a:b = S where a is the quoted currency b is the currency in which the price is expressed S is the price of the quoted currency a in units of currency b For example, $:¥ = 130 means the U.S. dollar is quoted at 130 Japanese yen (¥) per dollar. Or the U.S. dollar is priced at 130 yen.
Direct Exchange Quotes A direct exchange rate is the domestic price of foreign currency. For example, an American investor seeing a direct quote €:$ = 1.34 knows she will pay $1.34 for one euro. To a European investor, the direct quote is $:€ = 0.74627 which says that 1 dollar (foreign currency) is worth 0.74627 euro. An appreciation of the foreign currency causes an increase in the direct quote.
Example: Direct and Indirect Exchange Rates - Continued Answer: The pound is quoted in terms of dollars. This quote is a direct quote from the American viewpoint and an indirect quote from the British viewpoint. The pound is the quoted currency. Over a month, the pound’s price increased from $1.80 to $1.90, so the pound appreciated and the dollar depreciated.
quotations for the Korean won and the Brazilian real: $: won = 928.350 $: R$ = 1.9094 Calculate the R$:won rate: ($:won) ÷ ($:R$) = 928.35/1.9094 = 486.20 The resulting quotation is: R$:won = 486.20. One Brazilian Real is worth 486.50 won.
Foreign Exchange Market The international currency market has two main components: A worldwide Forex market between major banks and specialized currency dealers. This is a wholesale interbank market for large transactions. It is an Over The Counter (OTC) market, by telephone and electronic trading platforms, where trading takes place 24 hours a day, 5 days a week. It is the largest and most liquid financial market in the world. A retail market where investors and corporations deal with local banks.
Forex Market Conventions – 1 There is no need to quote both a direct and indirect rate, e.g. both $:€ and €:$. History mostly dictates the exchange rate direction that is selected: There is a decreasing order of seniority with the British pound as the senior currency. The Forex convention is to trade British pounds in units of other currencies, so the quote showing on Forex trading screens is the foreign exchange value of one GBP, that is, GBP:EUR, GBP:USD, or GBP:JPY.
Forex Market Conventions – 1 (cont’d) When the euro was introduced in 1999, it was given “seniority” just behind its British neighbor. Thus, the quote showing on Forex trading screens is the foreign exchange value of one euro, EUR:USD or EUR:JPY. The only exception is the British pound where the GBP:EUR is quoted. Finally, the dollar is quoted in units of all other currencies, for example, USD:JPY.
Forex Market Conventions – 2 Not all exchange rates are traded. In a world with a large number of currencies, there are a very large number of cross exchange rates. For example, with 20 currencies, there are 380 bilateral exchange rates. The exchange rates between two minor currencies are not traded on the Forex market. Only the dollar exchange rate with each minor currency is quoted. Hence to achieve a transaction between two minor currencies, one needs to perform two transactions involving the dollar (such as between the South Korean won and Brazilian real – hence our previous example with cross-rates).
Forex Market Conventions – 2 (cont’d) The obvious motivation for this rule is liquidity. At a given time, there are few transactions between two minor currencies, so it is more efficient to group all transactions against one major currency, the U.S. dollar.
Forex Market Conventions – 3 In the Forex market, quotations on trading screens are generally given with five significant digits and three-letter codes. For example, the USD:JPY quote could appear as 120.10 and the EUR:USD as 1.2515. Market makers quote both a bid and an ask price, and there is no additional fee or commission.
Bid-Ask Quotes Bid price: the exchange rate at which the dealer is willing to buy the quoted currency in exchange for the second currency. Ask (offer) price: the exchange rate at which the dealer is willing to sell the quoted currency in exchange for the second currency. The difference between the bid and ask price is called the spread. Midpoint price = (ask + bid)/2
represents the smallest price fluctuation in the currency price. It is equivalent to the “tick” on stock markets. E.g. €:$ = 1.3015 – 1.3019. The spread equals 4 pips.
Bid-Ask Spread Difference between bid and ask price. Can also be calculated as a percentage: Bid-ask spread = 100*(ask – bid)/ask Size of bid-ask spread increases with exchange rate uncertainty (volatility) and lack of liquidity because of the bank/dealer risk aversion. Spreads are larger for currencies that have a low trading volume (thinly traded currencies).
Arbitrage Conditions with Exchange Rates An arbitrage could be created if it were profitable to buy from one bank and sell to another bank. When describing arbitrage, we are usually discussing a riskless transaction that does not require any invested capital.
Triangular Arbitrage Triangular arbitrage involves three steps: Pick the cross-rate currency Determine whether the cross-rate bid-ask quotes are in line with the direct quotes by determining whether it is cheaper to buy foreign currency directly or indirectly. If the actual cross-rate quote is not in line with the quoted cross-rate quotes, an arbitrage opportunity exists.
Forward Rates Spot rates are quoted for immediate currency transactions (although in practice delivery takes place 48 hours later). Forward exchange rates are contracted today but with delivery and settlement in the future. In a forward, or futures, contract a commitment is irrevocably made on the transaction date, but delivery takes place later, on a date set in the contract.
Forward Premiums/Discounts Forward exchange rates are often quoted as a premium, or discount, to the spot exchange rate. When a trader announces that a currency quotes at a premium, the premium should be added to the spot exchange rate to obtain the value of the forward exchange rate. If a currency quotes at a discount, the discount should be subtracted from the spot exchange rate to obtain value of the forward exchange rate.
Forward Quotations with Bid-Ask Spreads - Example On the Forex market, you notice the following quotes: Spot: $:¥ = 105.00 – 105.50 One year interest rate ($): 3 ½ – 4% (0.035 – 0.04) One year interest rate (¥): ½ - 1% (0.005 – 0.01)
Interest Rate Parity The interest rate parity relationship is that the forward discount (premium) equals the interest rate differential between the two currencies. For two currencies, A and B, with the exchange rate quoted as the number of units of B for one unit of A,
Covered Interest Rate Arbitrage The process of simultaneously borrowing the domestic currency, transferring it into foreign currency at the spot exchange rate, lending it, and buying a forward exchange rate contract to repatriate the foreign currency into domestic currency at a known forward exchange rate. The net result of such an arbitrage should be nil.
Forex Trading for Beginners: The Ultimate Trading Guide. Learn Successful Strategies to Buy and Sell in the Right Moment in the Foreign Exchange Market and Master the Right Mindset.