Chapter 13

Chapter 13 - Ch. 13: The Foreign Exchange Market Spot Rate...

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Ch. 13: The Foreign Exchange Market Spot Rate Exchange rate is the price of one currency in terms of another. We want to look at the price of Swiss franc (SF) in terms of the dollar. The $ price of one Swiss franc (SF) = $/SF = $0.8312. Suppose an American importer wants to buy $10,000 worth of Swiss watches. This importer must convert the dollars to SF to buy the Swiss watches $10,000 are equivalent to $ 10,000/ $0.8312 = SF 12,030.79884 Foreign exchange markets also list quotations in terms of foreign currency units per $. This is the foreign price of the dollar. We can use the SF as the foreign currency SF/$ = 1/ $/SF = 1/ $0.8312 = SF 1.20307 per $1. Spread: Difference between selling (ask) rate and buying (bid) rate, from the bank’s point view = Selling rate Buying rate = ask rate – bid rate Its size varies according to the individual trader, the type of currency traded and banks’ views of conditions in the foreign exchange market. Example : Suppose the exchange rate is Can$ / $. Can $ 1.35 06 11 The bank is willing to bid Can $1.35 06 to buy US$ 1 and it will sell US$ 1 for Can $1.35 11 . Spread = 1.35 11 –1.35 06 = 0.00057 must be < 0.1% for normal spread. Spot foreign exchange market: Buying and selling foreign exchange and the trading takes 2 working days to clear. Arbitrage Exchange rates tend to be equal worldwide because of arbitrage. If they are not so, there would be profit opportunities for simultaneously buying a currency in the market while selling in another. This activity is known as arbitrage. The arbitrage occurs until the exchange rates in the two different countries are so close that it is not worth the transaction costs incurred from any further buying and selling.
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Bilateral Arbitrage: New York Market ($/SF) London Market ($/SF) SF1=$0.83 SF1= $0.84 SF is weaker in NY than in London Sell $ and buy SF Sell SF and buy $ Suppose you have dollars. Sell $0.83(stronger currency) to buy SFs (the cheaper currency) in New York where SFs are relatively cheap and simultaneously sell them where they are relatively expensive (London), thereby earning a profit of 1 cent per one SF. Net profit will be determined by transaction costs. If transaction cost exceeds 1 cent then no arbitrage will
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Chapter 13 - Ch. 13: The Foreign Exchange Market Spot Rate...

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