Forward Transactions

• In the FX markets, spot transactions are settled within 2 business days. If

participants would like to buy or sell currencies for delivery at some
point in the future, they engage in forward transactions.
• A forward transaction is undertaken today, but it is settled anywhere
between 3 business days to 2 years into the future. The forward quote is
the rate at which currencies are exchanged in the future settlement date.
• These rates depending on the trading environment is quoted in two
different ways:
– Outright Quotation
– Swap Quotation or Forward Swap Points
 Forward Quotations
Outright Forward Quote:
• Forward price is expressed as in spot, number of local
currency units per foreign currency
– Eg: 1 year Outright dollars per euro: EUR/USD1.3366-1.3374 or
EUR/USD1.3366/74
Swap Quotation or Forward Swap Points:
• Forward rates are often quoted in “Points” in reference to
spot rates
– Spot EUR/USD is 1.2016/17
– 1 year forward points: 29.60/28.75
 From Forward Points to Outright Forward

• If we are given “ forward points” we can calculate the

outright forward rate by:
– F=S+Forward Points
• Note that Forward/Swap points may be positive or negative.
In other words, depending of the sign of the swap points, we
either add or subtract swap points from bid /ask rates.
– Given swap points quotation of X/Y
– If X>Y swap points are treated as negative
– If X<Yswap points are treated as positive
 One more important piece of information

• Depending on the spot quotation (i.e depending on

the decimal points in the spot quotation) swap
points are divided by 10,000 or 100.
• If the spot quote has four decimals as in EUR/USD
spot quotes, we divide the swap points by 10,000
before we add or subtract them from spot bid and
offer rates (depending on the sign assigned to them).
• If the spot quote has 2 decimals as in EUR/JPY or
USD/JPY, swap points are divided by 100.
 From Forward Points to Outright Forward Rates
• Spot EUR/USD is 1.2016/17
– 1 year forward points: 29.60/28.75
– 29.60 means $0.002960 or 1/10,000 of the points
– 28.75 means $0.002875 or 1/10,000 of the points
– Since X=29.60>Y=28.75 Swap Points are negative
• Outright Bid: 1.2016-0.002960=1.1986
• Outright Offer: 1.2017-0.002875=1.1988
– Note that points expressed in the quotation divided by 10,000 (eg:
29.6/10,000=0.00296)
• 1 Year Outright Forward: 1.1986-1.1988 or 1.1986/88
 Summary: Forward Swap Points

• Forward Outright=Spot+ Forward Swap Points

• Basic Rule:
– If bid swap point is >ask swap point subtract 1/10000 of
the swap points from bid and ask rates (swap points<0)
– If bid swap point is < ask swap point add 1/10000 of the
swap points to bid and ask rates (swap points>0)
 Example….

• USD/CAD Spot 1.4120/26

– 6-m forward Swap: 58/44
– 6-m forward outright bid: 1.4120-(58/10,000)=1.4062
– 6-m forward outright offer:1.4126-(44/10000)=1.4082

• EUR/USD 1.4320-1.4325
– 1 yr forward swap points: 20/25
– 1 yr outright forward bid  1.4320+0.0020 =1.4340
– 1yr outright forward offer 1.4325+0.0025=1.4350
 Mid-rate

• In some cases instead of bid and offer rates, we use

an average of these two. Mid rates are used to make
general statements about exchange rates.
• For instance, daily or weekly changes in exchange
rates are often calculated by using mid rates.
• These are not very useful in trading currencies, but
it is good to know what we mean by mid-points.
 Example: Forward Bid/Offer Rates
Spot exchange rate:

Bid rate (SF/$) 1.2575

Ask rate (SF/$ 1.2585

One-month forward 10 to 15
3-months forward 14 to 22
6-months forward 20 to 30

1-m forward bid rate : 1.2575+0.0010=1.2585

1-m forward offer rate: 1.2585+0.0015=1.2600
1-month forward mid-rate= (1.2585+1.2600)/2=1.2593

3-m forward bid rate : 1.2575+0.0014=1.2589

3-m forward offer rate: 1.2585+0.0022=1.2607
3-month forward mid-rate= (1.2589+1.2607)/2=1.2598
 An Exception: JPY
• Since JPY is expressed with only two decimal
points, the swap points in JPY should be divided
into 100 rather than 10,000.
• Example: Spot Rate: 92.30-92.50
– 3-months Swap Point: 45/44

• Outright Forward Rates:

– Bid: 92.30-0.45=91.85
– Offer92.50-0.44=92.06
– Note that the spread is slightly larger for the 3-m forward
rate.
 Forward Premium or Discount

• Forward rates maybe larger or smaller than the spot

rates depending on the relative interest rates.
• If F>S, the base currency has a forward premium
– We can also interpret this as base currency is worth more
in forward relative to spot rate

• F<S, the base currency has a forward discount

– We can also interpret this as base currency is worth less
in forward relative to spot rate
Forward Premium/Discount of the Base Currency

F0,T -S0 360

Forward Premium/Discount= ( )
S0 d

Note that Forward rate has maturity T at time 0.

Forward Premium or Discount is annualized with the
Factor (360/d) where d=number of days forward.

Alternatively we can use (12/m)

where m= months in forward
Forward Premium/Discount of the Terms Currency

S0 -F0,T 360
Forward Premium/Discount= ( )
F0,T d

Note that Forward rate has maturity T at time 0.

Forward Premium or Discount is annualized with the
Factor (360/d).
 Forward Premium and Discounts
¥/$ ¥/$ Calculated
Period Days Forward Bid Rate Ask Rate Mid-Rate
spot 114.23 114.27 114.25000
1 month 30 113.82 113.87 113.84500
2 months 60 113.49 113.52 113.50500
3 months 90 113.05 113.11 113.08000
6 months 180 112.05 112.11 112.08000
12 months 360 110.20 110.27 110.23500
24 months 720 106.83 106.98 106.90500

6 month forward premium or discount of US (Base/Foreign Currency):

F-S/S x(360/180)=[(112.08-114.250)/114.250]x(360/180)=
=-3.799% (US dollar at 3.799% discount )

6 month forward premium or discount of JPY (Terms/Local Currency):

S-F/F x(360/180)=[(114.250-112.08)/112.08] x (360/180)
=3.872% (JPY is at 3.87% premium)
ARBITRAGE
 Arbitrage

• In practice we often see temporary deviations from

law of one price. Mostly, these are so small that
transaction costs wipe out the potential gains.
• However, in some short lasting occasions they reach
to levels that traders can make arbitrage profits.
• These deviations fade away quickly, as traders buy
in the low price environment and sell in high price
environment.
 Geographic Arbitrage

USD Quotes in CHF

London Tokyo

CHF 1.7140/60 CHF1.7165/70

Buy USD in London @1.7160 Sell USD in Tokyo @1.7165

CHF5000 gain for every USD10m

 Arbitrage Profit

• Buy 10m USD at 1.7160

• Pay 17,160,000 CHF
• Sell 10m USD at 1.7165
• Receive CHF17,165,000
• Net gain at 2T is CHF 5,000
 Cross Rates and Triangular Arbitrage

• In FX markets most of the quotations are against

USD.
• For instance when Citibank asks UBS its Swiss
Franc rate, that rate is quoted against USD unless
otherwise stated.
• Since bulk of dealings are done against the USD,
the "market rate" for any currency at any moment is
best reflected in its exchange rate against USD.
 Cross-Rates: Three Quotes

• Citibank Quote: $0.9045/€

• Barclays Quote $1.4443/£
• Dresdner Quote €1.6200/£
 Compare

• Cross Rate (available worldwide):

• ($1.4443/£)/($/0.9045/€)= € 1.5968
• Direct Quote of € against £
• € 1.6200/£ (available in UK and Eurozone)
• Can we benefit from this discrepancy?
– Yes! Buy GBP with Euro through cross rate and sell it at
direct rate!!
• Start with EURO. Sell EUR1,000,000 at 0.9045, get
USD 904,500
• Sell 904,500 @1.4443; get GBP626,254
• Sell GBP626,254 at 1.62, get €1,014,532
• Net Profit: €14,532 per 1m € recycled!
 Triangular Arbitrage

Citibank
End with €1,014,532 Start with EUR1,000,000

(1) Sell EUR1,000,000 to

Citibank Bank at $0.9045
Receive Receive $904,500

Dresdner Bank Barclays Bank

(3) Sell GBP at EUR1.62 €1,014, 532 (2) Sell 904,500 to Barclays
at $1.4443/£ get 626,254
 Triangular Arbitrage

New York

$1.060/ €

London Hong Kong

$1.5500/ £ € 1.5000/ £
 Compare

• (USD1.5500/GBP)/(USD1.060/Eur)
= EUR1.4623/GBP-Cross Rate
• EUR1.500/GBP-Direct Quote
• Can we benefit from this discrepancy?
– Yes! Buy GBP with Euro through cross rate and sell it at
direct rate!!
 Triangular Arbitrage

New York
Net Profit:EUR25,806
EUR/USD 1.060
(USD1.060=1 Euro) 1-Buy USD 1,060,000@ 1.06
3-Sell 683,871 @1.50
(Sell Euro 1,000,000 )
Get EUR 1,025,806
HK London

GBP/EUR1.5000 GBP/USD1.5500

2-Sell USD 1,060,000 @1.55

Receive GBP683,871
 Transaction Chain

• Start with EURO

• Pay EURO get USD in NY
• Sell USD get GBP in London
• Sell GBP get EUR in HK
• (EUR-final)-(EUR-start)=Arbitrage Gain
 Transaction Chain

• Pay 1,000,000 EUR to get USD 1,060,000

• Sell USD @ 1.5500/GBP get GBP683,871
• Sell GBP 683,871 @1.5000 get EURO EUR
1,025,806
• Net Profit=EUR 25,806
 Calculating Cross Rates With Bid and Ask Rates

• In the textbook, cross rate examples are not

considering bid/ask rates.
• When bid and ask rates are involved cross rate
calculations are a bit more complicated.
• I attempted to develop an algorithm, and if you use
it, it should work, but it is best to practice it to get
comfortable with it.
• If we learn this we can also go through a more
realistic “Triangular Arbitrage” example.
 Algorithm
• Can you get the cross rate by dividing one currency pair into
the other one? If “no” proceed to the next bullet point. If
yes, then:
– Cross Bid Rate=Bid of the nominator pair/Offer of the denominator pair
– Cross Offer Rate= Offer of the nominator pair/Bid of the denominator pair

• Can you get the cross rate by multiplying one currency pair
with the other? If yes then
– Cross Bid Rate=Bid of the First Pair x Bid of the Second Pair
– Cross Offer Rate=Offer of the first pair x Offer of the second pair

• End.
 Example: CAD/JPY Cross Rate
• Use the following USD based quotes to calculate CAD/JPY Cross Rate:
– USD/JPY 105.50-106.10
– USD/CAD 1.2840-1.2850
• Solution: To get CAD/JPY rate we need to divide USD/JPY rate to
USD/CAD rate. In other words CAD/JPY= (USD/JPY)/(USD/CAD)
• If we check the algorithm the answer to first statement in the algorithm
is “YES”. Then follow the rule.
– Bid Rate of CAD/JPY is= Bid of the nominator (USD/JPY) / Offer of the denominator
(USD/CAD)= 105.50/1.2850=82.10
– Offer Rate= Offer of the nominator (USD/JPY) / Bid of the denominator
(USD/CAD)=106.10/1.2840=82.63

• Cross Rate: CAD/JPY 82.10-82.63

 An intuitive explanation

• Bid side of the CAD/JPY implies that we deliver

CAD to the dealer and dealer pays us JPY. In other
words, we buy JPY with CAD.
• To purchase JPY with CAD, first we need to
convert CAD into USD.
– It takes CAD1.2850 to purchase 1 USD.
– If we deliver 1 USD to the dealer we get JPY 105.50
– In other words for every 1.2850 CAD we receive 105.50
JPY or for each CAD we get 105.5/1.2850=JPY 82.10
 Offer Side

• The offer side of the CAD/JPY implies that we pay

JPY to get CAD. In other words we buy the base
currency.
• We pay JPY106.10 to get 1 USD
• We pay 1 USD and get CAD 1.2480
• For each (106.10/1.2480)=82.63 JPY we get 1
CAD.
 Example-2
• Given the following rates, calculate EUR/CAD Cross rate:
– EUR/USD 1.2310-1.2315
– USD/CAD 1.2840-1.2850

• Calculate EUR/CAD Cross Rate:

• (EUR/USD) x (USD/CAD)=EUR/CAD or our answer to
first statement is “NO”. Our answer to second statement is
“YES”. Follow the rule stated in 2:
– Cross-Bid Rate= Bid x Bid= 1.2310 x 1.2840=1.5806
– Cross-Offer Rate= Offer x Offer=1.2315 x 1.2850=1.5825

• Hence EUR/CAD 1.5806-1.5825

•
 A more realistic Triangular Arbitrage Example:

• Assume that following rates appear in your screen:

– EUR/USD 1.3520 -1.3525
– USD/TRY 1.5890-1.5940
– EUR/TRY 2.1390-2.1433

• Can you see an arbitrage opportunity here?

 Cross Rate and Arbitrage Check
• The cross rate: EUR/TRY
– We can calculate the cross rate EUR/TRY from USD
based quoted:
– (EUR/USD )x( USD/TRY)=EUR/TRY
– In this case since the cross rate is obtained through
multiplication we should multiply bid of the first rate
with bid of the second rate (and offer to offer to calculate
the offer rate of the cross:
– Bid Rate=1.3520 x 1.5890=2.1483
– Offer Rate=1.3535 x 1.5940=2.1559
 – Bid Rate=1.3520 x 1.5890=2.1483
– Offer Rate=1.3535 x 1.5940=2.1559

• As these rate diverge from the direct quote of

– EUR/TRY 2.1390 -2.1433

• One can purchase the EUR directly at 2.1433, and

sell indirectly at 2.1483.
• The steps in the arbitrage will be shown in the next
slide:
• Use TRY100m to purchase EUR spot:
• TRY100,000,000 /2.1433=EUR46,657,024
• Buy USD at 1.3520
• EUR46,657,024 x 1.3520=$63,080,297
• Sell USD at 1.5890 against TRY
• =$63,080,297x1.5890=TRY100,234,591
• Arbitrage Profit: TRY 234,591
• The dollar equivalent is $147,634