THE FOREIGN EXCHANGE MARKET

1. Definition
 The foreign exchange market is an Over-The-Counter (OTC) global market
for trading of currencies. Participants are able to buy or sell currencies,
speculate on the currency exchange rates movement, arbitrage foreign
currency and can cover risk of foreign currency exchange rate
movements.
 The Foreign Exchange Market provides the physical and institutional
structure through which the money of one country can be exchanged for
that of another country (e.g. network of commercial banks)

2. Functions of the Foreign Exchange Market

The foreign exchange market is the mechanism by which participants:
 Transfer purchasing power between countries: allows people to “buy/sell
things” abroad
 Obtain or provide credit for international trade transactions (e.g. financing
for export/import)
 Minimize exposure to the risks of exchange rate changes: hedging
 The determination rate of exchange between currencies

3. Participants of the Foreign Exchange Market

There are four broad categories of participants operating in the foreign
exchange market

i. Individuals and Firms

 Individuals (such as tourists) and firms (such as importers, exporters)
conduct commercial and investment transactions in the foreign exchange
market.
 Their use of the foreign exchange market is necessary but nevertheless
incidental to their underlying commercial or investment purpose.
 Some of the participants use the market to “hedge” foreign exchange
risk.

ii. Speculators and Arbitrageurs

 Speculators and arbitrageurs seek to profit from trading in the market
itself.
 They operate in their own interest, without a need or obligation to serve
clients or ensure a continuous market.
 Speculators seek all the profit from expected exchange rate changes.
 Arbitrageurs try to profit from inconsistency of exchange rates in different
markets.

iii.Bank and Nonbank Foreign Exchange Dealers

 Banks and a few non-bank foreign exchange dealers operate in both the
interbank and client markets.
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 The profit from buying foreign exchange at a “bid” price and reselling it at
a slightly higher “offer” or “ask” price.
 Dealers in the foreign exchange department of large international banks
often function as “market makers.”
 These dealers stand willing at all times to buy and sell those currencies in
which they specialize and thus maintain an “inventory” position in those
currencies.

iv. Central Banks

 Central banks use the market to acquire or spend their country’s foreign
exchange reserves as well as to influence the price at which their own
currency is traded, known as FX market intervention.
 They may act to support the value of their own currency because of
policies adopted at the national level or because of commitments entered
into through membership in joint agreements such as the European
Monetary System.
 The motive is not to earn a profit as such, but rather to influence the
foreign exchange value of their currency in a manner that will benefit the
interests of their citizens.
 As willing loss takers, central banks differ in motive from all other market
participants.

4. Features of the Foreign Exchange Market

 The world’s largest market
 A twenty-four-hour market
 Consisting of an international network of traders
 Its most widely traded currency is the US dollar.
 An “Over-the-Counter” market with an exchange traded segment.

5. Types of Foreign Exchange Market

a. Spot Foreign Exchange Market
 In this market, foreign currencies are sold and bought for immediate
delivery.
b. Forward Foreign Exchange Market
 In the forward market, foreign currencies are sold and bought for future
delivery.
c. Currency Swap Market
 This is the simultaneous purchase and sale of a given amount of foreign
exchange for two different value dates

6. Transactions in the Foreign Exchange Market

 A foreign exchange transaction is an agreement between a buyer and a
seller that a fixed amount of one currency will be delivered for some other
currency at a specified date.

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 Foreign exchange means the money of a foreign country; that is, foreign
coins and bank notes (“cash”), bank balances, checks and drafts.
 Transactions in the foreign exchange market can be executed on a spot,
forward, or swap basis.

a. Spot Transactions
 Spot transactions are done in spot exchange market for immediate
delivery of foreign exchange.
 In the interbank market, a spot transaction involves the purchase of
foreign exchange with delivery and payment between banks to take
place, normally, on the second following business day.
 The spot exchange rate is used to settle these transactions.

b. Forward Transactions
 A forward transaction requires delivery at a future value date of a
specified amount of one currency for a specified amount of another
currency.
 The exchange rate to prevail at the value date is established at the time
of the agreement, but payment and delivery are not required until
maturity.
 Forward exchange rates are normally quoted for value dates of one, two,
three, six, and twelve months and are used to settle forward transactions.

c. Swap Transactions
 A swap transaction involves the simultaneous purchase and sale of a
given amount of foreign exchange for two different value dates.
 The most common type of swap is a spot against forward, where the
dealer buys a currency in the spot market and simultaneously sells the
same amount back in the forward market.
 Since this agreement is executed as a single transaction, the dealer incurs
no unexpected foreign exchange risk.

7. Foreign exchange rate

 Foreign exchange rate is defined as the number of units of one currency
which may be bought or sold for one unit of another currency.
 Foreign exchange rate is the price one currency relative to another
currency, written as, say, TZS/US$
a. Spot exchange rate
 The spot rate is the rate paid for immediately delivery of a currency or
within two business days after the day of the trade.
b. Forward exchange rate
 The forward rate is the rate to be paid for delivery of a currency at some
future date, with the exchange rate being established at the time the
contract is made.
c. Cross exchange rate
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 The exchange rate between two currencies, both of which are not the
official currencies of the country in which the exchange rate quote is
given in.
 For example, if an exchange rate between the US$ and £ was quoted in
an Tanzania, this would be considered a cross rate in this context,
because neither the £ or the $ is the standard currency of the Tanzania.
 However, if the exchange rate between the US$ and the TZS were quoted
in Tanzania, it would not be considered a cross rate because the quote
involves the Tanzania official currency.
 A cross rate is a rate which can be calculated from two other rates. For
calculation of cross rates, both rates must have one common currency.
 For settlement of international business transactions where the exchange
rate between the two currencies is unknown or not available.
 Cross rates are used to check an opportunity for profits from a process
known as Inter-Market Arbitrage or Triangular Arbitrage.

Example 1
If euro is selling for US$ 0.6000 and the Japan J¥ is US$ 0.1500, what is the
cross-exchange rate (€/J¥)?
Solution:
Given US$ 0.6000/Euro€ and US$ 0.1500/J¥, then
Euro€/J¥ = US$/J¥ ÷ US$/Euro€
= US$/J¥ × Euro€/US$
= 0.15000× 1/0.6000
= €0.2500/J¥

Example 2
Assume you want to determine the bid/offer cross rate of EUR/CHF or "Euro-
Swiss." Within the cross, Euro is the base currency and the CHF is the terms
currency.

Bid for euro Ask for euro

Euro/$ Buy euro/sell$ Sell euro/buy$
0.9791 0.9796
Bid for $ Ask for $
$/euro Buy $/sell SFr Sell$/buy SFr
1.4984 1.4991

Bid of the Cross: buy the base and sell the terms of the cross.
1. Buy EUR. As the trader you buy the EUR on your bid of .9791.
2. Sell CHF. As the trader you sell CHF and buy USD on your bid of 1.4984.
3. Multiply the two rates and get the cross-rate bid.

1 EUR = $0.9791 * 1.4984 CHF = EUR/CHF = 1.4671

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Offer of the Cross: sell the base and buy the terms.
1. Sell EUR. As the trader you sell the euro on your offer of .9796.
2. Buy CHF. As the trader you buy CHF and sell USD on your offer of 1.4991.
3. Multiply the two rates and get the cross-rate offer.

1 EUR = $0.9796 * 1.4991 CHF = EUR/CHF = 1.4685

 Bid: buy the base currency and sell the terms, multiply the two rates to
get the cross.
 Offer: sell the base currency and buy the terms, multiply the two rates to
get the cross.

8. Foreign exchange rate Quotations

a. Direct Quotation/ Price Quotation
 This is defined as the number of domestic currency units needed to
buy/sell one unit of foreign currency. It is also called American terms.
 For example, for a Tanzania viewpoint this would be shown as TZS.1,600
= US $ 1.00, written as TZS.1,600/US$.
 In other words, quotes using a country's home currency as the price
currency (e.g., TZS.1,600 = US $ 1.00, in the Tanzania) are known as
direct quotation or price quotation (from that country's perspective) and
are used by most countries.
b. Indirect Quotation/Quantity Quotation
 This is defined as the number of foreign currency units needed to buy/sell
one unit of domestic currency. It is also called European terms.
 For example, for a Tanzania viewpoint this would be shown as TZS.1= US
$ 0.000625, written as US$ 0.000625/TZS.
 In other words, quotes using a country's home currency as the unit
currency (e.g., TZS.1= US $ 0.000625 in the Tanzania) are known as
indirect quotation or quantity quotation and are common in UK, Australia,
New Zealand and the Eurozone.
Note: The quotation TZS/US$ 1,600 mean that 1 US$ is exchanged for
TZS.1,600. Here, US$ is called the "base currency" or "unit currency", while
TZS is called the "term currency" or "price currency".

9. Bid and offer prices

 Exchange rates are shown as a spread between two prices, in other words
dealers dealing in foreign currency quote two prices for an exchange rate,
for example the dealer might quote: TZS/US$ 1,500 – 1,600.
i. The lower ‘bid’ price
This is the price at which the dealer will buy the currency
ii. The higher ‘offer’ or ‘ask’ price
This is the price at which the dealer will sell the currency
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 Note: The spread between bid and ask prices exist for two reasons:
transaction costs and Profits.

10. Buying and selling Currencies

 Dealers buy at the bid price and sell at the ask price, profiting from the
spread between the bid and ask prices: bid < ask.
 Bid and ask quotations are complicated by the fact that the bid for one
currency is the ask for another currency.

Example 2
 A dealer provides you the following quote TZS/US$ 1,500 – 1,600. This
suggests that the bid price for the US$ is TZS1,500 and that the ask price
is TZS1,600.
 Clearly, a dealer willing to purchase 1 US$ at a price of TZS1,500 is
absolutely willing to sell 1 TZS at the reciprocal price of US$0.000667.
 Similarly, a dealer willing to sell 1 US$ at a price of TZS1,600 is absolutely
willing to buy TZS at the reciprocal price of US$0.000625. Then the
indirect version of this quote would be US$/TZS: 0.000625 - 0.000667.
 The quote could as well be written as US$/TZS: 0.000667 - 0.000625. By
quoting higher bid price than ask price, then the dealer is indicating that it
is willing to buy US$ (in the numerator) at US$0.000667/TZS or sell
US$0.000625/TZS.
 This is equivalent to buying TZS at US$0.000625/TZS and selling at
US$0.000667/TZS.

Rule for determining the currency that is being quoted is as follows:

 When the bid quote is lower than the offer quote, the dealer is buying and
selling the currency in the denominator of the quote,
 When the bid quote is higher than the offer quote, the dealer is buying
and selling the currency in the numerator of the quote.

Example 3
At the foreign currency dealer, you are able to see the following direct quote:
TZS/US$ 1,500 – 1,600.
Required
i. Convert the direct quote into indirect quote version.
ii. If the dealer buys and sells US$1,000, show calculations for the profit or
loss would be made on the transaction if direct quotation or indirect
quotation is used.

Solution:
i. Buying high selling low
Sell at ask price TZS1,600/US$ × US$1,000 = TZS1,600,000
Buy at bid price TZS1,500/US$ × US$1,000 = TZS1,500,000
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Profit from the transaction = TZS100,000

ii. Buying high selling low

Sell US$ at US$0.000625/TZS = TZS1,600,000
Buy US$ at US$0.000667/TZS = TZS1,500,000
Profit from the transaction = TZS100,000

Example 4
You want to buy s Swedish kroner (SKr). Your bank quotes SKr 7.5050/US$
bid and SKr 7.5150/US$.
Required:
What would you pay in dollars if you bought SKr10,000,000 at the current
spot rate?

11. The bid-ask spread

 The bid-ask spread is the spread between bid and ask rates for a
currency.
 It is based on breadth and depth of that currency as well as on the
currency volatility.
 This spread is the bank fee for executing the foreign exchange
transaction. It repays traders for the costs they incur in currency dealing.
 It is usually stated as a percentage cost of transacting in the foreign
exchange. The bid-ask spread is computed as follows:
 Bid-ask spread = (ask price – bid price)/ask price × 100%

Example 5
The rates for the US$/J¥ are as follows:

US$/J¥ bid ask

Spot 47.0725 – 47.0745
What is the bid-ask spread?

Bid-ask spread = (ask price – bid price)/ask price × 100%

Bid-ask spread = (47.0745– 47.0725) = US$0.0020/J¥.
The bid-ask spread US$0.00020/J¥ can be stated in percentage as follows:
Bid-ask spread = (47.0745– 47.0725)/47.0745 × 100% = 0.004%

11. Change in the Value of a Currency

a. Appreciation
 An increase in the value of a currency relative to other currencies,
 Using direct quotation, if the home currency is strengthening i.e.
appreciating, or becoming more valuable, then the exchange rate number
decreases.
b. Depreciation
 A decrease in the value of a currency relative to other currencies.
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 Using direct quotation, if the home currency is weakening, the exchange
rate number increases and the home currency is depreciating.
Note: In a currency pair, when the value of one currency rises, obviously the
value of other currency pair declines.

Example 6
 On January 1 2010, the spot rate was US$ 48.25/J¥. Suppose, on February
1 2010, the spot rate is US$ 46.75/J¥. During the one month period, as the
value of US$ has risen in comparison to J¥. In other words, US$ has
appreciated or J¥ has depreciated.
 In a simpler way, the concept can be understood as follows: On 1 January
2010, 1 J¥ is equivalent to US$ 48.25. Just after a month on 1 February
2010, 1 J¥ is equivalent to US$ 46.75. This clearly shows that J¥ value has
gone down compared to US$.
 Note: One currency will depreciate and other will appreciate but the
amount of percentage depreciation or appreciation will be different.
 Depreciation or appreciation of a base currency J¥ is given by:
= (New rate – Old rate)/Old rate
= (46.75 – 48.25)/48.25 = - 3.11%
 The J¥ has depreciated by 3.11%, the negative value indicate
depreciation.
 To find out the appreciation or depreciation for US$ can be found out by
first converting the existing quotations so that US$ becomes the base
currency.
 Hence the spot rate of 1January 2010 = 1/48.25 = J¥ 0.0207/ US$
 The spot rate on 1February 2010 = 1/46.75 = J¥ 0.0213/ US$
 Depreciation or appreciation of a base currency US$ is given by:
= (New rate – Old rate)/Old rate
= (0.0213 – 0.0207)/0.0207= 3.21%
 The US$ has appreciated by 3.21%, the positive value indicate
appreciation.
 Without even converting the spot rate to J¥ price of US$, the %
appreciation or depreciation (for US$) can be directly calculated as:
= (Old rate – New rate)/New rate
= (48.25-46.75)/ 46.75 = 3.21%
 Note: One currency will depreciate and other will appreciate but the
amount of percentage depreciation or appreciation will be different.

 Question:
 The current exchange rate between the euro and the US $ is
$1.1825/Euro. If the euro is expected to appreciate by 5% over the next 6
months, what is the expected exchange rate in six months?

Exchange Rate Determination

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 Exchange rates can be determined by applying the rate of appreciation or
depreciation to the relevant currency. When foreign currency is said to be
appreciated, domestic currency or the other currency is said to be
depreciated.

Answer and Explanation:

 Current Exchange Rate: 1 Euro = USD 1.1825
 When Euro appreciates by 5% over the next 6 months,
 1 Euro = USD (1.1825 * 1.05)
 1 Euro = USD 1.2416
 Hence, the expected rate after 6 months is $1.2416/Euro

12. Reasons for Currency appreciation and depreciation

Though many factors influence the domestic exchange rate, some important
factors affecting the exchange rate are as follows:
 Difference in national inflation rates: The currency of a country
experiencing higher inflation will depreciate and vice versa.
 Changes in the real interest rates: Currency of a country with higher real
interest rate will appreciate.
 Investment climate: A country with better investment climate will attract
investment thus leading to appreciation of the currency.
 Political uncertainty: a country with greater degree of political uncertainty
will exhibit higher depreciation.

13. Implication(s) of Currency appreciation and depreciation

 When the currency of your country appreciates relative to another
country, your country's goods prices increases abroad and foreign goods
prices decreases in your country.
 Makes domestic businesses less competitive
 Benefits domestic consumers

14. Arbitrage opportunity

 Arbitrageurs seek to earn risk-free profits by entering simultaneously (or
nearly simultaneous) into two or more markets.
 With the expectation of a risk-free profit, they exploit inconsistency of
prices in the markets.
 Arbitrage is not simply the act of buying a currency in one market and
selling it in another for a higher price at some later time.
 The transactions must occur simultaneously (or nearly simultaneous) to
avoid exposure to market risk, or the risk that rates may change on one
market before both transactions are complete.
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a. Spatial Arbitrage
 Arbitrage between segments of the FX market that are physically
separated.
 Example: Purchasing US$ in NBC Bank at TZS 1,500/US$ and selling US$
in CRDB Bank at a rate of TZS1,600/US$.

Example
Assume the following information

Bank A Bank B
Bid price for SFr. US$0.401 US$0.398
Ask price for SFr. US$0.402 US$0.400

a) Given this information, is arbitrage possible?

b) If so, explain the steps that would create the arbitrage, and compute
the profit from this arbitrage if you have US$1,000,000 to use.

b. Triangular Arbitrage
 Ignoring transaction costs, the prices for any three currencies must be
consistent with the relationship known as triangular parity.
 Triangular arbitrage is the process of trading out of the first currency,
say, U.S. dollar into a second currency, say, sterling pound, then trading it
for a third currency, say, the euro, which is in turn traded for the first
currency, the U.S. dollars.
 The purpose is to earn an arbitrage profit through trading from the second
to the third currency when the direct exchange between the two is not in
alignment with the cross-exchange rate.
 If we assume two exchange rates (quoted directly with a common
currency, say X) X/Y and X/Z, then the cross rates are obtained: Y/Z = X/Z
÷ X/Y = X/Z × Y/X or Z/Y = X/Y ÷ X/Z = X/Y × Z/X.
 If this relationship holds, then the rates are said to constitute arbitrage
equilibrium i.e., triangular parity; that is no profit can be made from
arbitrage, but when Y/Z ≠ X/Z ÷ X/Y ≠ X/Z × Y/X or Z/Y ≠ X/Y ÷ X/Z ≠ X/Y
× Z/X then arbitrage is possible.

15. The forward exchange rate

 The forward exchange rate (also referred to as forward rate or forward
price) is an exchange rate quoted today for settlement at some future
date
 It is the exchange rate negotiated today between a bank and a customer
upon entering into a forward contract agreeing to buy or sell some
amount of foreign currency at a future date.

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 The forward exchange rate is determined by the relationship among the
spot exchange rate and differences in interest rates between two
countries. Forward exchange rates have important theoretical
implications in forecasting future spot exchange rates.
 For the spot rate and for all forward rates (one month forward, two month
forward, three month forward, six month forward and so on) there
different bid and offer rates.

Example 7
The rates for the TZS/ US$ are as follows:
Spot 1,500 – 1,600
1 month 1,540 – 1,650
3 months 1,560 – 1,680
6 months 1,580 – 1,690

Today is 5 March. A Tanzania company has to pay US$ 300,000 to a supplier

at the end of first week of June, and wants to fix a rate of exchange now.
Required:
a. What forward rate can be obtained for a currency transaction?
b. What would the cost to the Tanzania Company be, in TZS?

16. How are forward rates derived?

 The forward or outright rates usually differ from the spot rate, but they
are not a forecast for the spot rate at the end of the term.
 If, for example, the rate for a 12-month outright US$/E€ is 1.4720, this
does not mean that the market expects a rate of 1.4720 in 12-month
time.
 The difference between the forward rate and the spot rate only reflects
the interest differential between the two currencies involved.
 Would the forward rates not conform to the interest differential, arbitrage
between the foreign exchange market and the euro deposit market would
be possible.
 Forward rates are derived by applying current interest rates to the spot
exchange rate. Here is an example!

Example 8
 Suppose that the spot rate US$1.50/£, and that the one-year interest rate
is 6% for sterling and 4% for US dollar. According to market prices this
means £1,000 has equivalent spot value of US$1,500.
 An investor with £1,000 who wants to exchange the sterling into dollar in
one year has two options of doing it. He can buy US$1,500 now (spot) and
invest the dollar for one year at 4% to earn US$1,560 at the end of one
year. Alternatively, he can invest £1,000 for one year at 6% to earn
£1,060 and then exchange the sterling for US dollars.

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 For market rates to stabilize, this means that given the current spot
exchange rate and one-year interest rates, £1,060 in one year has an
equivalent value of US$1,560 and so an appropriate one-year forward rate
now would (1,560/1,060), i.e. US$1.4717/£.
 Here the dollar would be stronger against sterling one-year forward (at
1.4717), compared to the spot rate (1.5000). This is because the interest
rate is lower on the dollar than on sterling.

17. Computing Forward rates in consideration of mid rates

 In general, the forward rate is calculated as follows:
 Forward rate = spot rate × (1 + [Variable currency interest rate ×
Days/B])
(1 + [Base currency interest rate × Days/B])
 The year day-count base B will be either 365 or 360 depending on the
convention for the currency in question. Variable currency = Quote
currency.

Example 9
You are given that spot rate is £1.5000/US$, US$ 184 days deposit rate is 6
%, £ 184 days deposit rate is 2 %.
Required:
What will be the 184-day forward £/US$ rate?
Solution
Forward rate = 1.5000 × (1 + [0.02 × 184/360])
(1 + [0.06 × 184/360])
= £ 1.4702/US$
Example 10
Suppose that the Spot mid-rate is £1.6315/US$. The 90-day sterling deposit
rate is 5.75% and 90-day US$ deposit rate is 6.15%. Assume 360 – day year.

Required:
What will be the 90-day forward £/US$ mid-rate?
Solution
Forward rate = 1.6315× (1 + [0.0575 × 90/360])
(1 + [0.0615 × 90/360])
= £1.6299/US$
Therefore, to deal forward the mid-rate is £1.6299/US$, so in effect US$1
buys £ 1.6299 in three months’ time as opposed to US$1.6315 today. Under
different circumstances sterling may be worth more in the future than at the
spot date.

18. Computing forward rate in consideration of bid or offer rates

 Since interest rates are usually quoted with a spread the bid and the offer
rate has to be taken into account when computing the bid and the offer

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 rate of an outright rate. In general the forward or outright rate is
calculated as follows:
 Forward rate (bid) = spot rate (bid) × (1+[Variable currency bid interest rate × Days/B])
(1 + [Base currency offer interest rate × Days/B])

 Forward rate (offer) = spot rate (offer) × (1+[Variable currency offer interest rate ×
Days/B])
(1 + [Base currency bid interest rate × Days/B])

Example 11
You receive the following quotes:
Spot £/US$ 1.5000-10
Interest rate US$, 184 days 5 7/8 - 6 %
Interest rate £, 184 days 2 – 2 1/8 %
Required:
What is the quotation of a 6-months (184 days) outright £/US$?

Solution
Using these prices, the quotation for a 6-months outright rate (US$/£) can be
computed as follows:
Forward rate (bid) = 1.5000 × (1+0.02 × 184/360)
(1+0.06 × 184/360)
= 1.4703
Forward rate (offer) = 1.5010 × (1+0.02125 × 184/360)
(1+0.05875 × 184/360)
= 1.4731
The 6-months £/US$ outright rate is 1.4703 –31.

19. Forward exchange rate Quotation

 Pip is the acronym for "price interest point". A pip is the smallest unit
by a currency quotation can change.
 For example, let us assume that on a given day, a bank quotes spot
US$/J¥ quote is US$ 48.75.
 The minimum value this rate can change is either US$ 48.74 or US$
48.76. In other words, for US$/J¥ quote, the pip value is US$0.01.
 However, in an interbank market, US$/J¥ rate is quoted up to 4 decimal
point. Hence minimum value change will be in the tune of US$0.0001.
 In a similar manner, minimum value a US$/Euro€ quote can change is
US$0.0001 as US$/Euro€ is quoted up to 4 decimal point.
 The difference between bid-ask spread is also quoted in pip terms. For
example, Spot US$/Euro€ is quoted at a bid price of US$1.0213 and an
ask price of US$1.0219. The difference is US$ 0.0006 equal to 6 “pips”.

a. Forward quotations can be made in "outright".

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 Example below lists the quotations (in full form) given by a bank for
offering forward contracts for various durations. The rates for the US$/J¥
are as follows:
US$/J¥ bid ask
Spot 47.0725 – 47.0745
1 week 47.0750 – 47.0775
2 weeks 47.0795 – 47.0835
1 month 47.0840 – 47.0890
2 months 47.0900 – 47.0965

 Exchange rate quotations can also be expressed in shorter form as shown

below.
US$/J¥ bid ask
Spot 47.0725 – 45
1 week 47.0750 – 75
2 weeks 47.0795 – 835
1 month 47.0840 – 90
2 months 47.0900 – 65

 This indicates that the spot bid is 47.0725 and spot ask is 47.0745. From
the details given, only the last digits in the bid rate gets replaced to arrive
the ask rate.
 All Quotations given above are known as “outright” quotations i.e.
quotations expressed in full form.

b. Forward quotations can be as spread (points) on the spot rate

 In terms of points, these quotations are known as “cash rates” or “swap
rates” or “basis points”. The cash or swap rates are nothing but the
difference between the forward rate and the spot rate.
 The difference between the spot rate and the forward rate is known as
spread
 The spot rate is expressed in outright form and the forward rates are
point form.
 The rates for the US$/J¥ are as follows:
US$/J¥ bid ask
Spot 47.0725 – 45
1 week 25 – 30
2 weeks 70 – 90
1 month 115 – 145
2 months 175 – 220
 Now how do we arrive at the actual forward rates? The answer is the cash
or swap rates are either added or subtracted from the spot rates to get
the forward rates in “outright” form.

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 Now the question is when these points are to be added and when to be
subtracted? There is a thumb rule to decide when points are added or
subtracted.
 If “Bid in points” > “Ask in points” then the points are subtracted from the
spot. If “Bid in points” < “ask in points” then the points are added to the
spot. The above thumb rule is also known as “High-Low” (Falling
points) or “Low-High” (Raising point) rule.
 High-Low Rule: If the bid points are higher (than the ask points), the
spot rate has to be made lower (by subtracting bid-ask points from spot
bid-ask rates) to find the forward rate.
 Low-High Rule: If the bid points are lower (than the ask points), the spot
rate has to be made high (by adding bid-ask points to spot bid-ask rates)
to arrive at the forward bid-ask rates.
 In the example above, as the “bid in points” < “ask in points”.
Hence these points are to be added to the spot rate to arrive at the
forward rates. When these points are added, the outright quotations will
be same as the details given below.
US$/J¥ bid ask
Spot 47.0725 – 47.0745
1 week 47.0750 – 47.0775
2 weeks 47.0795 – 47.0835
1 month 47.0840 – 47.0890
2 months 47.0900 – 47.0965

 Note: Forward quotations given above indicate the market collective

opinion about the future exchange rate movement. In future, US$ is
expected to depreciate.
 Now suppose, a foreign exchange dealer gives the following cash or swap
rates in points quotations
US$/J¥ bid ask
Spot 47.0725 – 45
1 week 35 – 30
2 weeks 40 – 33
1 month 60 – 45
2 months 75 – 55
 In the example above, as the “bid in points” > “ask in points”, these
points are subtracted from the spot rate to arrive at the forward rates.
When these points are subtracted, the outright quotations will be same as
the details given in below.
US$/J¥ bid ask
Spot 47.0725 – 47.0745
1 week 47.0690 – 47.0710
2 weeks 47.0685 – 47.0712
1 month 47.0665 – 47.0700
2 months 47.0650 – 47.0690
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 Note: Forward quotations given above indicate the market collective
opinion about the future exchange rate movement. In future, US$ is
expected to appreciate.
 The relationship between spot bid-ask spread, forward points and forward
bid-ask spread can be summarized as:
i. Bid-ask spreads of the forward price should always be greater than the
spot price. It is obvious as the forex dealer is taking more risk in a
forward contract than a spot contract. As given above, spot bid-ask
spread is US$0.0020/J¥ while for 1-week and 2-week forward it is
US$0.0025/J¥ and US$0.0040/J¥ respectively.
ii. Sum of the bid-ask spreads of the spot price and forward points should
equal the spread of the forward price. As given above, the spot bid-ask
spread is 0.0020. 1-week forward point bid-ask spread is 0.0005. Sum
of these two is 0.0025. Hence, bid-ask spread for 1 week forward
should equal to 0.0025. This aspect is corroborated with the outright 1-
week forward outright quotations.

20. Forward Premiums and Discounts

Forward rates may be quoted as a bid price and ask price in same way as for
spot rates
But may be quoted as discount or premium to the spot
Premiums or discounts means amount by which the forward rate differs with
spot rate
The size of the premium or discounts depends on the difference in interest
rates between the two currencies
The currency with lower interest rate is always stronger forward than spot
against the currency with higher interest rate
The rule for calculating forward rate from spot rate and premium or discount
is

a) Subtract a premium from spot rate

b) Add discount to the spot rate.
 Forward premiums and discounts indicate a currency’s value in the
forward market relative to the spot market.
 Whether the forward rate is weaker or stronger than the spot rate
depends on which currency has the higher and which has the lower
interest rate. The currency with lower interest rate is always stronger
forward than spot against the currency with the higher interest rate.
 In other words, the rules for premium or discount are that if interest rate
of a base currency is less than interest rate of a quote currency, then the
base currency will be at premium.
 If interest rate of a base currency is greater than interest rate of a quote
currency, then the base currency will be at discount.
 If the forward rate is lower than the spot rate, the base currency is at a
discount.
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 If the forward rate is higher than the spot rate, the base currency is at a
premium.
 Alternatively, the premium and discount on the foreign currency may be
expressed as a periodic or an annualized percentage deviation from
the spot rate.
 Forward premium (or discount) – Periodic = [(forward rate – spot
rate)/spot rate]. Where the exchange rate is stated in domestic currency
units per unit of foreign currency (direct quote).
 Forward premium (or discount) – Periodic = [(spot rate – forward
rate)/spot rate]. Where the exchange rate is stated in foreign currency
units per unit of domestic currency (indirect quote).
 Forward premium (or discount) – Annualized = [(forward rate – spot
rate)/spot rate] × (12 months/ Forward contract period). Where the
exchange rate is stated in domestic currency units per unit of foreign
currency.
 Forward premium (or discount) – Annualized = [(spot rate – forward
rate)/spot rate] × (12 months/ Forward contract period). Where the
exchange rate is stated in foreign currency units per unit of domestic
currency.

Example 12
Today’s spot rate is US$0.008433/¥. The 90-day forward rate is
US$0.008471/¥.
Required:
a. Calculate the forward premium on the Japanese yen in point basis and as
a percentage premium or discount over 90-day period.
b. Calculated the forward premium on the Japanese yen as an annualized
percentage premium.

Review Questions

Question 1
Assume you are a trader with Deutsche Bank (Germany). From the quote
screen on your computer terminal, you notice that Dresdner Bank (Germany)
is quoting €0.7627/US$ and Credit Suisse (Switzerland) is offering
SFr1.1806/US$. You learn that UBS (Switzerland) is making a direct market
between the Swiss franc and the euro; with a current rate of €0.6395/SFr.
Assume you have US$5,000,000 with which to conduct the arbitrage.
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Required:
a. Show how you can make a triangular arbitrage profit by trading at these
prices. (Ignore bid-ask spreads for this problem).
b. What happens if you initially sell dollars for Swiss francs?
c. What €/SF price will eliminate triangular arbitrage?
Question 2
The rates for the TZS/ US$ are as follows:
Spot 1,500 – 1,600
1 month 1,540 – 1,650
3 months 1,560 – 1,680
6 months 1,580 – 1,690

Today is 5 March. A Tanzania company has to pay US$ 300,000 to a supplier

at the end of first week of June, and wants to fix a rate of exchange now.
Required:
a. What forward rate can be obtained for a currency transaction?
b. What would the cost to the Tanzania Company be, in TZS?

Question 3
Suppose that the spot rate for the euro against the US dollar is US$1.1500/€.
The one-year rate of interest is 2.5% on the euro and 3.5% on the US dollar.
Required:
a. What would you expect the current one-year forward rate to be?
b. Is the dollar stronger or weaker one-year forward compared with the spot
rate? Why is this case?

Question 4
Today’s spot rate is US$0.008433/¥. The 90-day forward rate is
US$0.008471/¥.
Required:
a. Calculate the forward premium on the Japanese yen in point basis and as
a percentage premium or discount over 90-day period.
b. Calculated the forward premium on the Japanese yen as an annualized
percentage premium.

Forward premium = [(0.008471 – 0.008433)/0.008433] × (12/3)

= 0.018 = 1.80%
Here the 3 – month premium is 1.80%, we say that the yen is trading versus
the dollar at a 1.80% premium for delivery in 90 days.

Forward discount = [(118.05 – 118.58)/118.58] × (12/3)

= -0.0180 = -1.79%
Here the 3 – month discount is 1.80%, we say that the dollar is trading
versus the yen at a 1.80% discount for delivery in 90 days.

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Question 5
At the foreign currency dealer you are able to see the following direct quote:
TZS/US$ 1,500 – 1,600.
Required
a. Convert the direct quote into indirect quote version.
b. If the dealer buys and sells US$1,000, show calculations for the profit or
loss would be made on the transaction if direct quotation or indirect
quotation is used.

Question 6
Suppose CA$/US$ rate is given along with and AU$/US$ quotations as listed
below.

CA$/US$ AU$/US$ AU$/CA$

Bid Ask Bid Ask Bid Ask
1.1641 1.1646 1.2948 1.2956 ? ?

Required:
What is the cross rates for AU$/CA$?

Solution
From the above quotations, cross rate between AU$/CA$ has to be calculated
as follows:
 Bank buys 1 US$ and pays (sells) 1.1641CA$,
 Bank sells 1 US$ and receives (buys) 1.1646 CA$,
 Bank buys 1 US$ and pays (sells) 1.2948 AU$,
 Bank sells 1 US$ and receives (buys) 1.2956 AU$,

To get the bid rate for AU$/CA$ (CA$ as base currency and AU$ as quote
currency), the bank must sell AU$ and buy CA$. This is achieved in two steps
i.e. the bank must sell AU$ and buy US$ and simultaneously sell US$ and buy
CA$. This indicates that 1.1646 CA$ = 1.2948 AU$. In other words, 1 CA$ =
1.1118 AU$. To get the ask rate for AU$/CA$, the bank must sell CA$ and
buy AU$. This is achieved in two steps i.e. the bank must sell CA$ buy US$
and simultaneously sell US$ and buy AU$. This means that 1.1641 CA$ =
1.2956 AU$. In other words, 1 CA$ = 1.1129 AU$.
Hence the cross rate for AU$/CA$ will be:
Bid Ask
1.1118 1.1129

Question 7
Suppose that the Spot mid-rate is £1.6315/US$. The 90-day sterling deposit
rate is 5.75% and 90-day US$ deposit rate is 6.15%. Assume 360 – day year.
Required:
What will be the 90-day forward £/US$ mid-rate?
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Question 8
You receive the following quotes:
£/US$ 1.5000-10
Interest rate US$, 184 days 5 7/8 - 6 %
Interest rate £, 184 days 2 – 2 1/8 %
Required:
What is the quotation of a 6-months (184 days) outright US$/£?

Question 9
Mrs. TJS has US$5,000,000 and the following information of exchange rates
from one of the dealers:
Barclays bank:
US dollar quote for sterling pound: US$1.4650/£,
Deutsche bank in Germany:
The euro quote for US dollar: €0.8171/US$,
Dresden Bank:
Euro quote for sterling pound: €1.1910/£,
Required:
a. Is triangular arbitrage possible? Give reasons for your answer.
b. Using (a), explain the steps that Mr. TJS should take and compute his
profit.

Question 10
Today’s spot rate is US$0.009057355/¥. The 90-day forward rate is
US$0.008772945/¥.
Required:
a. Calculate the forward premium on the Japanese yen in point basis and as
a percentage premium or discount over 90-day period.
b. Calculated the forward premium on the Japanese yen as an annualized
percentage premium.

Question 11
A foreign exchange dealer in Kigali Rwanda provides quotes for the spot and
3-month forward rates for the RFr against the dollar.

Bid (RFr/US$) ask (RFr/US$)

Spot 4.0040 4.0200
3-month forward 3.9690 3.9888
Required:
a. What would you receive in dollars if you sell RFr 5 million at the spot rate?
b. What would it cost in dollars to purchase RFr 20 million forward 3-month?
When would you make payment?

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Question 12
Dollars are trading at SFr0.7465/US$ in the spot market. The 90-day forward
is SFr0.7432/US$.
Required:
a. What is the forward premium on the dollar in basis point terms?
b. What is the forward premium as an annualized percentage rate?

Question 13
Calculate appreciation or depreciation in each of the following:
a. If the dollar depreciates by 10% against yen, by what percent does the
yen appreciate against the dollar?
b. If the dollar appreciates by 1000% against TZS, by what percent does the
TZS depreciate against the dollar?

Question 14
The following quotes are received for spot, one month, three month, and six
months

Spot One month Three-month Six month

US$/£1 2.0015 – 30 19 – 17 26 – 22 42 - 35
US$/€1 1.6963 – 68 4 – 6 9 – 14 25 – 38

Required:
Convert the above swap rates into outright rates

Question 15
You are given the following information about currency rates for pound
sterling spot and forward

Currency Spot 1 month forward 3 month-forward

US ($) 1.5200 – 1.5210 0.32 – 0.27 c pm 0.89 – 0.84 c pm

Canadian ($) 1.8630 – 1.8640 0.30 – 0.20 c pm 0.90 – 0.80 c pm

Kenya (KES) 24.05¼ - 28.06¼ 2 3/8 – 1 7/8 c pm 6 3/4 - 6¼ c pm

Tanzania (TZS) 2072.20 – 10 – 20 c dis 45 – 55 c dis

2079.30

Required:
Calculate the cost or value in pounds to a customer who wishes to:
a. Buy US$.1,400 one month forward from his bank
b. Buy CA$25,000 spot
c. Buy TZS.75,000 three months forward
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d. Sell KES.28,000 one month forward
e. Sell TZS.20,000 three months forward
f. Sell CA$.6,000 one month forward

Question 16
A foreign exchange dealer provided the following quotations for the South
African Rand (SAR) against the Tanzanian Shilling (TZS) on the 31st
September 2004: -
TZS/SAR Spot 50 – 55
Three - month forward 2 – 7 dis

Required:
a. Calculate the percentage bid – ask spread on the three-month forward
TZS.
b. Calculate the profit made by the dealer in purchasing and selling SAR
1,000,000 three month forward.
c. Using the spot and forward offer prices calculate the forward premium or
discount on the SAR.

Question 17
Given the following market rates expressed in European terms of other
currency’s unit per US$
US$: € Spot 1,890.00 -1,892.00
One month forward 1,894.25 -1.897.50
US$: SFr Spot 3.4582 - 3.4600
One month forward 3.4530 - 3.4553

Required:
Calculate the forward cross rate for buying and selling € against the SFr.

Question 18
A commercial bank in Dar es Salaam, Tanzania, provided the following
foreign exchange quotes on 30th April, 2006.

TZS/£1 £/Euro1 TZS/US $1

Spot 2,404 – 2,420 0.4852 – 0.4892 1,050 – 1,060
1 year Forward 2,456 – 2,474 0.4956 – 0.4966 1,200 -1,260

Required:
a. How many TZS will the bank pay to purchase one Euro one year forward
from a customer?
b. Determine the one year forward percentage bid – ask spread on the £
against the US$.

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c. Calculate the spot and one year forward mid-prices for the £ against the
Euro and determine the one year forward premium or discount on the
Euro against the £.

Question 19
Mango Enterprises Ltd (MEL) is an import-export company based in Dar es
Salaam. On February 28th, the company contracted to buy 1,500 tons of
maize from Malawi at a price of Kwacha 11,820 per ton. MEL has arranged
that shipment of the product will be made directly to a customer in Uganda
who has bought the maize at UGS.4620 per ton. Of the total quantity, 500
tons will be shipped during March and the balance by the end of April. A
payment to the suppliers is to be made immediately on shipment, whilst one-
month credit from the date of shipment is allowed to the Ugandan customer.
Assume MEL arranges with its bank to cover rates as at 28th February being
those given below:

Kwacha UGS.
Spot 1.0745 - 1.0775 3.84 – 3.88
1 month forward 5 ½ - 10 ½ c dis 2 ½ - 1 ½ c pm
2 months forward 7 ½ - 17 ½ c dis 4 – 3 c pm
3 months forward 10.6 – 25 c dis 6 ½ - 5 ½ c pm

The bank charges exchange commission of TZS.10,000 on each transaction.

Required:
Calculate the profit or loss MEL will make on the transaction.

Question 20
Your given the following

S$/£1 SFr/£1

Spot 2.2815 – 2.2825 2.2365 – 2.2370

3 months 68 – 64 pm 45 – 49 ds

6 months 118 – 112 pm 92 – 100 ds

A company arranges the following transactions at these rates

a) It buys S$600,000 spot for £

b) It sells SFr400,000 three months forward in exchange for £

c) It buys £300,000 six months forward in exchange for S$

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Required:

What is exchange rate will apply to each of these transactions and what is the cash flows?

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