Lecture 4 (2) Flashcards
In general, we use S(j/k) to denote the price of one unit of currency k in terms of currency j in the spot market. Thus, denominator is referring to one unit of currency k
Cross-exchange rate
is an exchange rate between a currency pair where neither currency is the U.S dollar.
The cross-exchange rate can be calculated from the U.S. dollar exchange rates for the two currencies, using either european or american term quotations
S(j/k) = S($/k) x S(j/$)
S(k/j) = S(k/4) x S($/j)
Example S($/euro) = 1.1235
Bid price
Price at which the bank buys the currency at
E.g. Dealer will buy euros from you at the bid price of 1.25 per euro
Ask price
Price at which the bank sells the currency at
E.g. dealer will sell euros to you at the ask price of 1.26$
The bid ask spread
Difference between the bid and ask prices
It represents the dealers expected profit
The bid ask spread level varies across market levels
It is extremely narrow in the interbank market
mid rates
Average of the bid and ask rates are called
in the interbank market the standard size of trad is about _____ and bid ask quotes are normally in _____ decimal places
10 million
Four decimal places
Currency against currency trade
is when a customer wants to trade out a nondollar currency for another nondollar currency
Incorporating bid-ask spreads into cross-exchange rates gives us
S^b(SFr/pounds) = S^b($/pounds) x S^b(SFR/$)
E.g. $/£ bid–ask prices are $1.3442 to $1.3447
arbitrage
A zero-risk, zero-investment strategy from which a profit is guaranteed
The purpose of triangular arbitrage
To earn an arbitrage profit by trading among three currencies when the quoted cross-exchange rate is not in alignment with the implied cross-exchange rate
forward market
involves contracting today for the future purchase or sale of FX
no money changes hands upon entering the contract today
May be used to hedge FX exposure or to speculate in FX market
Forward price is usually higher (at a premium) or lower (at a discount) than spot price
Forward rate quotations use the following notations
FN(j/k) is the notation used to refer to the price of one unit of currency k in terms of currency j for delivery in N months
F notations is used to denote a forward exchange rate
Like spot quotes, forward quotes are either direct or indirect with one being the reciprocal of the other
Forward market (some info)
Common to express the premium or discount of a forward rate as an annualized percentage deviation from the spot rate
Forward premium (or discount) is useful for comparing against the interest rate differential between two countries
Forward premium or discount can be calculated using american or european term quotations
The formula for calculating the forward premium or discount for currency j over N period in american terms is
f-N,j = F-N($/j) - S($/j) / S($/j) x 360/days
The forward market some stuff
Due to government instituded capital controls, currencies of some emerging market countries are not freely traded
Not possible to obtain these currencies offshore in the spot market to settle a forward position
For many of these currencies, trading in non-deliverable forward (NDF) contracts exists
An NDF contract
Unlike a deliverable forward (DF) is settled in cash at the difference between the spot exchange on the maturity date of the contract and the NDF rate times the notional amount of the contract
From the banks standpoint an outright forward transactions is
An uncovered speculative position in a currency, even though it might be a part of a currency hedge to the bank customer on the other side of the transaction
Swap transactions
Provide a means for the bank to mitigate the currency exposure in a forward trade
Exchange-traded fund (ETF)
is a portfolio of financial assets in which shares representing fractional ownership of the fund trade on an organized exchange
Allow small investors the opportunity to invest in portfolios of financial assets that they would find difficult to construct individually
Assets invested in the global ETF industry reach a new record of 10,27 trillion at the end of december
Currency ETFs were first offered by Guggenheim investments in 2005 and traded on the NYSE
