CHAPTER: 4 Two-Way Markets Bid and Offer Rates ] n Chapters 2 and 3 we established the intrinsic nature of quotations in the money market and the foreign exchange market, and discussed the relationships among these markets using “the market rate.” In this chapter and the next one we will look at these subjects again, but now we will work with bid and offer rates. With the exception of retail stores, such as supermarkets, which nlitin fixed prices, the price in a market transaction depends heavily on whether one is on the buying or the selling side. One example of this situation is the person who is building a house with a two-car gatage. ‘The possibility of a teenage daughter having her own car in the near future looms almost as a certainty. As a consequence, the future house owner starts considering the possibility of enlarging the garage to hold three cars, since there is plenty of land for this. The following morning the prospective house owner calls the contractor. House owner: | have been thinking that we might want to have a garage large enough for three cars. How much do you think that will cost? ‘Contractor: Oh gosh! That's the type of thing that really creates a lot of trouble. I cannot see how we can change to a three-car garage for less than $8,000. House owner: Golly, | never realized that a garage was so ex- pensive! Perhaps, then, I should be thinking in the other ieee tion. Usually, one of our cars is rather old, and we would not mind so much leaving it outdoors. How much do you think I save if we garage? ‘Scanned with CamScannerYWOWAY MARKETS atD AND OPreR MAYOR Conireetor Well, once you have buill a worage for Wwe oars, you really do mot save that much by cutting down an the lwo ear job don't think we could reduce the prive by move than 67,000 {f You decided to eliminate the seeond-oar space Anybody who makes a market for any good has to buy al a coat lower than its expected selling price in order to stay in business for any length of time. In the financial markets which we are diseuasing, the buying rate is referred to as the Aid rote the selling rate is referred to as the afer rate or ask rote. A market where both bid and offer rates are quoted is called a two.way marker When we talk about the money markel, we must distinguish between marketable securities, such as commercial paper, and the hank money market In the first instance, individuals and corporations, as well as banks, participate in the buying and selling. In the tyterbank market, as the name indicates, the transwetions are restrieted to mem bers of the banking community Since our eventual purpdse in this chapter is to diseuss the fore exchange market, we shall restrict ourselves in thi Hlion to diseus ing the interbank money market rates, From the bank's point of view, these are the rates which are relevant for comparison with rates in the foreign exchange market. And, the banks are the ones who “make « market" in foreign exchange. Money market rates, in general, are dis: cussed in Chapters 7 and 10, When # bank quotes 77.25 percent for one-month money to a calling bank, the implications are the following: First, the rates are on a per annum basis. If one wishes to compute the amount of interest payments involved on a monthly basis, one would have to multiply the 7 percent figure by Mis and apply the resulting Interest rate figure to the amount borrowed or lent. Second, the first number, 7 percent, indicates the rate at which the quoting bank is willing to accept or borrow funds. The second rate, 7.25 percent, indicates the rate at which the quoting bank is willing to place or lend funds, The 0.25 percent spread between the two rates represents the quoting bank's profit if the two parts of the transaction (borrowing and placement) take place at these rates, (See Exhibit 4.1.) When individuals and corporations deal one side of the transaction. That is, ‘Scanned with CamScannerOY MARKETS: B10 nm OFFER RATES -05 1s the previous example, where the trader io willing to parchace German Garks ogsinst US. dollars at $0.5/DM. you must be willing to acl German marks ogainet US. dollars ot tat price. ta the same fevhimn if (© sell German marks US. dollars at $0.37/DM, you toast be nae willing to purchase Cenman marixs ageinst US. dollars ot that price i the transaction isto be cnutrmmatod That in. if trader is purchasing foreign exchange agsins: dollars {is selling the German mark egaingt US. dollars. from = German trader? This individual would likely respoad with numbers close to 270-277. Now we must be aware that the terms have changed: the German trader will quote the price of foreign exchange (in this case. US. dol- lars) terms of the domestic currency. German marks. Therefore. the» Customer) wanted to sell US. dollers and to purchase German marks, exchange rate would be DM270/$ (the price at which the trader ts willing to purchase the foreign currency. US. dollars}. If you wanted to purchase US. dollars and sell German marks. you would have to do so at the rate of DM277/S (the price et which the trader is willing to sell the foreign currency, US. dollars). Again. you notice that the spread is always in favor of the party quoting the rate and against the Party listening and dealing at 2 rate quoted by someone else. (See Exhibit 4.3.jp z ‘Scanned with CamScannera 06 - VORKIGN HXOHANGH AND MONEY MARENTS i seer ieeme nL | exninen ae A TWO-WAY QUOTE IN THE FOREIGN EXCHANGE MARKET IN THE UNITED STATES TRADER QUOTES FOR MARK: $0.36-$0.37 Catling customer Quoting bank Purchase mark Sout marks at $0.96/0M (soW gotiars) {purchase dollars) ‘Soll marks at $0.97/0M Purchase marks at '$0.37/0M (purchase dollars) (soll dollars) tlc eiecnhinntinesiecg eT, EXMINET aa A TWO-WAY QUOTE IN THE FOREIGN EXCHANGE MARKET IN GERMANY eerie, TRADER QUOTES FOR DOLLAR: 0M2.70-0M2.77 Quowny bank Cating customor Purchase dollars at OM70/8 Soil dollars at OM2.70/8 (oll marks) (purchaso marks) Soll dollars at OM2.77/S Purchaso dollars at 0M2.77/5 (purchaso marks) (sol! marks) a ee — oS At this point it is useful to note the relationship between the quotes given by the American trader and the German trader, When a trader says, “Willing to purchase German marks against U.S. dollars,” this is equivalent to saying, “Willing to sell U.S. dollars against German marks." The American trader will use the number $0.36/DM; the Ger- man trader will use the number DM2.77/$. A summary of these relation- ships in the example used here is presented in Exhibit 4.4. The relationship between the numbers used by the American and the German traders is one of reciprocity; 2.77 is approximately the recipro- cal of 0.36 (1 + 0.36 = 2.77). and 2.70 is approximately the reciprocal of 0.37. The figures 0.36 and 2.77 are known as the reciprocal rates wi ‘Scanned with CamScannerTWO WAY MARRETO Hin AND OFFER RATER Cane BXMIDIT 44 EXCHANGE RATES: RECIPROCAL RELATIONSHIPS IM TWO-WAY QUOTES QuoTes: United States = $0.96-90.97 i coment Ma 10-0M277 ele SS Sees Purchase marks at $0.96/0M Gell marke at 80.98/00 (sell dottars) F (purenane dotiars) or Purchase 7718 Soll marks at OM2.77/5 (set — oo (purchase dollars) 1 where —— = 2.77 0.36 Soll marks at $0.97/0M Purchase marks at $0.37/0M (purchase dollars) (soll dollars) , or ‘Sell marks at OM2.70/$ Purchase marks at OM2.70/$ (purchase dollars) (sell dollars) 1 where —— ~ 2.70 037 between the German mark and the U.S. dollar for the quoting trader to Purchase marke and sel! dollars. The figures 0.37 and 2.70 are the recip- rocal rates between the German mark and the U.S. dollar for the quoting trader to sell marks and purchase dollars. + ne ‘erstsmaws “~~ So far, we have déalt with only two currencies. Let's go back to a German trader and ask for the Price of dollars against Germen marks. Also, let's ask a French trader for the price of dollars against French francs. German trader: DM/s 2.8285-2.8295 French trader: FF/$ 4.5525-4.5575, ‘Scanned with CamScanneraeons mS sees wo joven the above . ay sell marks ‘and at which vate we Tach wader has oot we ‘ten quad give ofa a ri Oe eo: Trencs into what we would have to do with U.S. dollars on ae marks. As the Ger that must be the rate we ‘we want to purchase francs frones. that és the other rate to be used for our tion. quale: What. then, is the effective exchange rate of marks versus francs? We know the following: we must ask, How many marks equal FPL? We know that FF4 5525 equals DM2.8295. Then, what is the value of FFI? The answer is: ‘ (re sO seMonnse7 fF we must ask, How many French j:ancs equal DM1? The rate would be the reciprocal of 0.621527: ar. Cp ompeenions Following European custom, these quotes will be expressed as 1DM62.1527/FF100 anc FF160.8912/DM100. Quotes are given for 100 units of foreign currency. This practice reduces the number of decimal placa . ‘Scanned with CamScanner a2TWO-WAY MARggTe, B10 AwO OFFER RATES: BD ‘THE CHAIN “ Ifthe preceding computation ofordss flites appears complex. an alterna: tive approach is to apply the rule presented in Chapter 2. “the chain.” Using the samevsiti we ask: At what rate can we pathane French francs against marks, ‘expressed — terms? The four steps of the chain. then, are applied as lows: tablish the question that you want answered, starting with the currency of the terms you desire (DM): How many DM/FF? How many DM FF1 a Tre second statement begins with the same currency that ended the initial question (FF) and provides whatever infor- mation we have on that currency relevant to the type of transaction we wish to execute. Here, we want to purchase FF, which means we must use the rate at which the trader sells FF, that is, purchases USS. How many DM FFI FP4.5525 oe third step begins with the same currency that ended the ond equation ($) and provides whatever information we have on that currency regarding the type of transaction we wish to execute. Here, we want to sell DM, which means we must use tho rate at which the trader purchases DM, that is, sells USS. The last statement must finish with the same cur- rency whose terms you desired in the first question; in this example, DM. How many DM FFI FF4.5525 $1 Si DM2.8295 e final answer is given by comppting a ratio in which the product of the numbers in the right column of step 3 is the numerator and the product of the numbers in the left column is the denominator. The result of the division is the an- swer. ‘Scanned with CamScanner9 FORFION EXCHANGH AND MONEY MARKETS 1x hes = at ‘This is the sam 0295 528 0.621827 answer that was obtained earlier. Are cross rates just a nice convenience to express a price in terms of something that one understands? No. The importance of cross rates is that they do not always provide the same prices. The reason is that, on the one hand, the spreads in quotations for currenc'»: traded continu- ously are much narrower than those for currencies traded in smaller volume. For example, the spreads in quotations for French francs or German marks against U.S. dollars or pounds sterling are much nar- rower than for quotations of French francs against German marks or vice versa. Also, the particular position of a bank can explain quota- tions which are not in exact parity with the market. Therefore, when making a transfer of funds from one currency to another, it is important eck the various cross rates or alternative ways of performing the {ransaction. In addition, one must consider that the spread between buy and sell is always in favor of the trader. As a practical example, let's take the case of a French subsidiary of a US, multinational company declaring a dividend. At the same time, the parent company decides to increase the cupital of its subsidiary in Germany. The American finance officer then starts obtai tions, as shown in the table below. ‘The problem from the American company’s point of view is, what is the cheapest way to sell francs and purchase marks? Using marks as the 8 quola- Bid and Offer Quotes Bid Offer American bank — $/DM_ 0.3660 0.3062 (American terms) S/FF 0.1877 0.1879 French bank FF/S 59250 5.3260 (French terms) FF/DM_ 1.9495 1.9499 German bank = DM/$_—_2.7310 {German terms) DM/FF 0.5120 ‘Scanned with CamScannerTwo. i O-WAY MARKETS: BID AND OPFER RATES: 91 currency to compute tha Dollbwieg Rickiee. and using German terms, the company has 1, Deal directly with the French trader who is selling foreign currency (0M) at FF1.9499/DM. The reciprocal rate in terms of DM is Teas = DMo.512047/FF. 2. Deal directly with the German trader who is purchasing foreign currency (FF) at DM0.5128/FF. 3. Deal indirectly, using dollars as an intermediary. In the United States, the American trader is willing to purchase FF at $0.1877/FF, and also to sell DM at $0.3662/DM. Applying the chain, 1 FF1 $0.1877 $0.3662 DM1 The cost of exchange is 1_X 0.1877 x 1 = DMo.512561/FF. 1x1 X 0.3662 How many DM ee In summary. the options for converting French francs into German marks include the following (in multiples of 100): 1. Directly through the French trader DM51.2847/FF 2. Directly through the German trader. * DMS51.2800/FF 3. Indirectly through the American trader DM51.2561/FF American financial officers are often tempted to use an American bank because%f geographical convenience. However, the calculations show that in this case the direct quotation of the French bank is the best rate to use to accomplish the desired goal of transferring funds from French francs into German marks. For every FF100 the company can save DM0.0286 by using the French bank instead of the American one. So, in a $10 million transaction, a saving of $5,580 could be achieved.* Given the volume of funds moved across borders by multinational companics, it would not take many of these savings to pay the salary of the assistant treasurer who engages in these calculations. Whether or not the use of a direct quote (DM/FF) is more 1)M0.0286 equals 0.0558 percent of DMS1.28. On $10 million, this samc ‘Scanned with CamScanner—_—es. mney {usually ed <4 > the geous than going | various . C8 true wean ie aproads quoted OY the mat you is betier than ving twp spread 86 ncies other than the U.S. dollar anks. Thus. it is possible for one non-U.S. dollar currencies to be i i f the two Ww spreads in the quotations ol a oo ee artis 1g, dollar. There 1s no rule as to respective currenc CA sorininly justification for this rule ir 1, there 16 op aml uae to check the cross rate alternative. that it always pays Quality of a Quotation? How Can You Evaluate the trader should possess three A good quotation by a foreign exchange major qualitics: 1. Fast reply to the request for the quotation. 2. A narrow spread between bid and offer rates. 3. Willingness to deal a “reasonable amount” at the rates quoted. What constitutes a “reasonable amount” depends on the marketability of a given currency ‘and varies between the equivalent of US$500,000 and USS5 million. Financial officers usually are not at all reluctant to give all sorts of information to the bank regarding the company's position. A practical example will show the result: A treasurer calls the bank and announces thai the company has to make a payment in Swiss francs within a couple of months, and that it wishes to purchase the currency in ad- vance, That is, the treasurer is providing the bank with information as to what side of the transaction the company will be on. It does not require much imagination to anticipate that the quoted rate will take this. piece of information into account! The customer is clearly a buyer of Swiss francs against U.S. dollars; so, it is not very hard to conclude that the rate for selling Swiss francs offered by the bank is going’¢o be somewhat biased upward. “ From the previous paragraph, it is clear that one should not disclose ishes to buy or sella given currency. Instead, one should proach will not only reduce Ad whether one insii ‘Scanned with CamScannerTWO-WAY MARKETS: BID AND OFFER RATES: 99 any anticipatory “trending” of the rate by the quoting party, but it will also permit judgment about the relative quality of the rate, the spread between bid and offer, The typical bid-offer spreads in the spot market for currencies with & broad market is about 0.02 percent per mil. For example, given the bid rate DM1.7050/$, @ typical quote could be 1.7050-1.7054. However, in times of high uncertainty in the market the quote spread on maras could be as high as $0.01/DM. Currencies with a very narrow market often have @ spread as large as 1 percent. Given that for major currencies a spread of 0.50 percent is considered exceptionally large, a 1 percent spread on a regular basis for lesser traded currencies is substantial. For forward maturities the spreads are larger than for their spot counter- parts. In general, the following factors can be considered to affect the size of the spread between the bid and offer rates: (1) uncertainty be- cause of factors such as long maturities, time of the day when a market is not very broad (very early or very late or at lunchtime), and coming events such as the release of economic statistics; (2) amount of the transaction, which may make it difficult to close the position; and (3) availability of other market participants to close the position if the need arises. Information Content of Quotations The quotation given by a bank when compared with the market, or the quotations that most other people are making, can yield information on the type of transaction that the ba it prefers to buy or sell, Such a information as to the opinion of currency. For example, Standard market Specific bank's q For the customer dealing the market if the customer wi n ‘Scanned with CamScanner04 FOREIGN EXCHANGE AND MONEY MARKETS quote makes it possible for the customer to purchase at 19, instead of at the standard rate of 15, If the customer wishes to sell the ourrenay, then the market offers a better alternative than the specific bank, Thus, the quotation from the bank is designed to give an incentive to people to purchase from this specific bank, ‘This incentive is justified either if the bank has excess funds in that curreney, or if It expects the price of the currency to drop. As to the other side of the quotation, if any ill informed market participant sells to the bank at 9, the bank still has the opportunity to resell the nequired funds at the market rate of 10, In othor words, although the bank basically does not want to buy, It still does so happily at 9. The market is bidding 10, and the bank can sell immedi. ately at 10. The degree of departure of the bank's rate from the prevail. ing rate will indicate the extent to which one of the explanations pro- sented above holds true for the particular bank, Thus, in this ease, if thy bank were really pressured to sell the currency, it might go so far as to quote 0-12 Tf the bank's quotation were 12-16, it would clearly show that either the bank wants to be a buyer of the currency or that it oxpects its value to increase, Again. if the bank were very eager to maintaln this posturo, the quotations would likely go us far as 13-1622 ILis obvious from this discussion that the parly quoting the rate is in un advantageous position, provided the quoter knows what the market rate is. The trader can choose the bid and offer rates to quote in such a way that nothing can go wrong. The trader either accomplishes the objective pursued with a quote at odds with the market or makes a profit in an involuntary transaction suggested by an ill-informed trading part- ner. One should be forewarned, however, that one danger of taking the previous pars bid and offer ‘Scanned with CamScannerTWO-WAY MARKETS: BID AND OFFER RATES OF Quoted rate is 10 bid and 14 offer, the calling party may state a wish to sell at 11. The trader, the quoting party, may or may not improve the bid rate from 10 to 11. Even if the trader chooses not to buy at 11, informa- tion has been acquired about one market participant. If, during the next seconds or minutes, other callers also offer to sell at 11, then the quoting party should get the message that the market rate has probably changed. The party will probably quote something like 9 bid, 13 offered, next time. The final advantage for the trader is this: Most of the activity takes place at the calling party's telephone or telex expense. In a global busi such as foreign exchange, this expense can be very high, sometimes amounting to as much as US$1 million a year. Semmens PROBLEM 41 Given the bank quotes on money market rates shown in Table 4.1, determine the rates at which the calling party can place and borrow funds at this bank. ANSWER See Table 4.1. TABLE 4.1 Rates for Quoting and Calling Parties ee Calling party Bonk quote Placement Borrowing in % p.a. rate rate ‘Scanned with CamScanneeance AND MONEY MARKETS go FOREIGN EXC in the Exchange Mai pid and Offer Quotes rket Meaning of PROBLEM 42 A sophisticated custo exchange every day, P sterling against dollars. The bank quotes $2.401! following chart shows what the trader is prepares customer may do if the customer chooses to dea ho transacts substantial amounts of foreign and requests a two-way quote for (9-$2.4020 per £1. The 'd to do and what the } at that rate. mer, wh hones the bank 20/ £ ANSWER Bic! $2.4010/£ Offer $2. Teuder -willing to ‘Trader willing to buy f/sell $ sell £/buy $ Customer may Customer may sell £/buy S buy £/sell S ‘Selecting the Best Rate in a ‘two-Way Market—Rcciprocal Rates PROULEM 45 7 Beas exporter who sells to the United States received dollars which © would like to convert into Belgian francs Where should he do this aind why? Assume the following rate scenario: In New York: US$3.5780-US$3.5800 per BF100 In Brussels: BF 27.93-BF27.94 per USS1 ANSWER Option 1 In New York he i v can b elgic Si Thi Dein wt West. an buy Belgian francs at $3.58. This equals Option 2 In Brussels he can sell d : / a ollars at BF27.93 per $1. At $3.51 BF100 in New York the exporter gets BF0.0030 more dollars eon Brusscls. Selecting the Best Rate in a Two-Way Market—Cross Rates PROBLEM 4.4 A Dutch e: Dutch gui ‘Scanned with CamScanneeTWO-WAY MARKE ID AND OFFER RATES: 07 In Amsterdam: HM1.9030-111,9040 per US$1 In Amsterdam: HN38.41-1138.43 per HK$100 In Hong Kong: HK$4.9540-HKS4.9550 per US$1 In which city should the exporter deal and at what rate? Why? ANSWER @, He could sell Hong Kong dollars in Amsterdam at Hf98.41. 4, He could go via U.S. dollars; that is, sell Hong Kong dollars against U.S. dollars and buy guilders against U.S. dollars, ‘The cross-rate equivalent of these two transactions can then be compared with the direct rate of Hf30.41 to determine which alternative is more attractive, In Dutch terms, there= fore, we say: THN HK $100 HK$4.9550 [US$1 US$1 HN1,.9030 100 X_1_X_1.9030 .. 190.90. 99,4050 1 X 4.9550 4.9550 Going through the U.S. dollar the exporter can sell Hong Kong dollars at HM138.4056. Then, it is more attractive to sell Hong Kong dollars at the direct rate of Hf138.41 in Amsterdam PROBLEM 45 You are an exchange dealer and one of your customers asks you fora spot rate for French francs against German marks in German terms. The following rates prevail in the market. US$24.82-US$24.83 per FF100 US$58.15-US$58.18 per DM100 Being a professional dealer you give your customer a two-way quote. What are the bid and offer rates, assuming you want to ensure a DMO.03 profit regardless of whether your customer is buyii or selli My bid rate for French fr ‘Scanned with CamScannercerts ONWY MAR ow exenawer ano ™ wm rorr FF100 tron \USS2A.82 * ussse18 [DM100 £100 » 248,200 . 42.66 10 5.B16 German marks from the customer, then If | buy French francs against G: ; 1 z ust sell francs at $24.62 and buy marks at $58.18 in he market M42.66/FF100 Tho cross rate is ‘ oD When | buy I must subtract the desired ail profit margin Then, my bid rate for French francs g against German marks is DMaz2.63 My offer rate for French francs is. ? DM FF100 FF100 USS24.03 Ussse1s —(|DM100_ . 100 x 24.83 x 100 . 248,300 ~ 42.79 100 X 58.15 5.815 IfT sell French francs a; gainst German marks to the customer then 1 must buy francs at $24.83 a nd sell marks at $58.15 in the market. The cross rate is When I sell I must add the desired profit margin 0.03 Then, my offer rate for French francs inst German marks is DM42.73/FF100 == DM42.70/FF100 ‘Scanned with CamScannerwow AY MARERTS: BID AND OFFER RATES 9 Broker A: HKS4.9000-HK$4.9020 = USS1 SwP16680-SwP1 6005 = USS: Broker Bt 1KS4.0010-HKS4.9075 = US$i Sw) 6025-SwP1 6055 = US$! Broker C: HK$4 905-HKS4.9015 = US$1 SwP 1 0045-SwP1.6000 = US$ With which broker(s) will you deal? What are the rates? How many poirts did you make? ANewre Buy Swies france from broker A at SwP1.6050/USS. Sell Hong Kong dollars to broker C at HK$4.9015/USS. 7 KS SwPt SwF1.6050 |US$1 uss [LIK$4.9015 1X 1% 49015 . 30599 1.6080 x 1 Rate given to custome: 11KS3, »/SwF Rate obtained from brokers 3.0539 Spread 1IKS0.0031/SwP PRODLEM 47 The rate scenario for Danish kroner and Finnish markkas is as follow: In Oslo: US$1 = DKr4.8700-DKr4.8710 Fmk1 = DKr1.3122-DKr1.3140 US$1 = Fmk3.7120-Fmk3.7140 = mk0.7615 In Helsinki: A trader in spots an arbil what should Buy dollars Buy Danish ‘Scanned with CamScannees 10 FOREIGN HXCHANGE AND MONEY MARKET 4.8710 X 0.7615 = 3.7093 Ta. If the trader sells dollars and buys markkas at Fmk3.7120 in Helsinki, the net profit is Fmk0.0027/USS. PROOLEM 40 A French person who exports to Switzorkind would like to sell Swine francs against French francs. ‘The following market rutes prevail: FF4.0340-FF4.0350 per USS1 SwF1.6010-SwF 1.6020 per US$1 Your customer would like a cross rate for SwF/FF in French terms from you. What is your rate assuming you want a spread of 0.0010 points? ANSWER ? FF SwF1.6020 USS1 1X 1x 4.0340 _ 4.0340 = 25181 1.6020 x 1 1 I can sell Swiss francs against French francs in the market via U.S. dollars at FF2.5181. If I would like a spread of 0.0010 I have to buy from my exporting customer at a lower rate. Break-even rate FF2.5181/SwF Desired spread — 0.0010 Rate to exporter FF2.5171/SwF Note that when you buy from a customer, the spread is subtracted. The norinal pattern is that people buy something first, and then add a sproag a customer you add subtract the spi ‘Scanned with CamScanner