Lecture 2 Forex - Part 2 PDF

Advanced Finance Lecture 2 FOREX – Part 2 Dr. Hadeer Mounir [email protected] Remember… An exchange rate is the price of one country’s currency in terms of another country’s currency. Simply, how many units of one currency in return for another currency. 2 Methods of Quotations “exp...

Advanced Finance Lecture 2 FOREX – Part 2 Dr. Hadeer Mounir [email protected] Remember… An exchange rate is the price of one country’s currency in terms of another country’s currency. Simply, how many units of one currency in return for another currency. 2 Methods of Quotations “expressing”: Assume EGP is home currency 1. Direct Quotation or “American”: the price of 1 foreign currency in terms of home currency or simply the domestic price of foreign currency. The amount of home currency needed to purchase one unit of a foreign currency. USD 1.00=EGP48, expressed as EGP 48/$. How many EGP it takes to buy 1$. Base Currency Price Currency 2. Indirect Quotation or “European”: the price of 1 home currency in terms of foreign currency or the foreign price of a domestic currency. The amount of foreign currency required to purchase one unit of Home currency. EGP 1.00 = USD 0.02, expressed as $0.02/EGP. Base Currency Price Currency Notice that the two numbers are reciprocals of each other (1/48 = 0.02).  Spot and Forward Markets So far, spot market rates have been presented, where the spot rate is the current exchange rate for immediate delivery In practice, the settlement of the deal is within two days Additionally, currencies can be traded for delivery and settlement at specified future days. This takes place on the forward market. Common durations are: 1 month (30 days) 3 months (90 days) 1 year (360 days) On the forward market, forward exchange rates are quoted. Forward markets are used to protect against unexpected future changes in exchange rates because it allows to “lock” in an exchange rate for some future period of time.  Types of Transactions (Spot vs. Forward) 1. A spot transaction: payment and receipt of the foreign exchange on the spot/ exchange of currencies at immediate prices (i.e. exchange currency immediately); in practice, it is settled within two business days. So, the spot rate is the current exchange rate for immediate delivery. 2. A forward transaction (or forward trade or contract): an agreement/contract today to buy or sell a specified amount of a foreign currency for a future delivery date but at specified price agreed today (forward rate). So, the forward rate is the exchange rate specified in the forward contract. Common contract terms (durations) include 1 month (30 days), 3 months (90 days) and 1 year (360 days). For example, the spot exchange rate for the JPY is $0.5871 per JPY 1 and the 180- day (6-month) forward exchange rate is JPY 1= $0.5887. This means that you can buy a JPY today for $.5871 or you can agree to take delivery of a JPY in 180 days and pay $.5887 at that time. Types of Transactions (Spot vs. Forward) FD (forward discount): – if the forward rate < spot rate If the forward rate is below the present spot rate, the foreign currency is said to be at a forward discount (i.e. the foreign currency is selling at a discount ). For example, the £ per $ 6-month forward is less than its spot (2.0417 versus 2.056). FP (forward premium): if the forward rate > spot rate If the forward rate is above the present spot rate, the foreign currency is said to be at a forward premium (i.e. the foreign currency is selling at a premium). For example, the JPY per $ 1-month forward is greater than its spot (0.009034 versus 0.008999).  Forward Premium/Discount Suppose the exchange rate for the dollar is quoted as EGP 48.42 in the spot market and EGP 49.1 in the 90-day forward market. A. Is the dollar selling at a premium or a discount relative to the EGP? Spot: 1 $ = 48.42 EGP Forward: 1 $ = 49.1 EGP The dollar is selling at a premium because it is more expensive in the forward market than in the spot market. More EGP is needed in the forward to buy 1$. B. Does the financial market expect the EGP to strengthen relative to the dollar? Explain. No, the market expects the EGP to depreciate/ weaken relative to the dollar because it will take more EGP to buy one dollar in the future than it does today. Cross-Rates and Triangle Arbitrage The idea of cross rates is to relate two exchange rates with a third common currency. It enables you to calculate the exchange rate between the two currencies by considering the respective exchange rates to a third common currency. It is the implied exchange rate between two currencies, calculated by the relationship to a third (common) currency. Ex. : suppose that a USD costs 48 EGP and 0.9 EUR. What is the cross rate “implied rate” between EGP and Euro? 𝑬𝑮𝑷 𝟒𝟖 𝑬𝑼𝑹 𝟎.𝟗 = and = and USD is common currency 𝑼𝑺𝑫 𝟏 𝑼𝑺𝑫 𝟏 𝑬𝑮𝑷 𝑼𝑺𝑫 𝟒𝟖 𝟏 𝟒𝟖 To buy 1 EUR = x = x = = 53.3 EGP is needed. 𝑼𝑺𝑫 𝑬𝑼𝑹 𝟏 𝟎.𝟗 𝟎.𝟗 𝑼𝑺𝑫 𝑬𝑼𝑹 𝟏 𝟎.𝟗 𝟎.𝟗 To buy 1EGP = 𝑿 = x = = 0.01875 Euro is needed. 𝑬𝑮𝑷 𝑼𝑺𝑫 𝟒𝟖 𝟏 𝟒𝟖  Cross rates – Examples. Ex. : EUR/USD = 0.90, JPY/USD = 150. Calculate the implied cross rate. 𝟎.𝟗 𝟏 𝟎.𝟗 To buy 1 JPY = EUR/JPY = EUR/USD x USD/JPY = x = = 𝟏 𝟏𝟓𝟎 𝟏𝟓𝟎 = 0.006 EUR /JPY 𝟏 𝟏𝟓𝟎 𝟏𝟓𝟎 To buy 1 EUR = JPY/EUR = USD/EUR x JPY/USD = x = 𝟎.𝟗 𝟏 𝟎.𝟗 = 166.66 JPY/EUR Ex.: We know the dollar rates: USD/Euro =1.2461 and USD/GBP=1.7965 What is GBP/Euro, i.e. the GBP price of Euros?  In efficient markets, exchange rates should correspond to the cross rates. However, in practice, temporary arbitrage opportunities may occur. In efficient markets, the observed prices “actual market rates” should correspond to the cross “implied” rates. Else, there is an arbitrage opportunity, which is a trading strategy to make risk-free profit via buying and simultaneously sell the same security in different markets at different prices, and profit from the temporary price differences (= “free lunch”) Arbitrage: is riskless “risk-free” profit due to mispricing, obtained by buying low (undervalued) and selling high (overvalued). Note that there are no arbitrage opportunities in the equilibrium of perfect markets (“no-arbitrage principle”) However, due to countless markets and currency pairs, markets can (temporarily) be inefficient, meaning that arbitrage opportunities may occur. They are exploited by buying the undervalued security and selling the overvalued security. This leads to price adjustments (buying = demand. The price of the undervalued security increases; selling = supply. The price of the overvalued security decreases) that move prices in the direction of arbitrage-free prices. Triangle Arbitrage Triangle Arbitrage in currency markets, or triangular arbitrage, is a type of arbitrage that involves exploiting price discrepancies between three related currency pairs. Triangle Arbitrage occurs when exchange rates between three currency pairs are not in equilibrium, allowing traders to make riskless profits by exploiting these inefficiencies. Triangle Arbitrage called so because you deal with three currencies to make this profit. It involves converting one currency to another, then to a third currency, and finally back to the original currency, profiting from price inefficiencies.  Triangle Arbitrage - Realities in Practice The opportunity to exploit a triangle arbitrage may appear to be an easy opportunity to make a quick profit. Yet, arbitrage opportunities are rare, sophisticated algorithms usually exploit them within milliseconds, and that the transaction costs for small investors would outweigh any profit opportunity available. Speed & Automation: In real life, these arbitrage opportunities exist for only a few seconds, and automated trading algorithms are typically used to detect and execute arbitrage trades before the market corrects the discrepancies. Transaction Costs: In reality, profits are small, and high transaction costs can erode profits unless the arbitrage opportunity is large enough to cover fees and spreads.  Triangle Arbitrage If the Implied cross rate is not equal to the actual market rate then there is Arbitrage! To make Arbitrage profit: Buy undervalued currency and Sell Overvalued To make Arbitrage profit: You have to go through all 3 currencies It involves converting one currency to another, then to a third currency, and finally back to the original currency, profiting from price inefficiencies. “Whatever Currency you start with, you end with (to calculate round profit)” Looking at the Triangle, this is the sequence to go through: Common to Overvalued to Undervalued to Common Overvalued to Undervalued to Common to Overvalued Undervalued to Common to Overvalued to Undervalued Triangle Arbitrage - Example Example: Suppose that you have $1000 and you find the below rates: $1= KWD 0.2500, $1= C$ 1.500 The cross-rate in the market : KWD 1 =C$ 4.00 Requirements: 1) Show all Possible ways to buy C$? 2) Is there an Arbitrage Opportunity? 3) Explain how to take advantage if any? 4) How much profit can you make per round?  Triangle Arbitrage Example: Suppose that you have $1000 and find below rates: $1= KWD 0.25, and $1= C$ 1.5 The cross-rate in the market : KWD 1 =C$ 4 1) How many possible ways to buy C$? There are two possible ways: 1st way: Buy C$ Directly Convert $ directly to C$ ($1= C$ 1.5): $1000 x C$1.5 = C$1500 2nd way: Buy C$ Indirectly via Kuwaiti Dinars KWD: Convert $ to KWD then to C$ = Rate: ($1= KWD 0.25): $1000 x KWD 0.25 = KWD 250 then convert KWD to C$ using cross market rate (KWD 1 =C$ 4) = KWD 250 x C$ 4 = C$ 1000 Triangle Arbitrage 2) Is there an Arbitrage Opportunity? The two ways of buying C$ resulted in different amounts This indicates different prices for C$. Directly: Buy 1500 C$ with $1000. (rate C$1.5 per $1) Indirectly via KWD: Buy 1000 C$ with $1000. (rate C$1 per $1) This indicates the existence of Arbitrage opportunity! And we can make Riskless Profit. Triangle Arbitrage 3) In this case, How can we make money? “Buy low and sell high” The 1st method resulted in higher amount so we will continue with it. Note: To Make Arbitrage Profit, We have to go through all 3 currencies, and we have to start and end with same currency. Sequence: $ to C$ to KWD to $ $1= KWD 0.25, and $1= C$ 1.5, The cross-rate in the market : KWD 1 =C$ 4 1. Sell $1000 to buy C$ = $1000 * C$ 1.5 = C$ 1500 ($1= C$ 1.5) 2. Sell C$1500 to buy KWD at the market cross-rate (KWD 1 =C$ 4), you will receive C$1500/4= KWD 375 3. Sell KWD 375 to buy $. The exchange rate is $1= KWD 0.25, so you receive KWD 375/0.25= $1500, 4. You made a Round-Trip profit of $500 per $ 1000 (Started with $1000 and ended with $1500). Another way of solving for Triangle Arbitrage: We can calculate the Implied Cross rate and compare it to the actual market rate, if they are different, then there is an arbitrage opportunity and then we need to determine the overvalued currency and the undervalued currency to know the sequence of converting: (Market Rates $1= KWD 0.25, $1= C$ 1.5, KWD 1 =C$ 4) Implied Cross rate: 1 KWD = 1.5 / 0.25 = 6 C$. Actual Market rate: KWD 1 =C$ 4. Again the inconsistency here indicates Arbitrage! KWD is undervalued while C$ is overvalued in the Market. In this case, Starting with $ (common currency) you convert to C$ (Overvalued currency) then sell the overvalued and buy KWD (the undervalued currency) then convert back to the currency you started with ($) to calculate your round profit. Sequence: $ to C$ to KWD to $ (Same sequence as in previous slide) Now solve as before: Another way of solving for Triangle Arbitrage: Sequence: $ to C$ to KWD to $ (Same sequence as in previous) 1. Sell $1000 to buy C$ = $1000 * C$ 1.5 = C$ 1500 ($1= C$ 1.5) 2. Sell C$1500 to buy KWD at the market cross-rate (KWD 1 =C$ 4), you will receive C$1500/4= KWD 375 3. Sell KWD 375 to buy $. The exchange rate is $1= KWD 0.25, so you receive KWD 375/0.25= $1500, 4. You made a Round-Trip profit of $500 per $ 1000 (Started with $1000 and ended with $1500). Ex. Suppose the exchange rates for the Sterling pound and Euros are: £ per $1 = 0.50 € per $1 = 2 Suppose that the cross-rate is €2 per £. Is this consistent? Explain how to make some money? This is not consistent because The implied cross rate is 2/0.5 = 4 € per £, while The Actual Market rate = €2 per £. Hence, there is an arbitrage opportunity. Sterling undervalued and Euro Overvalued. Assume we start with $1000 (common): $ to € to £ to $ Sell $1000 to buy Euro at rate € per $1 = 2 = $1000x2 = 2000 Euro, Sell Euros (overvalued) to buy Sterling (undervalued) at actual market cross- rate (€2 per £) = 2000Euros / 2 = 1000 sterling, then convert back to dollars (common) at £ per $1 = 0.50 = 1000 sterling/0.5 = 2000 $. This gives us a Round-Trip profit of $1000 per Round. Cross Rates - Example Your Egyptian Company is dealing with CIB Bank. The Company wants to invest in Japan, where it needs 3000,000Yen. Determine the minimum amount of EGP necessary to obtain the 3000,000Yen based on the below CIB rates. How many ways are there to obtain Yen? EGP/1 Yen 0.34 - 0.35 EGP/1 EUR 53.9 - 54.1 EUR/1 Yen 0.0064 - 0.0065 Here we have two ways to obtain Yen from CIB: 1st way: Buy Yen Directly from CIB (Sell EGP and Buy Yen): 1 Y = 0.34 EGP – 0.35 EGP Buy Yen (Bank sells) at Ask Price: 3000,000Y * 0.35 EGP = EGP 1,050,000 2nd way: Buy Yen Indirectly via Euro from CIB (sell EGP to buy Euro then sell Euro to buy Yen) 1 Y = 0.0064 EUR – 0.0065 EUR Buy Yen at Ask Price: 3000,000Y * 0.0065 EUR = 19,500 EUR The Euro amount in EGP: 1 EUR = 53.9 EGP – 54.1 EGP “Sell EGP & Buy EUR at Euro Ask Rate ” = 19,500EUR * 54.1 EGP = EGP 1,054,950 The minimum amount of EGP is in the 1st way (EGP 1,050,000).