suggested end of chapter 5 solutions

8/11/2019 Suggested End of Chapter 5 Solutions

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CHAPTER 5 THE MARKET FOR FOREIGN EXCHANGE

SUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTER

QUESTIONS AND PROBLEMS

QUESTIONS

1. Give a full definition of the market for foreign exchange.

An!er" #roadl$ defined% the foreign exchange (FX) market encom&ae the converion of

&urchaing &o!er from one currenc$ into another% 'ank de&oit of foreign currenc$% the extenion of

credit denominated in a foreign currenc$% foreign trade financing% and trading in foreign currenc$

o&tion and future contract.

(. )hat i the difference 'et!een the retail or client market and the !holeale or inter'ank

market for foreign exchange*

An!er" The market for foreign exchange can 'e vie!ed a a t!o+tier market. One tier i the

wholesaleor interbank marketand the other tier i the retailor client market. International 'ank

&rovide the core of the ,- market. The$ tand !illing to 'u$ or ell foreign currenc$ for their

o!n account. Thee international 'ank erve their retail client% cor&oration or individual% in

conducting foreign commerce or making international invetment in financial aet that reuire

foreign exchange. /etail tranaction account for onl$ a'out 10 &ercent of ,- trade. The other

2 &ercent i inter'ank trade 'et!een international 'ank% or non+'ank dealer large enough to

tranact in the inter'ank market.

3. )ho are the market &artici&ant in the foreign exchange market*

An!er" The market &artici&ant that com&rie the ,- market can 'e categori4ed into five

grou&" international 'ank% 'ank cutomer% non+'ank dealer% ,- 'roker% and central 'ank.

International banks &rovide the core of the ,- market. A&&roximatel$ 155 to (55 'ank

!orld!ide make a market in foreign exchange% i.e.% the$ tand !illing to 'u$ or ell foreign

currenc$ for their o!n account. Thee international 'ank erve their retail client% the bank

customers% in conducting foreign commerce or making international invetment in financial aet

that reuire foreign exchange. Non-bank dealersare large non+'ank financial intitution% uch


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a invetment 'ank% mutual fund% &enion fund% and hedge fund% !hoe i4e and freuenc$ of

trade make it cot+ effective to eta'lih their o!n dealing room to trade directl$ in the

inter'ank market for their foreign exchange need.

6ot inter'ank trade are speculative or arbitrage tranaction !here market &artici&ant

attem&t to correctl$ 7udge the future direction of &rice movement in one currenc$ veru another

or attem&t to &rofit from tem&orar$ &rice dicre&ancie in currencie 'et!een com&eting dealer.

FX brokersmatch dealer order to 'u$ and ell currencie for a fee% 'ut do not take a

&oition themelve. Inter'ank trader ue a 'roker &rimaril$ to dieminate a uickl$ a

&oi'le a currenc$ uote to man$ other dealer.

Central banks ometime intervene in the foreign exchange market in an attem&t to

influence the &rice of it currenc$ againt that of a ma7or trading &artner% or a countr$ that it

8fixe9 or 8&eg9 it currenc$ againt. Intervention i the &roce of uing foreign currenc$

reerve to 'u$ one: o!n currenc$ in order to decreae it u&&l$ and thu increae it value in

the foreign exchange market% or alternativel$% elling one: o!n currenc$ for foreign currenc$ in

order to increae it u&&l$ and lo!er it &rice.

0. ;o! are foreign exchange tranaction 'et!een international 'ank ettled*

An!er" The inter'ank market i a net!ork of correspondent banking relationships% !ith large

commercial 'ank maintaining demand de&oit account !ith one another% called corre&ondent

'ank account. The corre&ondent 'ank account net!ork allo! for the efficient functioning of

the foreign exchange market. A an exam&le of ho! the net!ork of corre&ondent 'ank account

facilitie international foreign exchange tranaction% conider a U.S. im&orter deiring to

&urchae merchandie invoiced in guilder from a


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exchange. The for!ard &rice ma$ 'e the ame a the &ot &rice% 'ut uuall$ it i higher >at a

&remium? or lo!er >at a dicount? than the &ot &rice.

2. )h$ doe mot inter'ank currenc$ trading !orld!ide involve the U.S. dollar*

An!er" Trading in currencie !orld!ide i againt a common currenc$ that ha international

a&&eal. That currenc$ ha 'een the U.S. dollar ince the end of )orld )ar II. ;o!ever% the euro

and @a&anee $en have tarted to 'e ued much more a international currencie in recent $ear.

6ore im&ortantl$% trading !ould 'e exceedingl$ cum'erome and difficult to manage if each

trader made a market againt all other currencie.

. #ank find it necear$ to accommodate their client: need to 'u$ or ell ,- for!ard% in

man$ intance for hedging &ur&oe. ;o! can the 'ank eliminate the currenc$ ex&oure it ha

created for itelf '$ accommodating a client: for!ard tranaction*

An!er" S!a& tranaction &rovide a mean for the 'ank to mitigate the currenc$ ex&oure in a

for!ard trade. A swap trasa!t"# i the imultaneou ale >or &urchae? of &ot foreign

exchange againt a for!ard &urchae >or ale? of an a&&roximatel$ eual amount of the foreign

currenc$. To illutrate% u&&oe a 'ank cutomer !ant to 'u$ dollar three month for!ard

againt #ritih &ound terling. The 'ank can handle thi trade for it cutomer and

imultaneoul$ neutrali4e the exchange rate rik in the trade '$ elling >'orro!ed? #ritih &ound

terling &ot againt dollar. The 'ank !ill lend the dollar for three month until the$ are needed

to deliver againt the dollar it ha old for!ard. The #ritih &ound received !ill 'e ued to

liuidate the terling loan.

. A B


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. )hat i triangular ar'itrage* )hat i a condition that !ill give rie to a triangular ar'itrage

o&&ortunit$*

An!er" riangular arbitrage i the &roce of trading out of the U.S. dollar into a econd

currenc$% then trading it for a third currenc$% !hich i in turn traded for U.S. dollar. The &ur&oe

i to earn an ar'itrage

&rofit via trading from the econd to the third currenc$ !hen the direct exchange 'et!een the t!o

i not in alignment !ith the cro exchange rate.

6ot% 'ut not all% currenc$ tranaction go through the dollar. Bertain 'ank &eciali4e in

making a direct market 'et!een non+dollar currencie% &ricing at a narro!er 'id+ak &read than

the cro+rate &read. Neverthele% the im&lied cro+rate 'id+ak uotation im&oe a dici&line

on the non+dollar market maker. If their direct uote are not conitent !ith the cro exchange

rate% a triangular ar'itrage &rofit i &oi'le.

15. Over the &at ix $ear% the exchange rate 'et!een S!i franc and U.S. dollar% S,rCD% ha

changed from a'out 1.35 to a'out 1.25. )ould $ou agree that over thi ix+$ear &eriod% the S!i

good have 'ecome chea&er for 'u$er in the United State*

B,A Guideline An!er"

The value of the dollar in S!i franc ha gone u& from a'out 1.35 to a'out 1.25. Therefore% the

dollar ha a&&reciated relative to the S!i franc% and the dollar needed '$ American to

&urchae S!i good have decreaed. Thu% the tatement i correct.


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F/O#E6S

. A 'ank i uoting the follo!ing exchange rate againt the dollar for the S!i franc and the

Autralian dollar"

S,rCD H 1.=25+1.=5

ADCD H 1.((=+1.(3=

An Autralian firm ak the 'ank for an ADCS,r uote. )hat cro+rate !ould the 'ank

uote*

'id ADCS, H >'id ADCD?C>ak S,CD? H 1.((=C1.=5H1.52

ak ADCS, H >ak ADCD?C>'id S,CD? H 1.(3=C1.=25 H 1.5

. Given the follo!ing information% !hat are the N


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15.


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)hat JCS, &rice !ill eliminate triangular ar'itrage*

Solution" To make a triangular ar'itrage &rofit the


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suggested end of chapter 5 solutions

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