Forex Quotations and Arbitrage

8/19/2019 Forex Quotations and Arbitrage

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Forex Quotations and Arbitrage


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Introduction

• Most of the trades in the world are with strong economiessuch as The United States ,Jaan, !erman", United#ingdom,etc$

• There are of course trade transactions between othercountries as well$

• %hile ban&s maintain corresondent'ban&ing relationswith ban&s in other countries ,the" would ob(iousl" refer

to maintain it with those countries ban&s with whom theircustomers ha(e significant trade (olume$

• This is because maintaining such account in another ban&abroad cost fees for the boo&&eeing chores erformed$


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• The accounts held b" a ban& abroad are called nostroaccounts, (ostro accounts, or loro accounts

• *ostro, +ostro and loro are italian words$

• *ostro means domestic ban&s account held with a foreign ban& $for e$g$ IndusInd -an&s Account with )itiban&,USA$

• +ostro means Foreign ban&s account with domestic

ban& $for e$g$ Scotia ban&s account with S-I$• .oro means third art" account$ For eg$ .ondon ban&

a"ing an amount /to French ban&0 b" crediting French ban&s account held with US ban&$


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)orresondent -an&ing

• *ostro and +ostro are corresondent ban&ing accounts$If a

U)1 -an& customer has to get US2 3m in chicago, then

U)1 -an& will use its own account with Amex -an&

/*ostro -an&0 to effect remittances$

• It is ob(ious that ban&s in almost all the countries of the

world would ha(e corresondent ban&s in all strong

economies$ Additionall" the" also maintain such

relationshi with the regional countries$

• US dollar is the most commonl" used and the strongest

(ehicle currenc" in the international mar&et so far$


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+ehicle )urrenc"

• US dollar is the most commonl" used and the strongest

(ehicle currenc" in the international mar&et so far$

• The external (alue of domestic currenc" gets established in

the local foreign exchange mar&et against a ma4or

currenc"$ This currenc" is an" of the uni(ersall" acceted

ma4or international currenc" such as US2,!-5 or 6U7$

Such currenc" is called (ehicle currenc"$

• In India effecti(e from 3883,US2 I*7 9uotation gets

established in the local mar&et$ This 9uotation is &nown as

+ehicle )urrenc" Quotation$


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• %hen rates are re9uired against an" other currenc", sa")A2I*7, local mar&et 9uote of US2 )A2 is used toestablish the desired :)ross 7ate of )A2 I*7$

• +ehicle currenc" thus gets eliminated after cross ratescalculation$

• The +ehicle currenc" therefore ro(ides the connectinglin& between the domestic currenc" and all other

international currencies$ The choice of +ehicle )urrenc" isformall" influenced b" the following factors;

30 5oular In(oicing currenc" for exorts and imorts of thecountr"


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)>I5S

• In the United States, where almost all foreign exchange

transactions are cleared, a comuter based )learing >ouse

Interban& 5a"ment S"stem /)>I5S0 handles tens of

thousands of a"ments reresenting transactions worth

se(eral hundred billion dollars each da"$

• )>I5S can be thought of as a sort of international ban&ers

la" mone"$

• 2uring the da", all international ban&s ma&ing dollar

a"ments to one another ass this chis mone" to one

another in lieu of real mone" $


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• At the end of the da" the game'master totals u

e(er"bod"s )>I5S mone" to see the net amount that is

owed b" who to whom, and real mone" /?Fed Funds0 is

transferred in that amount$

• Also &nown as )>A5S ,clearinghouse automated a"ment

s"stem$


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S%IFT

• The imro(ement in the domestic US clearing s"stem

utili@ed for international transactions has been followed b"

imro(ement in international ban& communications that

lin& national clearing s"stem$

• -an&s from 3 countries formed the Societ" for

%orldwide Interban& Financial Telecommunications i$e$

S%IFT that began oerations at the end of 38$

• S%IFT consists of national data concentration centres ,

which are connected b" leased telehone lines to oerating

centres in -elgium, the *etherlands, and the United States$


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Foreign 6xchange Quotations

• The executi(es in the ban&s who offer rice 9uotes for

foreign exchange and deals in Forex are called as :traders$

• %hen a cororate customer as&s for a rice 9uote for U#

5ound Sterling, for US dollars to a trader, he would 9uote

in the following manner;

3$B3C


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/


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• The difference between bid rate and as& rate /offer rate 0 is

called as bid as& sread /bid offer sread0$ In the first

examle bid as& sread is C$CCCB dollar /er one ound0$

• In normal mar&et trader exects ?to be hit on both sides ofhis 9uote in roughl" e9ual amounts$ This means he assumes

there is aroximatel" e9ual demand to bu" and sell the

currenc"$

• -id as& sread is the measure of the following;/30 It is margin to co(er transactions costs and other costs$

/


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/=0 If trader is being hit on one side more than the other side ,

then this sread indicates his encouragementGdiscourage'

ment on either side$

-I2'AS# S576A2 in 5ercentage terms;

The sread is generall" exressed in ercentage b" the e9uation;

/a0 Sread As& /sell0 7ate'-id /bu"0 7ateGAs&/sell0 7ate x

3CC

*ote that here denominator is :As& rate$ %ith this we calculatethe ercentage which -id rate is lower/at discount0 as

comared to As& rate$


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• /b0 Sread As& /sell07ate K -id/bu"0 7ateG-id /bu"0

7ate x3CC

• %ith this we calculate the ercentage b" which, As& rate is

higher /at remium0 as comared to -id rate$

• 6xressing -id as a discount o(er As& is more commonl"

ractised and hence we shall adhere to formula/a0 for our

calculations$


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• 2irect Quote;

Foreign 6xchange rate exressed in terms of domestic

currenc" er unit of foreign currenc" is called as 2irect

Quote$

For instance, DB$=< 7s$G is a direct 9uote in India$

Indirect 9uote;

Foreign 6xchange rate exressed in terms of foreign currenc" er unit /or er hundred units0 of domestic currenc" is

called as Indirect Quote$

For instance,


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Quotes

• American Terms /Quotes0; Since US dollar is the most oular (ehicle currenc", foreign exchange rates areexressed in terms of US dollar$ If the" are exressed as

number of US dollars er unit of another currenc" then it iscalled as 9uote in American Terms$

For instance, C$88LCG or 3$EB3=G

6uroean terms /Quotes0 ;

If foreign exchange rates are exressed as number of units ofanother currenc" er US then it is called as 9uote in6uroean Terms$

For instance, 3$C3


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• Indicati(e Quote;

Mar&et ma&ers rice which is not firm$ >e will firm u the same

onl" when customer starts negotiating serious contract with details$

)71SS 7ates ;

2ef; An exchange rate between the two currencies, neither of which

is the US dollar$ /In strict terms, ?neither of them is a (ehicle

currenc"0

Alternati(el",It is a rate between third air of currencies, b" using the rates of two

airs, in which one currenc" is common$


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• A cross rate is usuall" constructed from the indi(idual

rates of the two currencies with resect to the US dollar

/(ehicle currenc"0$

• Following examle illustrates the concet of cross rates;

An Indian imorter is to settle his bill in )anadian dollars$

>is oeration in(ol(es bu"ing of )anadian dollars against

ruees$ >e re9uires 9uote for; )anG7s$ *either of these is

a common currenc"$ Forex Trader /-an&er0 will call forUSG)an and USG7s$ 9uote$ This means trader shall first

bu" )anadian dollars against US dollars$


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Arbitrage

• 2ef; The simultaneous urchase and sale /or lending and

borrowing0 of two assets in order to rofit from a rice

disarit"$

In simlistic terms if one goldsmith is read" to sell gold at ECC

7s$G!ram and another goldsmith is read" to bu" gold for

EC< 7s$G!ram, then one can easil" b" 1ne #ilogram of gold

from the first goldsmith and sell it to the second one, then he

will rofit 7s$


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• In erfect mar&et there should not be an" arbitrage

oortunit"$ -ut in ractise such oortunities exist and

as arbitrageurs sot it and use it,these oortunities

(anish and hence ?e9uilibrium is established again$

• 1n the sot exchange ,two t"es of arbitrages are

ossible;

/30 !eograhical arbitrage /Two oint arbitrage0

/


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!eograhical Arbitrage

• 2ef$; The trading ractise of bu"ing a currenc" in one

geograhical mar&et and selling it in another in which the

rice is higher$

• !eograhical arbitrage consists of bu"ing a currenc"

where it is the cheaest and selling it where it is the dearest

so as to ma&e a rofit from the differences in the rates$

• In ideal mar&et, there should not be an" arbitrage

oortunit" because of geograh"$

• 6seciall" in forex mar&et there is nothing li&e :natural

cro or :oil'field ad(antage to an" countr", er se$


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• Also there is no shimentGtransortation cost that lea(es ga for

theoretical arbitrage$ Forex mar&ets are wired mar&ets$

• All ban&s forex treasuries oerate round the cloc& on


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Triangular Arbitrage

• The rocess of bu"ing and selling foreign exchange between

three different currencies in order to rofit from a discreanc"

in cross rates$

• Triangular arbitrage occurs when three currencies are in(ol(ed$

• >ence if cross rates as calculated with our calculations are

different from actual 9uotes for those currencies, then such

oortunit" of arbitrage is a triangular arbitrage$

• If 9uotes of three currenc" airs are a(ailable ,sa" 7s$,N and$Then an Indian exorter willing to bu" it through two

routes/30 -u" with a(ailable 9uote between 7uee and 2ollar


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/e will t"icall" calculate 7uee cost b" both the routes and

ot for the cheaest$

If cost b" the two routes is different , then it is an indication

of otential arbitrage oortunit" $

Forex Quotations and Arbitrage

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