CFA Level I Study Session

1
CFA Level I Study Session 6Handouts

• 2. A. Foreign Exchange

2
My Essentials of Exchange Rates

• calculate currency cross rates, given two spot
  exchange quotations involving three currencies
• calculate the profit on a triangular arbitrage
  opportunity, given the bid-ask quotations for the
  currencies of three countries
• Direct Quoted Exchange Rate Always!!!!!
• units of home currency per unit of foreign
  currency (0.01 US/Yen) Domestic on top
• Bid Rate
• Rate at which Bank buys foreign currency.
• Ask Rate
• Rate at which Bank sells foreign currency.
• Remember that banks always buy foreign currency
  low and sell it high. i.e You always get the
  worst deal!!!!

3
Simple Exchange Rate Calculations

• Bid/Ask Spread
• Bid-Ask Spread is calculated as percentage of ask
  price.
• Banks always buy foreign currency low and sell it
  high!!!
• Forward Premium or Discount
• Forward exchange rate contract calls for
  delivery, at a fixed future date, of specified
  amount of one currency against dollar payment.
• Understand meaning of discount/premium for
  currencies.
• Make sure you annualize the premium/discount!!!!!!
  !!

4
Cross Rates - No Bid-Ask Spread
Domestic Currency
DC/VC _______
DC_________/US
Vehicle Currency (US)
DC/FC _______
FC_________/US
FC/VC _______
Foreign Currency
5
You Sell FC to get DCCross Bid Rate with Bid-Ask
Spread
Home Currency
DC_________/US
Vehicle Currency (US)
DC/FC _______
FC_________/US
Foreign Currency
6
You Buy FC with DCCross Ask Rate with Bid-Ask
Spread
Home Currency
DC_________/US
Vehicle Currency (US)
DC/FC _______
FC_________/US
Foreign Currency
7
Cross Rate Arbitrage
Domestic Currency
DC/VC _______
DC_________/US
Vehicle Currency (US)
DC/FC _______
FC_________/US
FC/VC _______
Foreign Currency
RULE Buy FC Low, Sell FC High! If DC/FC lt
(DC/)/(FC/) then buy FC on direct side and
sell through cross.
8
Cross Rates Visually
Cross Bid Rate DC Bid/FC Ask (CBBA)
Cross Ask Rate DC Ask/FC Bid (CAAB)
9
Calculate forward ask premium for Indian rupee
1-Year forward in terms of Canadian .

• Ask rate on the rupee in terms of CDN implies
  that you are in Canada and that the Indian rupee
  is the foreign currency. Remember ask/bid rates
  are to buy the foreign currency in terms of the
  home currency. How to think about the formula?
• You have Canadian and want Rupees. Buy US with
  CDN (get the bank's ask rate for US) then sell
  the US for Rs (get the bank's bid rate for US).
• Cross Ask Spot Rate Ask Rate / Bid Rate
  _______________________
• Cross Ask Forward Rate Ask Rate / Bid Rate
  _____________________
• Forward Premium Forward - Spot/Spot x 100
  ___________________

10
Covered Interest Parity Arbitrage
New York
t 0
t 1
t 0
t 1
London

• Arbitrage Profit 1,030,000 - 1,017,360
  12,640 if borrow in London and lend in U.S.
• Transaction costs (bid-ask spreads, etc.) will
  reduce these profits.

11
Bilateral Arbitrage Midpoint Condition

• calculate the widest interval within which the
  mid-point of the bid-ask spread in the domestic
  country must remain to allow no arbitrage between
  the currencies of the domestic country and a
  foreign country

1 - tc Sf
tc transaction cost
Sf FC/DC
Home Country
1
1 - tc2 x Sf x (1/Sf)x
Foreign Country
1 - tc x Sf
k 1 - tc
1 - tc(1/Sf)x
12
Example of Bilateral Arbitrage

• Assume indirect exchange rate is Sf 1/US.
• No transactions costs, direct exchange rate is
  1/Sf 1US/.
• Now transaction costs of .04
• Bilateral exchange rate points
• Assume no bid-ask only midpoint quote 1.0010/
• Midpoint is outside the 1.0008 maximum of (1/Sf)
  x
• How to make money here?
• Sell 1 for 1.0010 and pay .04 1.0010 x
  .9996 1.0006
• Then take 1.0006 and sell at 1US/, pay .04 to
  earn 1.0006 x .9996 1.0002

13
Types of Exchange Rate Questions

• Simple Calculations
• Bid-Ask Spread
• Forward Premium or Discount
• Harder Calculations
• 2 currencies plus transaction costs Bilateral
  Arbitrage points.
• 3 currencies plus 2 exchange rates Cross Rate
  calculation (bid or ask)
• 3 currencies and 3 exchange rates Triangular
  Currency Arbitrage
• 2 currencies, 1 exchange rate, and 2 interest
  rates calculate forward rate
• 2 currencies, 2 exchange rates, and 2 interest
  rates covered interest arbitrage