Spot Markets and rates

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

Major currencies
According to the basics of foreign exchange market, 7 major currency pairs are traded most in the market. These are: EUR/USD = "Euro" USD/JPY = "Dollar Yen" GBP/USD = "Cable" or "Sterling" USD/CHF = "Swissy" USD/CAD = "Dollar Canada" (CAD referred to as the "Loonie") AUD/USD = "Aussie Dollar" NZD/USD = "Kiwi"

Base currency
Base currency in foreign exchange referred to as the first currency in any currency pair. It shows how much the base currency is worth as measured against the second currency. Also the currency your account is denominated in.

Quote currency
The second currency in any currency pair is referred to as quote currency in foreign exchange market. This is the value of a medium of exchange as compared to the base currency. Also known as counter currency or terms currency.

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 quotes 1.3200/03, 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 the market maker's ask or offer price. For example, if the EUR/USD quotes 1.3200/03, you can buy 1 Euro at the offer price of US$1.3203.

 Spread The difference between the sell quote and the buy quote or the bid and offer price. For example, if EUR/USD quotes read 1.3200/03, the spread is the difference between 1.3200 and 1.3203, or 3 pips. Ask/Bid -1 = Spread

Explanation with example

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

I now hand over $AUD 3,000. The teller, for every AUD that I give her, gives me back $USD 0.8158 which off course is $USD 2, 447.4. The above example highlights an Exchange rate. Exchange rates are usually quoted in two different ways an indirect quote and a direct quote.

 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. In short it just means that the home currency is the base currency or first currency expressed in terms of the foreign currency. If we live in Australia an example of an indirect quote 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 of the foreign currency and x units of the home currency. If we live in Australia we can convert the indirect quote AUD/USD 0.8168, into a direct quote of approx USD/AUD 1.2243. Also known as European Terms

 The bid price is the price the bank is willing to buy the currency for. If you wanted to sell one Australian dollar to the bank they would buy it to from you for $USD 0.8158. This is known as the bid price. The ask price is the price the bank is willing to sell the currency for. If you wanted to buy one Australian dollars from the bank you would need to give them $USD 0.8168. This is known as the ask price.

BID AND ASK, DIRECT AND INDIRECT

Use 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%

REMEMBER
The indirect bid rate is the reciprocal of the direct ask The indirect ask rate is the reciprocal of the direct bid The direct bid rate is the reciprocal of the indirect ask The direct ask rate is the reciprocal of the indirect bid

European and American Quote

Majority of the countries express foreign exchange prices for one US dollar which is known as European terms. The following quote is an example to European 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 an example to American terms: US $ 0.0095 / or 1 : 0.0095 US $

Pip
In terms of forex a pip is the smallest increment a currency can move, it is usually the fourth decimal place in a quoted price. If for example, the Australian dollar moves from $0.8342 to $0.8343 we can say the Australian dollar has increased in value by one pip. If the Australian dollar moves from $0.8342 to $0.8242 we can say the Australian dollar has decreased in value by one hundred pips.

Pip Value
To get the value of one pip in a currency pair, an investor has to divide one pip in decimal form (i.e. 0.0001) by the current exchange rate, and then multiply it by the notional amount of the trade.

Spot Market
A foreign exchange spot market is a market for trading one currency against the another in such a way that the delivery takes place within 2 days of the execution of the trade. It usually takes two days to transfer cash from one bank to the other. The price is based on the ongoing exchange rate i.e. the current value of one country's currency relative to the another. A currency's spot rate is expressed as its value relative to the US dollar i.e the number of US dollars needed to buy one unit of the other currency.

Cross rates
A cross rate is the currency exchange rate expressed by a currency pair in which none of the currencies involved is the official currency of the country in which this quotation is made. E.g. if the currency exchange rate between a JPY and a GBP is quoted in a US newspaper, this would be called a cross rate 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 is involved in this pair.

At a more general level, the exchange rates expressed by any currency pair that does not involve the US dollar are called cross rates. Thus, this broader definition implies that the exchange rate of the currency pair GBP/JPY would be a cross rate, regardless of the country in which this quotation is being made.

Computing cross rates

Assume that the following major exchange rates are known: EUR/USD = 1.0060/65 GBP/USD = 1.5847/52 USD/JPY = 120.25/30 USD/CHF = 1.4554/59 To calculate GPB/CHF GBP/USD: Bid: 1.5847 Offer: 1.5852 USD/CHF: 1.4554 1.4559 GBP/USD X USD/CHF = 1.5847 X1.4554 1.5852 X 1.4559 GBP/CHF 2.3063 2.3079

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 cross rates determined by these rates? And the CLP/BRL bid and ask rates?

SOLUTION
The BRL/CLP cross rate is given by the division 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 the BRL/USD ask by the CLP/USD bid Can you provide an explanation?

EXPLANATION
The international currency market is dominated by a few central currencies. Banks prefer to keep stock of a few currencies to reduce their intermediation costs and risks In Latin America, the USD is the currency of choice for international transactions Thus, there is no direct market between BRL and the CLP, or any other Latin Americancurrency. All transaction pass by the USD.

PAYMENTS AND RECEIVABLES

A Brazilian importer from Chile will make a payment that involves first exchanging the BRL by USD (that will be an ask rate) and then an exchange of the USD by CLP (that will be the USD/CLP ask which is the CLP/USD bid). The resulting cross-rate will be the BRL/CLP ask. What about a Brazilian exporter to Chile?

ANSWER
The Chilean buyer will exchange CLP for USD (that will be the CLP/USD ask) and the USD will be then exchanged for BRL at the USD/BRL ask, which is the BRL/USD bid For the Brazilian exporter this is equivalent to selling the CLP received for BRL, using the BRL/CLP bid rate, which is the result of the cross rate above

NUMERICAL SOLUTION
Provided rates: CLP/USD 480.00-480.15 BRL/USD: 1.745-1.747 BRL/CLP rates: BRL/CLP bid: 1.745/480.15 = 0.003634 BRL/CLP ask: 1.747/480.00 = 0.003640 CLP/BRL CLP/BRL bid: 1/0.003640 = 274.73 CLP/BRL ask: 1/0.003634 = 275.16

Practice ques
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Arbitrage
Any foreign exchange dealer can engage in exchange arbitrage. Exchange arbitrage involves the simultaneous purchase and sale of a currency in different foreign exchange markets.

Types of Arbitrage
Geographical Arbitrage Triangular Arbitrage

Geographical Arbitrage

Arbitrage becomes profitable whenever the price of a currency in one market differs from that in another market. Suppose the pound quoted in NY is $1.75, but pound quoted in London is $1.78. Then an arbitrager in NY and his partner in London 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.

Triangular Arbitrage
A triangular arbitrage strategy involves three trades, exchanging the initial currency for a second, the second currency for a third, and the third currency for the initial.

Example
Suppose the pound is quoted at 2.0000 dollars per pound. Suppose that the euro is quoted at 1.3000 euros per dollar Suppose that the pound is quoted at 2.5000 euros per pound Trade 1 dollar for 1.3 euros. Trade 1.3 euros for 1.3/2.5 = .52 pounds. Trade for more than 1 dollar and make a profit.

Exercise
Assume the following information: Value of Canadian dollar in U.S. dollars $.90 Value of New Zealand dollar in U.S. dollars $.30 Value of Canadian dollar in New Zealand dollars NZ$3.02. explain the steps that would reflect triangular arbitrage, and compute the profit from this strategy if you had $1,000,000 to use.

Appreciation and depreciation of Spot rate

A currency appreciates against another currency when its value rises in terms of the other currency. In a currency pair, when the value of one currency rises, obviously the value of other currency pair declines. For example on January 1 2010, the spot rate was INR 48.25/USD. Suppose, on February 1 2010, the spot rate is INR 46.75/USD. During the one month period, the value of INR has risen in comparison to USD. In other words, INR has appreciated or USD has depreciated.

Measurement of Appreciation/ Depreciation

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Reasons for appreciation or depreciation 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 vice versa. Changes in the real interest rates: Currency of a country with higher real interest rate will appreciate.

Investment climate: A country with better investment climate will attract investment thus leading to appreciation of the currency.

Political uncertainty: a country with greater degree of political uncertainty will exhibit higher depreciation.

Interpreting TC/ TT Rates

TC (Travelers Cheques) buying rate indicates the rate at which bank buys Travellers cheques and pays INR. TC selling rate is the rate at which banks sell Travellers cheques and receives INR. 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. TT Selling rate indicates the rate at which the bank sends an outward remittance through telegraphic transfer.

Cash Buying USDINR EUROINR GBPINR

Table 13.4: TC/TT rates and interpretation. Cash TC Buying TC Selling T.T Buying Selling 48.44 50.62 48.61 50.50 48.78 66.05 68.94 66.15 68.83 66.52 73.53 76.61 73.72 76.50 74.09

T.T Selling 50.22 68.36 75.97

Interpreting Bill Buying/Bill Selling Rates:

Bill Buying rate: Suppose an Indian exporters has exported goods and the foreign counterpart has raised a bill. The Indian exporter 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 the maturity period of the bill, the bank is going to charge a higher commission. Hence the Bill buying rate will be lesser than TT Buying rate. In a bill buying, the bank will pay INR to the exporter and buy foreign currency from the exporter.

Bill Selling Rate: Suppose an Indian importer has raised a bill to the foreign exporter. On the maturity of the bill, the Indian importer has to pay to the foreign counterpart through the bank. In this case, the bill selling rate would be applicable. In bill selling, the bank will pay foreign currency and buy INR from importers. Bill selling is higher than TT selling rates.

Some practice ques

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