G. Square Off

To make the inflows of a given currency equalto the outflows of that currency, banks adjust their bid and offer rates.

The only method that would “square off” theforeign exchange position is to raise both rates or lower both rates.

ⅤArbitrage vs.Speculation

A. Arbitrage

--creating aposition to realize a riskless (sure) profit from market disequilibrium. Norisk involves, only gain.

How can an arbitrage firm make money?

To understand the idea of arbitrage profitopportunity in the foreign exchange market, let consider two examples.

a. Two-point arbitrage: the simplest case – only two currencies

As arbitrageurs buy and sell currency, bankswill adjust their prices.

b. Triangular Arbitrage (Three-point arbitrage): A case of threecurrencies.

Need to compute an implicit cross rate forthe missing market.

Implicit Cross-Rate – the implied thirdexchange rate, given two exchange rates involving three currencies.

c. Rules:

If Sd/e· Se/f·Sf/d< 1, buy the currencies in the denominators with the currencies in thenumerators.

If Sd/e· Se/f·Sf/d> 1, sell the currencies in the denominators for the currencies in thenumerators.

B. Speculation

--creating a position to realize a profit from his/her expectation.

Risk-taking behavior

Betting on the actual future price > or< expected future price.

Could either gain or lose

套汇交易

Arbitrage

1. Here are some quotes of the Japanese yen/U.S. dollarspot exchange rate given simultaneously on the phone by three banks:

      Bank A:121.15–121.30

      Bank B:  121.22–121.35

      Bank C:  121.20–121.25

 Are these quotes reasonable? Do you havean arbitrage opportunity?

2.Here are some quotes of the Swiss franc/U.S.dollar spot exchange rate given simultaneously on the phone by three banks:

      Bank A:1.3435–1.3440

      Bank B:  1.3435–1.3445

      Bank C:  1.3445–1.3450

 Are these quotes reasonable? Do you havean arbitrage opportunity?

3. Doug Bernard specializes incross-rate arbitrage. He notices the following quotes:

Swiss franc/dollar = SFr1.5971/$

Australian dollar/U.S. dollar =A$1.8215/$

Australian dollar/Swiss franc =A$1.1440/SFr

A. Ignoring transaction costs,does Doug Bernard have an arbitrage opportunity based on these quotes?

B. If there is an arbitrageopportunity, what steps would he take to make an arbitrage profit, and howwould he profit if he has $1,000,000 available for this purpose.

Short-term Foreign Exchange Rate Movements

A CD/$ bank trader is currentlyquoting a small figure bid-ask of 35-40, when the rest of the market is tradingat CD1.3436-CD1.3441. What is implied about the trader’s beliefs by his prices?

Arbitrage Solution

1. These quotes are reasonable. There is noway to make a riskless arbitrage by buying dollars for yen from one bank at itsask rate and selling dollar for yen to another at its bid rate. If you need tobuy dollars, you are better off buying them from Bank C at 121.25 yen perdollar. If you need to sell dollars, you are better off selling them from BankB at 121.22 yen per dollar.

2. These quotes are unreasonable since they deviate from Bank A to Bank C by more than the spread; for example, Bank A’s ask rate (1.3440 Swiss francs per dollar) is smaller than Bank C’s bid rate (1.3445 Swiss francs per dollar). There is, therefore, an obvious arbitrage opportunity. One can buy Bank A’s dollars for 1.3440 Swiss francs per dollar, sell these dollars to Bank C for 1.3445 Swiss francs per dollar, and thereby make a profit of 0.0005 franc per dollar traded. This is a riskless, instantaneous operation that requires no initial investment.

3.

A. The implicit cross-ratebetween Australian dollars and Swiss franc is A$/SFr = A$/$ x $/SFr=(A$/$)/(SFr/$) = 1.8215/1.5971 = 1.1405. However, the quoted cross-rate ishigher at A$1.1.1440/SFr.

So, triangular arbitrage ispossible.

B. In the quoted cross-rate ofA$1.1440/SFr, one Swiss franc is worth A$1.1440, whereas the cross-rate basedon the direct rates implies that one Swiss franc is worth A$1.1405. Thus, theSwiss franc is overvalued relative to the A$ in the quoted cross-rate, and DougBernard’s strategy for triangular arbitrage should be based on selling Swissfrancs to buy A$ as per the quoted cross-rate. Accordingly, the steps DougBernard would take for an arbitrage profit is as follows:

i. Sell dollars to get Swissfrancs: Sell $1,000,000 to get $1,000,000 x SFr1.5971/$ =SFr1,597,100.

ii. Sell Swiss francs to buyAustralian dollars: Sell SFr1,597,100 to buy SFr1,597,100 xA$1.1440/SFr =A$1,827,082.40.

iii. Sell Australian dollarsfor dollars: Sell A$1,827,082.40 for A$1,827,082.40/A$1.8215/$ =$1,003,064.73.

Thus, your arbitrage profit is$1,003,064.73 - $1,000,000 = $3,064.73.

Short-term Foreign Exchange Rate Movements  Solution

The trader must think theCanadian dollar is going to appreciate against the U.S. dollar and therefore heis trying to increase his inventory of Canadian dollars by discouragingpurchases of U.S. dollars by standing willing to buy $ at only CD1.3435/$1.00and offering to sell from inventory at the slightly lower than market price ofCD1.3440/$1.00.