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International Finance
FINA 5331
Lecture 5: Balance of Payments
concluded.
The market for foreign exchange
Read: Chapters 5
Aaron Smallwood Ph.D.
Official reserves
• The official settlements balance,
sometimes referred to as the overall
balance, is the total balance on the current
account plus the balance on all NONOFFICIAL reserve transactions.
• It must be exactly offset by the balance on
official reserves transactions
Official reserves
• When a country buys foreign reserves (for
example, if the People’s Bank of China acquires
dollars):
– China’s assets increase: Debit entries in official
reserves (a deficit)
– Offset by an official settlements surplus
• If a country must sell official reserves (Thailand
in 1997 because of speculative attacks):
– The country’s reserve assets decrease: Credit entries
in official reserves (a surplus)
– Offset by an official settlements deficit.
Foreign Exchange Market
Products and Activities
• A spot contract is a binding commitment for an
exchange of funds, with normal settlement and
delivery of bank balances following in two
business days (one day in the case of North
American currencies).
• A forward contract, or outright forward, is an
agreement made today for an obligatory
exchange of funds at some specified time in the
future (typically 1,2,3,6,12 months).
Foreign Exchange Market
Products and Activities
• Forward contracts typically involve a bank and a
corporate counterparty and are used by
corporations to manage their exposures to
foreign exchange risk.
• A foreign exchange swap is the simultaneous
sale of a currency for spot delivery and purchase
of that currency for forward delivery.
• Foreign exchange swaps can be used by
dealers to manage the maturity structure of their
currency positions.
Foreign Exchange Market
Products and Activities
• Speculation entails more than the assumption of
a risky position. It implies financial transactions
undertaken when an individual’s expectations
differ from the market’s expectation.
• Arbitrage is the simultaneous, or nearly
simultaneous, purchase of securities in one
market for sale in another market with the
expectation of a risk-free profit.
FX Players
• Broadly speaking the FX market consists
of 5 groups
– International banks
– Bank customers
– Non-bank dealers
• Include investment banks, mutual funds, and
hedge funds.
– FX brokers
– Central banks
The Market for Foreign Exchange
• The FOREX market is the largest market
in the world.
• According to the BIS, in 2010, daily
turnover in April in FOREX market hit
almost $4 TRILLION dollars.
•Table 1
•Global foreign exchange market turnover by instrument1
•Average daily turnover in April, in billions of US dollars
•Instrument
•1998
•2001
•2004
•2007
•2010
•Foreign exchange instruments
•1,527
•1,239
•1,934
•3,324
•3,981
•Spot transactions²
•568
•386
•631
•1,005
•1,490
•Outright forwards²
•128
•130
•209
•362
•475
•Foreign exchange swaps²
•734
•656
•954
•1,714
•1,765
•Currency swaps
•10
•7
•21
•31
•43
•Options and other products³
•87
•60
•119
•212
•207
•1,705 11
•1,505 12
•2,040 26
•3,370 80
•Memo: Turnover at April 2010
exchange rates Exchange-traded
derivatives 5
•4
•3,981 166
•1 Adjusted for local and cross-border inter-dealer double-counting (ie “net-net” basis). 2 Previously classified as part of the so-called "Traditional FX
market". 3 The category "other FX products" covers highly leveraged transactions and/or trades whose notional amount is variable and where a
decomposition into individual plain vanilla components was impractical or impossible. 4 Non-US dollar legs of foreign currency transactions were
converted into original currency amounts at average exchange rates for April of each survey year and then reconverted into US dollar amounts at
average April 2010 exchange rates. 5 Sources: FOW TRADEdata; Futures Industry Association; various futures and options exchanges. Reported
monthly data were converted into daily averages of 20.5 days in 1998, 19.5 days in 2001, 20.5 in 2004, 20 in 2007 and 20 in 2010.
Daily Trading Volumes by Hour
Spot Exchange Rates
Spot Rate Quotations
• Indirect quotation
– the price of a U.S. dollar in the foreign
currency
– e.g. the yuan price of the dollar = RMB
6.5605 on March 24.
• Direct Quotation
– the price of a unit of foreign currency:
given by 1/Indirect Quotation
– e.g. $/Euro = 1/0.7055=$1.4174
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 the thing.
• The bid-ask spread is the difference
between the bid and ask prices.
Example:
• If the bid ask spread for RMB is:
– $0.1600 -$0.1610:
– How many RMB do we receive if we sell
$10,000?
$10,000/0.1610 = 6,211.18.
– What is we wanted to sell RMB 10,000?
RMB10,000 * .1600 = $1,600.
Cross Rates
• Suppose that S($/€) = .50
– i.e. $1 = 2 €
• and that S(¥/€) = 50
– i.e. €1 = ¥50
• What must the $/¥ cross rate be?
$ $ €
since   ,
¥ € ¥
$1 €1
$1


 S ($ / ¥)  .01 or $1  ¥100
€2 ¥50 ¥100
Triangular Arbitrage
Suppose we
observe these
banks posting
these exchange
rates.
$
Barclays
Credit
Lyonnais
S(¥/$)=120
S(£/$)=1.50
First calculate the
implied cross
rates to see if an
arbitrage exists.
¥
Credit Agricole
S(¥/£)=85
£
Triangular Arbitrage
The implied S(¥/£)
cross rate is S(¥/£) = 80
Credit Agricole has
posted a quote of
S(¥/£)=85 so there is an
arbitrage opportunity.
$
Barclays
Credit Lyonnais
S(¥/$)=120
S(£/$)=1.50
¥
Credit Agricole
S(¥/£)=85
So, how can we make money?
Buy the £ @ ¥80; sell @ ¥85. Then trade yen for dollars.
£
Triangular Arbitrage
As easy as 1 – 2 – 3:
$
1. Sell $ for £,
Barclays
2. Sell £ for ¥,
S(¥/$)=120
3
3. Sell ¥ for $.
Credit
Lyonnais
1
S(£/$)=1.50
2
¥
Credit Agricole
S(¥/£)=85
£
Triangular Arbitrage
Sell $100,000 for £ at S(£/$) = 1.50
receive £150,000
Sell our £ 150,000 for ¥ at S(¥/£) = 85
receive ¥12,750,000
Sell ¥ 12,750,000 for $ at S(¥/$) = 120
receive $106,250
profit per round trip = $ 106,250- $100,000 = $6,250
Cross Currency Exchange Rates with BidAsk Spreads
• Consider the example on page 122
– Suppose, relative to the US $, we are given the bid
ask spread in the market for pounds (e.g. $/£).
What then is the bid ask spread in the market for
$?
• Bid price is the inverse of the ask price.
• If bid-ask spread in the market for pounds is: $1.9712-17,
the bid price in the market for $=
St
£/$
 1 / 1.9717  0.5072
– Can show that the ask price is 0.5073
Triangular Arbitrage
• Previous triangular arbitrage is unrealistic since
traders face no transactions costs.
• We want to consider examples with bid-ask
spreads.
• See example on pages 122-123, with the
following quotes:
– Market for pounds: $1.9712-17
– Market for euros: $1.4739-44
– Market for pounds: €1.3305-10
• Implied price in the third market is 1.3370-77. POUND
UNDERVALED!
Exploit the arbitrage opportunity
• Suppose we start with $1,000,000
• First, we need to get euros so we can buy
pounds in the 3rd market.
– Start by selling dollars for euros:
• We receive: $1,000,000/1.4744 = €678,242.00
– Sell euros for pounds:
• We receive: €678,242.00/1.3310 = £509,573.25
– Finally, sell pounds for dollars
• We receive: £509,573.25*1.9712 = $1,004,470.79
• PROFIT: $4,470.79.