Foreign Exchange Spot markets

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Basics of foreign Exchange market The foreign exchange market is the market where currencies

of different countries are bought and sold . It is primarily an over the counter market with trades

accounting for most foreign currency transactions. Foreign exchange market is a worldwide network of traders,

connected by telephone lines and computer screens. operates 24 hours a day


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Base currency

Base currency in foreign exchange referred toas the first currency in any currency pair. Itshows how much the base currency is worthas measured against the second currency.

Also the currency your account isdenominated in.


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Quote currency

The second currency in any currency pair isreferred to as quote currency in foreignexchange market. This is the value of amedium of exchange as compared to the basecurrency.

Also known as counter currency or termscurrency.


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Spot Market The market for buying and selling currencies at the current

market rate. Sell Quote / Bid Price The sell quote is displayed on the left and is the price at which

you can sell the base currency. It is also referred to as the

market maker's bid price. For example, if the EUR/USD quotes1.3200/03, you can sell 1 Euro at the bid price of US$1.3200.

Buy Quote / Offer Price The buy quote is displayed on the right and is the price at which

you can buy the base currency. It is also referred to as themarket maker's ask or offer price. For example, if theEUR/USD quotes 1.3200/03, you can buy 1 Euro at the offerprice of US$1.3203.


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Spread

The difference between the sell quote and thebuy quote or the bid and offer price. Forexample, if EUR/USD quotes read 1.3200/03,the spread is the difference between 1.3200and 1.3203, or 3 pips.

Ask/Bid -1 = Spread


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Explanation with example .

I am in Australia and I wish to travel to America. I need toexchange my AUD for USD. I visit my bank and I read theexchange rate information as below:

I now hand over $AUD 3,000. The teller, for every AUD that Igive her, gives me back $USD 0.8158 which off course is $USD2, 447.4.

The above example highlights an Exchange rate . Exchangerates are usually quoted in two different ways an indirectquote and a direct quote.


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Indirect quote A quote that expresses a currency price in terms of one unit of

the home currency and x units of the foreign currency. Inshort it just means that the home currency is the basecurrency or first currency expressed in terms of the foreigncurrency. If we live in Australia an example of an indirectquote would be AUD/USD 0.8168.

Also known as American Terms. Direct Quote

A quote that expresses a currency price in terms of one unit ofthe foreign currency and x units of the home currency. If welive in Australia we can convert the indirect quote AUD/USD0.8168, into a direct quote of approx USD/AUD 1.2243. Alsoknown as European Terms


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The bid price is the price the bank is willing tobuy the currency for. If you wanted to sell oneAustralian dollar to the bank they would buy itto from you for $USD 0.8158. This is known asthe bid price.

The ask price is the price the bank is willing tosell the currency for. If you wanted to buy oneAustralian dollars from the bank you would

need to give them $USD 0.8168. This is knownas the ask price.


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BID AND ASK, DIRECT AND INDIRECTUse the rates: EUR/USD 0.6767 and 0.6770 for the bid

and the ask What are the USD/EUR bid and ask quotes?USD/EUR bid = 1/(EUR/USD ask) = 1/0.677 =

1.4771 USD/EUR ask = 1/(EUR/USD bid) = 1/0.6767 =1.4778 What is the bid-ask spread in percentage form in the

US?1.4778/1.4771 -1 = 0.04%


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REMEMBER

The indirect bid rate is the reciprocal of thedirect ask

The indirect ask rate is the reciprocal of thedirect bid

The direct bid rate is the reciprocal of theindirect ask

The direct ask rate is the reciprocal of theindirect bid


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European and American Quote

Majority of the countries express foreign exchange prices for one US dollarwhich is known as European terms . The following quote is an example toEuropean terms:

105.00 / US $ or 1 US $ : 105.00 This quote shows the amount of Japanese Yen that can be purchased for one

US $ which can be also named as Japanese terms.

Second, several countries express US dollar price for one unit of other

currencies which is known as American terms . The following quote is anexample to American terms:

US $ 0.0095 / or 1 : 0.0095 US $


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Pip Value

To get the value of one pip in a currency pair,an investor has to divide one pip in decimalform (i.e. 0.0001) by the current exchangerate, and then multiply it by the notionalamount of the trade.


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Cross rates

A cross rate is the currency exchange rate expressed by acurrency pair in which none of the currencies involved is theofficial currency of the country in which this quotation ismade. E.g. if the currency exchange rate between a JPY and aGBP is quoted in a US newspaper, this would be called a crossrate since none of the currencies of this pair is the US dollar.However, if the same rate is quoted in a Japanese newspaper,it would not be a cross rate, since Japans official currency isinvolved in this pair.


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At a more general level, the exchange rates

expressed by any currency pair that does notinvolve the US dollar are called cross rates.Thus, this broader definition implies that theexchange rate of the currency pair GBP/JPYwould be a cross rate, regardless of thecountry in which this quotation is being made.


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Computing cross rates

Assume that the following major exchange rates are known:EUR/USD = 1.0060/65GBP/USD = 1.5847/52USD/JPY = 120.25/30USD/CHF = 1.4554/59

To calculate GPB/CHFGBP/USD: Bid: 1.5847 Offer: 1.5852USD/CHF: 1.4554 1.4559GBP/USD X USD/CHF = 1.5847 X1.4554 1.5852 X 1.4559GBP/CHF 2.3063 2.3079


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EXAMPLE OF A CROSS RATE

Here are some interbank quotes: The bid and ask rates for the USD in Chilean

pesos (CLP) are: 480.00 and 480.15 The bid and ask rates for the USD in Brazilian

reais (BRL) are: 1.745 and 1.747 What are the BRL/CLP bid and ask crossrates determined by these rates? And theCLP/BRL bid and ask rates?


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SOLUTION

The BRL/CLP cross rate is given by thedivision of the BRL/USD rate by the CLP/USD

rate The BRL/CLP bid is the division of the BRL/USD

bid by the CLP/USD ask The BRL/CLP ask is the division of theBRL/USD ask by the CLP/USD bid Can you provide an explanation?


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EXPLANATION

The international currency market is dominated by afew central currencies. Banks prefer to keep stock ofa few currencies to reduce their intermediation costsand risks

In Latin America, the USD is the currency of choicefor international transactions

Thus, there is no direct market between BRL and the

CLP, or any other Latin Americancurrency. Alltransaction pass by the USD.


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PAYMENTS AND RECEIVABLES

A Brazilian importer from Chile will make apayment that involves first exchanging the BRLby USD (that will be an ask rate) and then anexchange of the USD by CLP (that will be theUSD/CLP ask which is the CLP/USD bid). Theresulting cross-rate will be the BRL/CLP ask.

What about a Brazilian exporter to Chile?


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ANSWER

The Chilean buyer will exchange CLP forUSD (that will be the CLP/USD ask) and the

USD will be then exchanged for BRL at theUSD/BRL ask, which is the BRL/USD bid For the Brazilian exporter this is equivalent to

selling the CLP received for BRL, using theBRL/CLP bid rate, which is the result of thecross rate above


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NUMERICAL SOLUTION

Provided rates:CLP/USD 480.00-480.15BRL/USD: 1.745-1.747

BRL/CLP rates:BRL/CLP bid: 1.745/480.15 = 0.003634BRL/CLP ask: 1.747/480.00 = 0.003640

CLP/BRLCLP/BRL bid: 1/0.003640 = 274.73CLP/BRL ask: 1/0.003634 = 275.16


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Arbitrage

Any foreign exchange dealer can engage inexchange arbitrage.

Exchange arbitrage involves the simultaneouspurchase and sale of a currency in differentforeign exchange markets.


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Types of Arbitrage

Geographical Arbitrage Triangular Arbitrage


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Geographical Arbitrage .

Arbitrage becomes profitable whenever the price of acurrency in one market differs from that in another market.

Suppose the pound quoted in NY is $1.75, but pound quoted inLondon is $1.78. Then an arbitrager in NY and his partner inLondon can take the following steps:

(a) buy 10 M pounds in NY: cost = $17.5 M(b) sell 10 M pounds in London: revenue = $17.8 M(c) profit = $300,000 less the cost of telephone, cable transfer.

The supply of pound shrinks in NY, increases in London.


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Triangular Arbitrage

A triangular arbitrage strategy involves threetrades, exchanging the initial currency for asecond, the second currency for a third, andthe third currency for the initial.


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Example

Suppose the pound is quoted at 2.0000 dollarsper pound.Suppose that the euro is quoted at 1.3000euros per dollarSuppose that the pound is quoted at 2.5000euros per pound

Trade 1 dollar for 1.3 euros. Trade 1.3 eurosfor 1.3/2.5 = .52 pounds. Trade for more than1 dollar and make a profit.


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Exercise

Assume the following information:Value of Canadian dollar in U.S. dollars $.90Value of New Zealand dollar in U.S. dollars $.30

Value of Canadian dollar in New Zealand dollarsNZ$3.02.

explain the steps that would reflect triangular

arbitrage, and compute the profit from this strategyif you had $1,000,000 to use.


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Appreciation and depreciation of Spotrate

A currency appreciates against another currency when itsvalue rises in terms of the other currency. In a currency pair,when the value of one currency rises, obviously the value ofother currency pair declines.

For example on January 1 2010, the spot rate was INR48.25/USD. Suppose, on February 1 2010, the spot rate is INR46.75/USD. During the one month period, the value of INR hasrisen in comparison to USD. In other words, INR has

appreciated or USD has depreciated.


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Measurement of Appreciation/Depreciation

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Reasons for appreciation ordepreciation of currency

Some important factors affecting the exchange rate are: Difference in national inflation rates: The currency of a

country experiencing higher inflation will depreciate and viceversa.

Changes in the real interest rates: Currency of a country withhigher real interest rate will appreciate.


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Investment climate: A country with betterinvestment climate will attract investmentthus leading to appreciation of the currency.

Political uncertainty: a country with greaterdegree of political uncertainty will exhibithigher depreciation.


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Interpreting TC/ TT Rates TC (Travelers Cheques) buying rate indicates the rate at which

bank buys Travellers cheques and pays INR. TC selling rate isthe rate at which banks sell Travellers cheques and receivesINR. Obviously the TC buying rate will be lesser than TC selling

rate. TT (Telegraphic Transfer) buying rate indicates the rate at

which bank convert foreign inward remittances to INR. TTSelling rate indicates the rate at which the bank sends an

outward remittance through telegraphic transfer.


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Table 13.4: TC/TT rates and interpretationCash Buying Cash

SellingTC Buying TC Selling T.T B

USDINR 48.44 50.62 48.61 50.50 EUROINR 66.05 68.94 66.15 68.83

GBPINR 73.53 76.61 73.72 76.50


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Interpreting Bill Buying/Bill SellingRates:

Bill Buying rate: Suppose an Indian exporters has exported goodsand the foreign counterpart has raised a bill. The Indianexporter would sell the bill to the bank (bank will buy the bill)and bank will pay a discounted value to the exporter. At the

maturity of the bill, the bank will place the bill to the drawee(counterparty to the Indian exporter). Depending on thematurity period of the bill, the bank is going to charge ahigher commission. Hence the Bill buying rate will be lesserthan TT Buying rate. In a bill buying, the bank will pay INR tothe exporter and buy foreign currency from the exporter.


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Foreign Exchange Spot markets

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