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Foreign Exchange Arithmetic

Forex transactions can be spot or forward transactions. Spot transactions involve the immediate exchange of currencies while forward transactions set the exchange rate today for a future date. Exchange rates quote one currency in terms of units of another currency, such as EUR/USD. Direct quotations express one currency in terms of another, like USD/INR. Indirect quotations express the value of a currency against a domestic currency. Cross rates quote exchange rates between currencies that do not involve the US dollar. Arbitrage involves taking advantage of temporary price differences between markets to make a risk-free profit.

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5K views9 pages

Foreign Exchange Arithmetic

Forex transactions can be spot or forward transactions. Spot transactions involve the immediate exchange of currencies while forward transactions set the exchange rate today for a future date. Exchange rates quote one currency in terms of units of another currency, such as EUR/USD. Direct quotations express one currency in terms of another, like USD/INR. Indirect quotations express the value of a currency against a domestic currency. Cross rates quote exchange rates between currencies that do not involve the US dollar. Arbitrage involves taking advantage of temporary price differences between markets to make a risk-free profit.

Uploaded by

meghaparekh11
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© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
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Forex transaction, are of two kinds:

a) Spot transaction b) Forward transaction.

Always quoted as 1 unit of base currency = xx units on variable currency

Base currency = Variable/Quoted currency (EG-eur/chf/inr)


1 unit xxx Units

 Bid Rate : the rate at which the customer can buy the quoted currency in exchange
for the base currency , and

 Offer Rate : the rate at which the customer can sell the quoted currency in exchange
for the base currency. (EG)

Direct and Indirect Quotations

 For direct quotation, the value of one unit of the foreign currency is expressed in
terms of the domestic currency. For example in the dollar rupee 1 dollar = 46 rs.

 For indirect quotation, a foreign currency's value is expressed in terms of one unit of
domestic currency. (EG USD/JPY/AUD)
 Cross Rates

Exchange rates where neither of the two currencies quoted is “dollar”.


For eg. EUR/INR, EUR/GBP, GBP/CHF etc.

To calculate cross rates where

 If USD is the “BASE” currency in both the legs of the transaction,


Calculate 1 CHF = x JPY
USD/JPY = 114.50/60 USD/CHF=1.1410/1.1420

Answer : 1.1420 CHF = 1 USD = 114.50 JPY


Hence can conclude 1.1420 CHF = 114.50 JPY
So 1.00 CHF = XX JPY
=114.50/1.1420

 If USD is the “VARIABLE’ currency in both the legs of the transaction,


Calculate 1 EURO = x GBP
EUR/USD = 1.2150/60 GBP/USD =1.8210/20

Answer : If I sell 1 EUR = I get 1.2150 USD


But if I give 1.8220 USD then
Hence can conclude 1.8220/1.2150

 If USD as base AND variable currency cross multiply. (EG)


 Forward Transaction = SPOT +- FORWARD (Premium OR Discounts)

Method of quoting forward rates is to specify the amount by which the forward rate
differs from the spot rate. It is also referred as “Forward Points”.

 If the forward points are to be deducted from the spot rate, the bank will quote a
larger number on the left for the bid rate and a lower number on the right for the
offered rate.

 If the forward points are to be added to the spot rate, the bank will quote a lower
number on the left for the bid rate and a higher number on the right for the offered
rate.

 What happens if this rule wasn’t applicable?

 Example 1

A UK company has to pay a supplier euro 1,000,000 in one month. The spot rate
euro/pound is 0.6620-0.6630 and the one-month forward points are 24-16.
1) What rate would the bank quote for a forward contract?
2) What will the company pay for the euros?
3) What can the company do if the spot rate in one month has changed to euro 1 =
£0.6640?
 Example
If a client is buying yen in exchange for Swiss francs, find the following:

 The spot cross rate


 The three month forward cross rate

Points Spot 3 mnths Frwrd

Yen 122.690-122.750 300-270


Swiss Franc 1.5028-1.5038 154-146

 Analysis:

Spot Cross Rate 122.690


Bank sells Yen for $ 1.5038
“SFR1= Yen 81.587”

Three month forward cross rate


Bank sells yen for $ (122.690-0.300)
Bank buys SFR for $ (1.5038-0.0146)
=122.390/1.4892
SFR=Yen 82.185
1) If following is the exchange rate scenario, what will be the
forward rates?

a) Spot US$1=DEM 1.8235/45


Forwards Spot/1Mnth 17/18
Spot/2Mnth 37/35
Spot/3Mnth 56/53

b) Spot US$1=Rs 42.8325/8650


Forwards Spot/August 0.17/18
Spot/Sept 0.35/37
Spot/Oct 0.53/56
2) If exchange rates in interbank markets are:
US$1=Rs.41.2550/2650
US$1=FRF6.0500/0550
At what rate can one buy FRF against rupees?

3) If exchange rates in interbank markets are:


US$1=Rs.41.2550/2650
GBP1=US$1.6520/27
At what rate can an importer buy1 GBP against rupees?
 Suppose M/s Brit & Co. wants to buy GBP against DEM on 1,2, and
3 month forward basis, what quote will the market derive for each
one?
Spot US$1=DEM 1.8235/45
Forward Spot/1 Mnth 17/18
Spot/2 Mnth 35/37
Spot/3 Mnth 53/56

Spot GBP1=US$ 1.6284/91


Forward Spot/1 Mnth 16/15
Spot/2 Mnth 34/32
Spot/3 Mnth 53/50
 Arbitrage:
 Arbitrage is an operation by which one make “risk free” profit by undertaking offsetting
transactions.

 Arbitrage can be in interest rates i.e. borrow in one centre and lend in another centre
at higher rate and arbitrage can occur in exchange rates also i.e. buy a currency in
one market and sell in another.

 The banks usually quote all the currencies against US$ but of late this trend is
changing and many market makers quoting exchange rate without involving SU$.

 For example a bank in London may quote GBP against DEM. Foreign exchange
traders are always on look out for currency arbitrage opportunities on the basis of
prevailing exchange rates of different currencies by using a currency in one market
and selling in another. This keeps the exchange rates of different currencies uniform
in various markets.

 Example:

 US$ is quoted at Ney York at GBP1= US$1.6535 and the DEM in Frankfurt being
quoted at US$1=DEM 1.8137. At the same time London bank is quoting Sterling at
GBP1= DEM 2.9988.
 Is their any Arbitrage opportunity?
 Solution:
A smart trader will immediately sniff the opportunity and take advantage through
“TRANGULAR CURRENCY ARBITRAGE”, as follows:
 Sell US$1,000,000 at US$1=DEM 1.8137 and get DEM 1,813,700.
 Sell these DEM 1,813,700 at GBP1=DEM 2.9988 in Frankfurt and get GBP
604808.59
 Sell GBP 604808.59 in London at GBP 1= US$1.6535 and get US$ 1,000,051.
 Net Profit equals US$ 51 per million US$.

In such cases, transaction cost is spread. With a view to make the illustration simple
to understand, two way quotes have not been given. When one is playing on
arbitrage, the spread is against him. Therefore bid and offer rates should be chosen
with great care.
However with present day communication system arbitrage opportunities are hardly
their in any market. This way of making profits is also known as “Money Machine”.

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