Transactions in Foreign Currency Markets

# Transactions in Foreign Currency Markets - TRANSACTIONS IN...

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TRANSACTIONS IN FOREIGN CURRENCY MARKETS Appreciation (Depreciation) The rate of appreciation (depreciation) is the percentage change in the value of the foreign currency. Arithmetically, The rate of appreciation = [(current exchange rate-initial exchange rate)/initial exchange rate] Example: The exchange rate for Mexican peso was 0.1086 in December 2001, and .0913 in November 2003. This means Mexican peso depreciated against the US dollar. The rate of change is (-.0913-0.1086)/0.1086 = -0.0173/0.1086 = -.159. In other words, from December 2001 to November 2003, the Mexican peso depreciated 15.9 % against the US dollar. Cross Rates Given the exchange rate between the US dollar and currency B and the exchange rate between the US dollar and currency A, we can find the exchange rate between currency A and currency B. In November 10th 2003, the value of Malaysian ringgit (\$/Malaysian ringgit) was \$0.2632, and the value of Indian rupee (\$/Indian rupee) was \$0.02212. We can find the value of Malaysian ringgit in terms of Indian rupee as Indian rupee/Malaysian ringgit = (\$/Malaysian ringgit) / (\$/Indian Rupee) = .2632 / .02212 = 11.90

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In other words, we need about 11.90 Indian rupees to buy one Malaysian ringgit. Similarly, the value of Indian rupee in terms of Malaysian ringgit could be found as Malaysian ringgit/Indian rupee = (\$/Indian rupee) / (\$/Malaysian ringgit) = .02212 / .2632 = .084, which is equal to 1/11.90. Arbitrage Arbitrage is the process of buying the currency in one market and selling it in another taking advantage of discrepancies in exchange rates. This can be done in two ways: Exchange rates for the same pair of currency are different in two financial centers: Suppose that at 10 am Eastern time, you (a foreign currency trader) noticed that the value of a British pound in terms of US dollars is \$1.67 in New York while the same rate in London is \$1.68. (Note that at 10:00 am Eastern time, the local time in London is 3:00 pm, and the foreign currency market is still open.) This provides an opportunity to make profits as British pound is cheaper in New York market than it is in London market. You buy the British pound where it is cheaper, New York, and sell it where it is more expensive, London. Suppose that you have \$1,000 to use in arbitrage. \$1,000 will buy you \$1,000 / 1.67 = 598.8 British pounds. You sell these British pounds in London to buy back US dollars. This transaction will give you \$1006. Thus, you make a profit of \$6 (or .6%) from these two transactions. The arbitrage process equalizes exchange rates in different financial centers: In our example, as traders buy British pounds in New York, demand for British pound, and hence the exchange rate, will increase in New York. On the other hand, as people sell British pounds in London, this will reduce the demand for
British pound, and hence the exchange rate, in London. As a result, exchange rates in the two centers converge to each other. Triangular arbitrage:

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## This note was uploaded on 03/20/2008 for the course ECON 333 taught by Professor Yavas,cemilepan,lu during the Fall '06 term at Penn State.

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Transactions in Foreign Currency Markets - TRANSACTIONS IN...

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