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THE INSTITUTE OF FINANCE MANAGEMENT

INSTITUTE OF FINANCE MANAGEMENT CHUO CHA USIMAMIZI WA FEDHA

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BAcc III BBF III
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AFU 08504: INTERNATIONAL FINANCE

THE ECONOMICS OF FOREIGN EXCHANGE MARKET

TUTORIAL QUESTIONS
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TQ1. Provide a precise definition of the market for foreign exchange.

TA1. The foreign exchange market is the market in which national currencies are bought and sold
against one another. This market is called the “foreign exchange market” and not the “foreign
currency market” because the commodity that is traded on the market is more appropriately called
“foreign exchange” than “foreign currency”.

TQ2. What does the term foreign exchange rate mean? Briefly identify the factors affecting foreign
exchange rate.

TA2. The spot exchange rate is the price of one currency in terms of another for immediate delivery.

The Factors are:

Inflation rate
Interest rate
Balance of payment
Government debt
Terms of trade
Political stability and performance
Speculation
Recession

TQ3. Who are the market participants in the foreign exchange market and what is the difference
between the retail or client market and the wholesale or interbank market for foreign exchange?

TA3. Large Commercial Banks. Large commercial banks make the market (i.e. they are price
makers) by standing ready to buy and sell currencies at the exchange rate they declare.
Other Financial Institutions. Other financial institutions such as investment banks and mutual
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funds conduct their foreign exchange operations themselves and not through banks.
Foreign Exchange Brokers. The function of the broker is to spread market information and to
bring together buyers and sellers with matching needs. Brokers differ from dealers in that they do
not take position themselves, but obtain their “living” by charging commission fees.
Commercial Customers. These include individuals and companies utilizing the services of
commercial banks to buy and sell foreign exchange in order to finance international trade and
investment operations.

Central Banks. These participate in the foreign exchange market because they act as bankers for
their governments and also because they run the exchange rate and monetary policies.

On the retail side commercial banks deal with customers, but on the wholesale side they deal in
the inter-bank or the wholesale market, i.e. with other banks.

TQ4. What is meant by a currency trading at a discount or at a premium in the forward market?

TA4. If the Forward Rate is HIGHER than the Spot Rate the currency is trading at A FORWARD
PREMIUM.
If the Forward Rate is LOWER than the Spot Rate the currency is trading at A FORWARD
DISCOUNT.

TQ5. What is triangular arbitrage? What is a condition that will give rise to a triangular arbitrage
opportunity?

TA5. Exchange traders are continuously alert to the possibility of taking advantage, through
currency arbitrage transactions, of exchange inconsistencies in different money centers. These
transactions involve buying a currency in one market and selling it in another. Cross rates can be
used to detect opportunities for inter market arbitrage. This particular activity is called triangular
arbitrage because it involves moving through three different exchange rates. Currency arbitrage
activities tend to keep exchange rates uniform in the various markets.

TQ6. Why is the profit from triangular arbitrage riskless?

TQ7. What is a forward contract and what do the terms premium and discount mean in this context?

TQ8. Define a Point. When do we say that the points are rising and when do we classify points as
being falling?

TQ9. What are the principal uses/functions of the foreign exchange market?

TA9. Transfer of Purchasing Power

The foreign exchange market is used to transfer funds from one nation and currency to another.
This is also known as the transfer of purchasing power. Transfer of purchasing power is necessary
because international trade and capital transfer transactions involve parties living in different
countries with different currencies.
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Currency Risk Hedging and Speculation

The foreign exchange market may also be used for hedging and speculative purposed. The forward
market can be used to hedge foreign currency receivables and foreign currency payable, so called
forward market hedge. Speculative activities involving the foreign exchange market include spot
speculation and forward speculation.

TQ10. Four concepts: appreciation, depreciation, revaluation, and devaluation are all related to
changing the value of a currency. Provide a concise definition of each.
TA10. Appreciation: Refers to a rise in the value of a currency against other currencies under
flexible (floating) exchange rate system.
Depreciation: Refers to a decline in the value of a currency against other currencies under flexible
(floating) exchange rate system.
Revaluation: Refers to an official increase in the value of a currency by the government of that
currency under a fixed exchange rate system.

Devaluation: Refers to an official reduction in the value of a currency by the government of that
currency under a fixed exchange rate system.

TQ11: [Currency Trading]

The following spot rates are observed in the foreign exchange market:
Currency Units Required to Buy One TZS
Kenya (KES) 0.15
Uganda (UGS) 3.45
Zambia (ZK) 6.75
Malawi (MK) 5.85

Required:
On the basis of this information, compute to the nearest second decimal the number of
(a) TZS that can be acquired for UGS25,000
ANS
1TZS = 3.45UGS
XTZS = 25000UGS

XTZS = 7246.38TZS

(b) MK that can be acquired for TZS30,000,000

ANS
ITZS = 5.85MK
TZS30,000,000 = XMK

XMK = 175,500,000MK

(c) UGS dollar that TZS9,000,000 can buy

ANS
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ITZS = 3.45 UGS

TZS9,000,000 = XUGS

XUGS = 31,050,000UGS

(d) KES that TZS200,000 will buy

ANS
1TZS = 0.15KES
TZS200,000 = XKES
XKES = 30,000KES

TQ12: [Forward Differentials]

Given below are spot and forward rates expressed in TZS per unit of the KES and UGS
Rates Kenyan Shilling (KES) Ugandan Shilling (UGS)
Spot 15.60 0.30
30-days forward 16.10 0.25
60-days forward 16.40 0.50
90-days forward 16.90 0.59
180-days forward 17.80 0.58

Required:
1. Is the 90-days forward KES quoted at a discount or at a premium?
It is quoted at a premium of 16.9 – 15.6 = 1.3

From Forward Premium or Discount = [FR – SR]/SR x Days in a Year/Length of

Forward Contract in Days x 100

Premium differential = [16.9 – 15.6]/15.6 x 365/90 x 100 = 33.79%

2. Is the 90- days forward contract in UGS trading at a discount or at a premium?

It is quoted at a premium of 0.59 – 0.3 = 0.29

From Forward Premium or Discount = [FR – SR]/SR x Days in a Year/Length of

Forward Contract in Days x 100

Premium differential = [0.59 – 0.3]/0.3 x 365/90 x 100 = 392%

3. Relative to the UGS is the 180 – days forward TZS quoted at a discount?
ANS
SPOT RATE UGS/TZS = 1/0.3
FORWARD RATE UGS/TZS= 1/0.59
Therefore, it has been quoted at a discount

4. Relative to the TZS is the 90 – days forward KES quoted at a discount?

ANS
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Spot rate KES/TZS = 1/15.60

Forward rate UGS/TZS = 1/16.9
Therefore, it has been quoted at a

Compute the forward premium or discount in each of the above cases.

TQ13: [Forward Differentials]

Given below are spot and forward quotations for the US$ against the Tanzanian shilling (TZS).
Spot Rate: US$: TZS 1560 – 1572
1 Month Forward: 5 – 8 dis.
3 Months forward 9 – 3 pm
45 Days Forward 7 – 5 pm
Assume a 365 Day Year

Required:

1. One-month forward percentage bid-ask spread on the US$

ANS
From Percentage Spread = [Ask Price – Bid Price]/Ask Price x 100%
= [1564 – 1555] / 1564 x 100% = 0.5754%

2. 45 Days forward percentage bid-ask spread on the TZS

ANS
From Percentage Spread = [Ask Price – Bid Price]/Ask Price x 100%
= [1/1567 – 1/1577] / 1/1567 x 100% = 0.%

3. Three months forward premium or discount on the US$

4. One month forward premium or discount on the TZS

TQ14: [Swap Rates and Outright Rate Quotations]

The following quotes are received for spot, one month, three month and six-month Euro (€) and Pound
sterling (₤):

Spot One Month Three Six Month

₤: $2.0015 – 30 19 – 17 26 – 22 42 – 35

€: $1.6963 – 68 4–6 9 – 14 25 – 38

Required: Convert the above swap rates in outright rates.

TQ15: [Foreign Exchange Trading]

You are given the following information about currency rates for pound sterling spot and forward.
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Currency Spot 1 Month Forward 3 months Forward

US (Dollar) 1.5200 - 1.5210 0.32 - 0.27c pm 0.89 - 0.84 c pm

Kenya (KES) 24.05¼ - 28.06¼ 2⅜ - 1 ⅞c pm 6¾ - 6¼ c pm

Tanzania (TZS) 2072.20 - 2079.30 10 - 20c dis 45 - 55c dis

Required:
Calculate the cost or value in pounds to a customer who wishes to:
(a) buy US $ 1400 one month forward from his bank
(b) sell KES 28,000 one month forward
(c) sell TZS 20,000 three months forward

TQ16: [Cross Rates and Triangular Arbitrage]

1. The TZS/US$ exchange rate is TZS1500 = US$1, and the UGS/TZS exchange rate is TZS1 =
UGS3.50. What is the UGS/US$ exchange rate?
ANS
UGS/US$ = [UGS/TZS] / [US$/TZS]
= [3.5] / [1/1500] = 5250

2. The following exchange rates are available:

TZS per US$ TZS1650/US$
Canadian dollar per US dollar C $1.2646/US $
TZS per Canadian Dollar TZS1390/C$

Required
Are there any opportunities for market arbitrage? Show how a Tanzanian arbitrageur can benefit from
the possible arbitrage between the three markets.
ANS
Yes, there are opportunities for market arbitrage.
Assume an arbitrageur has 1,000,000 units of the TZS
Exchange TZS 1,000,000 for US$ spot at TZS 1650/US$ to obtain US$ 606.06
Convert the US$ 606.06 into C$ spot at C$ 1.2646/US$ to realize C$ 766.42
Exchange the C$ 766.42 for TZS at TZS 1390/C$ to have TZS1,065,329.6
Arbitrage profit = TZS1,065,329.6 – TZS 1,000,000 = TZS 65,329.6

(3) Assuming no transaction costs, suppose: £1 = US$ 2.4110 in New York, US$ = TZS 1,400 in
Tanzania, and TZS2300 = £1 in London. How would you take profitable advantage of these
rates?
ANS
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Assume you have 1,000,000 TZS.

Exchange 1,000,000 TZS for £ spot TZS2300/£ to obtain £434.78
Convert the £434.78 into US$ spot at US$2.4110/£ to realize US$ 1048.25
Exchange the US$ 1048.25 for TZS at spot US$ = TZS 1,400 to have TZS 1,467,556.41
Arbitrage profit = TZS 1,467,556.41 – TZS 1,000,000 = TZS 467,556.41

TQ17: [Cross Rates in the Presence of Bid-Ask Spread]

(a) Suppose the direct quote for sterling in New York is 1.7110-5. What is the direct quote for
dollars in London?
ANS
IN NY DIRECT QUOTE FOR £ BID ASK
$/£ 1.7110 1.7115
IN LONDON DIRECT QUOTE FOR $ BID ASK
£/$ 0.5843 0.5845

(b) Suppose the spot quote on the EURO in New York is $ 1.3302-10, and the spot quote on the
£ is $ 1.9180-90
• What is the direct spot quote for the £ in Frankfurt?
Applying cross rate EURO/£ = [EURO/$]/ [£/$]
EURO/£ bid = [ 1.3302]/ [1.9190] = 0.6932
EURO/£ ask = [1.3310]/ [1.9180] = 0.6940
IN Frankfurt DIRECT QUOTE FOR £ BID ASK
£/EURO 0.6932 0.6940

• Compute the percentage bid-ask spreads on the £ and the EURO.

ANS
From Percentage Spread = [Ask Price – Bid Price]/Ask Price x 100%
= [0.6940 – 0.6932] / 0.6940 x 100% = 0.08%

TQ18: [Cross Rates and Foreign Exchange Trading]

A commercial bank in Dar es Salaam, Tanzania, provided the following foreign exchange quotes on
30th April, 2006.
TZS/£ £/Euro TZS/US$
Spot 2404 – 2420 0.4852 – 0.4892 1050 – 1060
1 Year Forward 2456 – 2474 0.4956 – 0.4966 1200 – 1260
REQUIRED:
(i) How many TZS will the bank pay to purchase one Euro one year forward from a
customer?
(ii) Determine the one-year forward percentage bid-ask spread on the £ against the US$.
(iii) Calculate the spot and one year forward mid-prices for the £ against the Euro and
determine the one year forward premium or discount on the Euro against the £.
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TQ19: [Cross Rates and Foreign Exchange Trading]

A foreign exchange dealer provided the following quotations for the South-African Rand (SAR)
against the Tanzanian shilling (TZS) on the 31st September 2004:

TZS/SAR Spot 50 – 55
Three Months Forward 2 – 7 dis.

Required:

(i) Calculate the percentage bid-ask spread on the three-month forward TZS

(ii) Calculate the profit made by the dealer in purchasing and selling SAR1, 000,000 three
months forward.

(iii) Using the spot and forward offer prices calculate the forward premium/discount on the
SAR