in Exhi
28、bit 5.6.Solution: The cross-rate formula we want to use is:S(j/k) = S($/k)/S($/j).The triangular matrix will contain 4 x (4 + 1)/2 = 10 elements.SF$Euro138.051.5481.68731.3112Japan (100)1.1214.4979.9498Switzerland.4440.8470U.K1.90772. Using Exhibit 5.4, calculate the one-, three-, and six-month forw
29、ard 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)orFN(CD/SF) = FN(CD/$)/FN(SF/$).We will use the top formula that uses A
30、merican term forward exchange rates.F1(CD/SF) = .8485/.8037 = 1.0557 F3(CD/SF) = .8517/.8043 = 1.0589F6(CD/SF) = .8573/.8057 = 1.06403. Restate the following one-, three-, and six-month outright forward European term bid-ask quotes in forward points.Spot1.3431-1.3436One-Month1.3432-1.3442Three-Month
31、1.3448-1.3463Six-Month1.3488-1.3508Solution: One-Month01-06Three-Month17-27Six-Month57-724. Using the spot and outright forward quotes in problem 3, determine the corresponding bid-ask spreads in points. Solution: Spot5One-Month10Three-Month15Six-Month205. Using Exhibit 5.4, calculate the one-, thre
32、e-, 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
33、f1,CD = (.8037 - .8037)/.8037 x 360/30 = .0000f3,CD = (.8043 - .8037)/.8037 x 360/90 = .0030f6,CD = (.8057 - .8037)/.8037 x 360/180 = .0050The pattern of forward premiums indicates that the Canadian dollar is trading at an increasing premium versus the U.S. dollar. That is, it becomes more expensive
34、 (in both absolute and percentage terms) to buy a Canadian dollar forward for U.S. dollars the further into the future one contracts.6. 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
35、. 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(/$) x 360/Nf1,$ = (.5251 - .5242)/.5242 x 360/30 = -.0023f3,$ = (.5268 - .5242)/.5242 x 360/90 = -.0198f6,$ = (.5290 - .5242)/.5242 x 360/180
36、= -.0183The pattern of forward premiums indicates that the British pound is trading at a discount versus the U.S. dollar. That is, it becomes more expensive to buy a U.S. dollar forward for British pounds (in absolute but not percentage terms) the further into the future one contracts.7. Given the f
37、ollowing information, what are the NZD/SGD currency against currency bid-ask quotations?American TermsEuropean TermsBank QuotationsBidAskBidAskNew Zealand dollar .7265 .72721.37511.3765Singapore dollar .6135 .61401.62871.6300Solution: Equation 5.12 from the text implies Sb(NZD/SGD) = Sb($/SGD) x Sb(
38、NZD/$) = .6135 x 1.3765 = .8445. The reciprocal, 1/Sb(NZD/SGD) = Sa(SGD/NZD) = 1.1841. Analogously, it is implied that Sa(NZD/SGD) = Sa($/SGD) x Sa(NZD/$) = .6140 x 1.3765 = .8452. The reciprocal, 1/Sa(NZD/SGD) = Sb(SGD/NZD) = 1.1832. Thus, the NZD/SGD bid-ask spread is NZD0.8445-NZD0.8452 and the S
39、GD/NZD spread is SGD1.1832-SGD1.1841.8.Assume you are a trader with Deutsche Bank. From the quote screen on your computer terminal, you notice that Dresdner Bank is quoting 0.7627/$1.00 and Credit Suisse is offering SF1.1806/$1.00. You learn that UBS is making a direct market between the Swiss franc
40、 and the euro, with a current /SF quote of .6395. Show how you can make a triangular arbitrage profit by trading at these prices. (Ignore bid-ask spreads for this problem.) Assume you have $5,000,000 with which to conduct the arbitrage. What happens if you initially sell dollars for Swiss francs? Wh
41、at /SF price will eliminate triangular arbitrage?Solution: To make a triangular arbitrage profit the Deutsche Bank trader would sell $5,000,000 to Dresdner Bank at 0.7627/$1.00. This trade would yield 3,813,500= $5,000,000 x .7627. The Deutsche Bank trader would then sell the euros for Swiss francs
42、to Union Bank of Switzerland at a price of 0.6395/SF1.00, yielding SF5,963,253 = 3,813,500/.6395. The Deutsche Bank trader will resell the Swiss francs to Credit Suisse for $5,051,036 = SF5,963,253/1.1806, yielding a triangular arbitrage profit of $51,036.If the Deutsche Bank trader initially sold $
43、5,000,000 for Swiss francs, instead of euros, the trade would yield SF5,903,000 = $5,000,000 x 1.1806. The Swiss francs would in turn be traded for euros to UBS for 3,774,969= SF5,903,000 x .6395. The euros would be resold to Dresdner Bank for $4,949,481 = 3,774,969/.7627, or a loss of $50,519. Thus
44、, it is necessary to conduct the triangular arbitrage in the correct order.The S(/SF) cross exchange rate should be .7627/1.1806 = .6460. This is an equilibrium rate at which a triangular arbitrage profit will not exist. (The student can determine this for himself.) A profit results from the triangu
45、lar arbitrage when dollars are first sold for euros because Swiss francs are purchased for euros at too low a rate in comparison to the equilibrium cross-rate, i.e., Swiss francs are purchased for only 0.6395/SF1.00 instead of the no-arbitrage rate of 0.6460/SF1.00. Similarly, when dollars are first
46、 sold for Swiss francs, an arbitrage loss results because Swiss francs are sold for euros at too low a rate, resulting in too few euros. That is, each Swiss franc is sold for 0.6395/SF1.00 instead of the higher no-arbitrage rate of 0.6460/SF1.00.9.The current spot exchange rate is $1.95/ and the thr
47、ee-month forward rate is $1.90/. Based on your analysis of the exchange rate, you are pretty confident that the spot exchange rate will be $1.92/ in three months. Assume that you would like to buy or sell 1,000,000.a.What actions do you need to take to speculate in the forward market? What is the ex
48、pected dollar profit from speculation?b.What would be your speculative profit in dollar terms if the spot exchange rate actually turns out to be $1.86/.Solution: a.If you believe the spot exchange rate will be $1.92/ in three months, you should buy 1,000,000 forward for $1.90/. Your expected profit will be: $20,000 = 1,000,000 x ($1.92 -$1.90).