CHAPTER 4 THE MARKET FOR FOREIGN EXCHANGE
SUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTER
QUESTIONS AND PROBLEMS
2. What is the difference between the retail or client market and the wholesale or interbank market for
Answer: The market for foreign exchange can be viewed as a two-tier market. One tier is the
wholesale or interbank market. The other tier is the retail or client market. International banks
provide the core of the FX market, both wholesale and retail. In the retail market, banks buy or sell
foreign currency serving their (retail) clients – non-financial business and individuals – in cross-
currency exchange for trade and international investment. Retail transactions account for about 16
percent of FX trades. The other 84 percent is interbank trades between and among international banks
or non-bank dealers large enough to transact in the interbank market.
3. Who are the market participants in the foreign exchange market?
Answer: The market participants that comprise the FX market can be categorized into five groups:
international banks, bank customers, non-bank dealers, FX brokers, and central banks. International
banks provide the core of the FX market. Approximately 100 to 200 banks worldwide make a market
in foreign exchange, i.e., they stand willing to buy or sell foreign currency for their own account.
These international banks serve their retail clients, the bank customers, in conducting foreign
commerce or making international investment in financial assets that requires foreign exchange. Non-
bank dealers are large non-bank financial institutions, such as investment banks, whose size and
frequency of trades make it cost- effective to establish their own dealing rooms to trade directly in the
interbank market for their foreign exchange needs.
Most interbank trades are speculative or arbitrage transactions where market participants attempt to
correctly judge the future direction of price movements in one currency versus another or attempt to
profit from temporary price discrepancies in currencies between competing dealers.
IM-1 FX brokers match dealer orders to buy and sell currencies for a fee, but do not take a position
themselves. Interbank traders use a broker primarily to disseminate as quickly as possible a currency
quote to many other dealers.
Central banks sometimes intervene in the foreign exchange market in an attempt to influence the price
of its currency against that of a major trading partner, or a country that it “fixes” or “pegs” its currency
against. Intervention is the process of using foreign currency reserves to buy one’s own currency in
order to decrease its supply and thus increase its value in the foreign exchange market, or
alternatively, selling one’s own currency for foreign currency in order to increase its supply and lower
5. What is meant by a currency trading at a discount or at a premium in the forward market?
Answer: The forward market involves contracting today for the future purchase or sale of foreign
exchange. The forward price may be the same as the spot price, but usually it is higher (at a premium)
or lower (at a discount) than the spot price.
7. Banks find it necessary to accommodate their clients’ needs to buy or sell FX forward, in many
instances for hedging purposes. How can the bank eliminate the currency exposure it has created for
itself by accommodating a client’s forward transaction?
Answer: Swap transactions provide a means for the bank to mitigate the currency exposure in a
forward trade. A swap transaction is the simultaneous sale (or purchase) of spot foreign exchange
against a forward purchase (or sale) of an approximately equal amount of the foreign currency. To
illustrate, suppose a bank customer wants to buy dollars three months forward against British pound
sterling. The bank can handle this trade for its customer and simultaneously neutralize the exchange
rate risk in the trade by selling (borrowed) British pound sterling spot against dollars. The bank will
lend the dollars for three months until they are needed to deliver against the dollars it has sold
forward. The British pounds received will be used to liquidate the sterling loan.
IM-2 9. What is triangular arbitrage? What is a condition that will give rise to a triangular arbitrage
Answer: Triangular arbitrage is the process of trading out of one currency, say the US dollar, into a
second currency, then trading it for a third currency which is in turn traded for US dollars. The
purpose is to earn an arbitrage profit via trading from the second to the third currency when the direct
exchange between the two is not in alignment with the cross exchange rate.
Most, but not all, currency transactions go through the US dollar. Certain banks specialize in making
a direct market between non-dollar currencies, pricing at a narrower bid-ask spread than the cross-rate
spread. Nevertheless, the implied cross-rate bid-ask quotations impose a discipline on the non-dollar
market makers. If their direct quotes are not consistent with the cross exchange rates, a triangular
arbitrage profit is possible.
2. Using US dollar data in Exhibit 4.4 (the first two data columns) for forward cross-exchange rates for
the Canadian dollar and the swiss franc, calculate the one-, three- and six-month forward rates
between the Canadian dollar and the Swiss franc. State the cross-rates in Canadian-direct terms.
The formulae we want to use are:
F NC$/SF) = F (N/SF)/F N$/C$)
F NC$/SF) = F (N$/$)/F (NF/$).
We will use the top formula that uses American term forward exchange rates.
3. Restate the following one-, three-, and six-month outright forward European term bid-ask quotes in
Spot 1.3431 - 1.3436
One-Month 1.3432 - 1.3442
Three-Month 1.3448 - 1.3463
Six-Month 1.3488 - 1.3508
One-Month 01 - 06
Three-Month 17 - 27
IM-4 Six-Month 57 - 72
4. Using the spot and outright forward quotes in problem 3, determine the corresponding bid-ask
spreads in points.
5. Using Exhibit 4.4, calculate the one-, three-, and six-month forward premium or discount for the
Canadian dollar in European terms. For simplicity, assume each month has 30 days.
Solution: The formula we want to use is:
fN,C$v$= [(F NC$/$) - S(C$/$))/S(C$/$)] x 360/N
f1,C$v$= [(1.1813 - 1.1823)/1.1823 ] x 360/30 = -0.0101
f3,C$v$= [(1.1792 - 1.1823)/1.1823 ] x 360/90 = -0.0105
f6,C$v$= [(1.1762 - 1.1823)/1.1823 ] x 360/180 = -0.0103
In every instance – for one month, three month and six month forward rates – the forward rate is less
than the spot rate expressed iterms of Canadian dollars per US dollar. Theseforex market prices
reflect an anticipated ap preciation of the Canadian dollar. The U S dollar is at a forwarddiscount
to the Canadian dollar.
In terms of US dollars per Canadian dollar ($/C$), the forward rates are consistentgreater than the
spot rate, likewise reflecting an anticipated depreciation of the US dollar vis-à-vis the Canadian
dollar. The Canadian dollar is at a forwardpremium to the US dollar. In detail …
N,$vC$ = [(FN($/C$) - S($/C$)) / S($/C$)] x 360/N
1,$vC$ = [(0.8465 – 0.8458 ) /0.8458 ] x 360/30 = 0.0099
3,$vC$ = [(0.8480 – 0.8458 ) /0.8458 ] x 360/90 = 0.0104
6,$vC$ = [(0.8502 – 0.8458 ) /0.8458 ] x 360/180 = 0.0104