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worldwide make a market in foreign exchange, i.e., they stand willing to buy or sell foreign currency for their own account. These international 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, 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 judge 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 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 currency against. Intervention is the process of using foreign currency reserves to buy one?s own currency in order to decrease its supply and thus increase its value in the foreign exchange market, or alternatively, selling one?s own currency for foreign currency in order to increase its supply and lower its price.
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 deutsche mark 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.
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 depreciate against the U.S. dollar and therefore he is trying to reduce his inventory of Canadian dollars by discouraging purchases of CD 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/$1.00.
*9. What is triangular arbitrage? What is a condition that will give rise to a triangular arbitrage opportunity?
Answer: Triangular arbitrage is the process of trading out of the U.S. dollar into a second currency, then trading it for a third currency, which is in turn traded for U.S. dollars. The purpose is to earn an arbitrage profit via trading from the second to the third currency when the direct exchange between the two is not in alignment with the cross exchange rate.
Most, but not all, currency transactions go through the dollar. Certain banks specialize in making a direct market between non-dollar currencies, pricing at a narrower bid-ask spread than the cross-rate spread. Nevertheless, the implied cross-rate bid-ask quotations impose a discipline on the non-dollar market makers. If their direct quotes are not consistent with the cross exchange rates, a triangular arbitrage profit is possible.
PROBLEMS
3. Restate the following one-, three-, and six-month outright forward European term bid-ask quotes in forward points.
Spot
1.3431-1.3436
1.3432-1.3442 1.3448-1.3463
One-Month
Three-Month Six-Month
Solution:
One-Month
1.3488-1.3508
01-06 17-27
Three-Month Six-Month
57-72
4. Using the spot and outright forward quotes in problem 3, determine the corresponding bid-ask spreads in points.
Solution:
Spot
5
10 15
One-Month
Three-Month Six-Month
20
7. Given the following information, what are the DM/S$ currency against currency bid-ask quotations?
Bank Quotations
American Terms European Terms
Bid
Ask
Bid Ask
Deutsche Marks .6784 .6789 Singapore Dollar .6999 .7002
1.4730 1.4741 1.4282 1.4288
Solution: Equation 4.12 from the text implies S(DM/S$b) = S($/S$b) x S(DM/$b) = .6999 x 1.4730 = 1.0310. The reciprocal, 1/S(DM/S$b) = S(S$/DMa) = .9699. Analogously, it is
implied that S(DM/S$a) = S($/S$a) x S(DM/$a) = .7002 x 1.4741 = 1.0322. The reciprocal, 1/S(DM/S$a) = S(S$/DMb) = .9688. Thus, the DM/S$ bid-ask spread is DM1.0310-DM1.0322 and the S$/DM spread is S$0.9688-S$0.9699.
8. Assume you are a trader with Deutsche Bank. From the quote screen on your computer terminal, you notice that Dresdner Bank is quoting DM1.6230/$1.00 and Credit Suisse is offering SF1.4260/$1.00. You learn that UBS is making a direct market between the Swiss franc and the mark, with a current DM/SF quote of 1.1250. 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? What DM/SF price will eliminate triangular arbitrage?
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