Outline

 Definition of Bid-Ask Spread.

 Bid-ask quotations in FX market.
 Bid-Ask Prices in Cross-Rates.
 Market Microstructure and Bid-Ask Spread
 Triangular Arbitrage with Bid-Ask Spread
 Covered Interest Arbitrage (CIA) with Bid-Ask
Spread

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 Definition of Bid-Ask Prices
 The bid price is the price at which you get paid
from your broker, or equivalently, the price at
which your broker pays you.
 The ask price is the price at which you pay your
broker, or equivalently, the price at which your
broker accepts your payment.
 In a word, you sell at the bid price, and you buy at
the ask price. The ask price is always higher than
the bid price.
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 Definition of Bid-Ask Prices
 In the more strict sense, the bid price is the highest
price a dealer is willing to pay you, and the ask
price is the lowest price that the dealer is willing
to accept from you.
 If the bid and the ask price for one share of Microsoft is
$30 and $31, respectively, that means you can sell one
share of Microsoft to your broker for the maximum of
$30, but you need to pay at least $31 to get one share of
Microsoft from your broker.

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 The Bid and the Ask Prices
in the FX Market
 In the FX market trading facing the both bid and the
ask prices, we need to be very clear about which
currency is the underlying currency.
 The bid price quoted as $1.9072/£ means the underlying is £,
and you are trading £, evaluated in $. In particular, it means
that you can sell £1 to the dealer for a maximum of $1.9072.
 On the other hand, the bid price quoted as £0.5242/$ means
that the underlying is $, and you are trading $, evaluated in
£. In particular, it means that you can sell $1 to the dealer for
a maximum of £0.5242.

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 The Bid and the Ask Prices
in the FX Market
Bid Ask
S($/£) 1.9072 1.9077
Reciprocal Reciprocal
equals equals

S(£/$) 0.5242 0.5243

In each row, the numbers refer to quotations for selling and buying the
underlying currency. The underlying currency is £ for the first row,
and $ for the second row
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 The Bid and the Ask Prices
in the FX Market
The reciprocal relationship between American and
European bid and ask quotation $/£
1
S  $ / £ = a
b

S  £/ $
1
S  $ / £ = b
a

S  £/ $
Intuitively, your selling £ with $ must mean your buying
$ for £. In the first place we have a bid rate (price) with £
as the underlying, and in the second place we have an
ask rate (price) with $ as the underlying.
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 Bid-Ask Prices: an Example
 Assume that the $/£ bid-ask prices are $1.9072-$1.9077 /
£, compute the £/$ bid-ask prices. 　
 Answer:
1 1
S b (£ / $)  a
  £0.5242/$
S ($ / £) $1.9077 / £
1 1
S a ( £ / $)  b
  £0.5243/$
S ($ / £) $1.9072 / £

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 Bid-Ask Spread
 The bid-ask spread is the difference between ask
prices and bid prices.
 In the previous example, the bid-ask spread for the pound
rate is $ (1.9077-1.9072)/£=$0.0005/£, or 0.0262% of the
average prices.
 The bid-ask spread represents the brokers’
expected profits, since it ensures that brokers
always buy low and sell high.
 Consequently, bid-ask spread represents an important
transaction cost for the traders.
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 Bid-Ask Spread
 When compared across different financial markets, bid-ask
spreads are usually quoted as the percentages of the
average bid-ask price (why?)
 The percentage bid-ask spreads tend to be the lowest in FX
market, particularly for the actively traded currency pairs.
In contrast, the bid-ask spreads are higher in equity and
derivative markets.
 In equity markets, the percentage bid-ask spreads tend to
be lower for large (blue chip) stocks, and higher for small
stocks.
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 Determinants of Bid-Ask Spread
 Generally speaking, the higher the trading volume is, the
narrower is the bid-ask spread as a percentage of the
average prices.
 Brokers need to charge fees to cover their costs and provide a
minimum profit margin to run their business. The fees will, of
course, be borne by the traders.
 If the trading volume is high, brokers can charge a low bid-ask
spread for each transaction and still earn enough fees to cover their
costs. If the trading volume is low, brokers will have to charge
high bid-ask spread for each transaction to keep themselves in
business.

10
Market Microstructure and Bid-Ask Spread
 Market Microstructure refers to the mechanics of how a
marketplace operates. It includes :
 market structure and design. An important question: how market
structure affects trading costs and whether one structure is more
efficient than another.
 price formation and discovery
 Transaction cost and timing cost
 Information and disclosure. An important question: the impact of
information transparency on the behavior of the market participants
 Bid-ask spread is an important study object in the literature
of market microstructure.
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Market Microstructure and Bid-Ask Spread
 A study by Huang and Masulis (1999) on the bid-
ask spreads in the spot FX market : Bid-ask spread
tends to
 increase with FX exchange rate volatility
 decrease with broker competition
 decrease when the percentage of large dealers in the
marketplace increases
 FX market tends to have the lowest bid-ask
spread, evaluated as the percentage of the average
price.
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 Bid-Ask Prices in Cross-Rates
 Recollect that the cross exchange rate, S(€/ £), can be
obtained from S($/ £) and S(€/$) as follows:
S ( € /￡)  S ($ /￡)  S ( € / $)

 Recognizing transaction costs implies:

S b ( € /￡)  S b ($ /￡)  S b ( € / $)
and
S a ( € /￡)  S a ($ /￡)  S a ( € / $)

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 Bid-Ask Prices in Cross-Rates

S b (￡/ € )  S b ($ / € )  S b (￡/ $)
S a ( € /￡)  S a ($ /￡)  S a ( € / $)
Intuitive way to understand bid-ask prices in cross rates:
 For the bid prices, if you want to sell € for
￡ , you
need to first sell € for $ , and then to sell $ for ￡ .
 For the ask prices, if you want to buy ￡ using € , you

need to first buy $ using € , and then to buy ￡ using $.

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 Bid-Ask Prices in Cross-Rates:
An Example
 Assume that the $/£ bid-ask prices are $1.9072-$1.9077 /
£, and the $/€ bid-ask prices are $1.3108-$1.3112 /€.
What are the €/ £ bid-ask prices ？ 　
 We’ve already computed the £/$ bid-ask prices as follows:

S b (£ / $)  £0.5242/$
{ a .
S (￡ / $)  £0.5243/$
 Similarly, the €/$ bid-ask prices can be computed as €0.7627-
€0.7629/$

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 Bid-Ask Prices in Cross-Rates:
An Example
 Assume that the $/£ bid-ask prices are $1.9072-$1.9077 /
£, and the $/€ bid-ask prices are $1.3108-$1.3112 /€.
What are the €/ £ bid-ask prices ？ 　
 The €/ £ bid-ask prices are thus
S b ( € /￡)  S b ($ /￡)  S b ( € / $)
 1.9072　  0.7627= € 1.4546／￡
 and
S a ( € /￡)  S a ($ /￡)  S a ( € / $)
＝1.9077  0.7629= ￡1.4554/ €

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Triangular Arbitrage, the Old Example

Suppose we
$
observe these
Barclays
banks posting Credit Lyonnais
these exchange S(¥/$)=100
S($/£)=2.00
rates.

¥ Credit Agricole
Is there any £
arbitrage S(¥/£)=210
opportunity?

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Triangular Arbitrage with Bid-Ask Spreads

Suppose the
following bank Barclays $
Credit Lyonnais
quotations after
(¥/$)=100
Sb (¥/ S b($/£)=2.00
taking into S a
$)=105
account the bid- S a($/£)=2.05
ask spreads.
Credit Agricole
Does there still ¥ £
S (¥/£)=210
b
exist an arbitrage
opportunity? S a (¥/£)=215

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Triangular Arbitrage with Bid-Ask Spreads

What if we use
the old strategy? Barclays $
Credit Lyonnais
1. Sell ¥ for $, (¥/$)=100
Sb (¥/ S b($/£)=2.00
a
S $)=105
2. Sell $ for £, S a($/£)=2.05

3. Sell £ for ¥ Credit Agricole

¥ £
S (¥/£)=210
b

S a (¥/£)=215

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Triangular Arbitrage with Bid-Ask Spreads
b a 1
 Sell ¥10,000,000 for $ at S ($/¥) =1/ S (¥/$)=¥ 105 /$, and
receive $95,238
b 1
 Sell $ 95,238 for £ at S (£/$) = 1/ S a ($/£)=£ 2.05 /$, and
receive £46,458
b
 Sell £46,458 for ¥ at (¥/ £)=¥210/£, and receive ¥
S
9,756,180

Loss per round trip is ¥243,820 ！

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Triangular Arbitrage with Bid-Ask Spreads

What if we go
counter- Barclays $
Credit Lyonnais
clockwise?
(¥/$)=100
Sb (¥/ S b($/£)=2.00
a
1. Sell ¥ for £, S $)=105
S a($/£)=2.05
2. Sell £ for $,
Credit Agricole
¥ £
3. Sell $ for ¥ S (¥/£)=210
b

S a (¥/£)=215

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Triangular Arbitrage with Bid-Ask Spreads
b a 1
 Sell ¥10,000,000 for £ at S (£/¥) =1/ S (¥/£)=¥ 215 /£, and
receive £46,512.
b
 Sell £ 46,512 for £ at S ($/£) = $ 2.00/£, and receive
$93,023.
b
 Sell $93,023 for ¥ at (¥/$)=¥100/$, and receive ¥
S
9,302,000

Loss per round trip is ¥698,000, which is even more ！

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 A Question about Bid-Ask Price
for Cross Rate
 Given the following information, what are the
NZD/SGD currency against currency bid-ask
quotations?
American Terms European Terms
Bid Ask Bid Ask
NZD .7265 .7272 1.3751 1.3765
SGD .6135 .6140 1.6287 1.6300

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 Bid-Ask Spread in Interest Rates
 If you deposit an amount in Hang Seng bank, the rate
that you get is the ___ rate. If you obtain a loan from
Hang Seng bank, the rate that you pay is the ___ rate.
 The difference between the two rates is the bid-ask
spread in interest rates, which is already quoted in
percentages.
 Bid-ask spread in interest rates is the foundation for
the traditional banking business.

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 Bid-Ask Spread in Interest Rates
 Much analysis of bid-ask spread in the FX
market can be used to analyze the bid-ask
spread in interest rates:
 If you borrow from the bank and then deposit the
amount into the same bank, you will lose money.
 Competition among banks tend to decrease the spread.
 Arbitrage profits can be partly or even completely eaten
by interest rate bid-ask spreads.

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 Bid-Ask Spread in Interest Rates
 Whereas (percentage) bid-ask spreads in the
FX market tend to be lowest, bid-ask spreads
in deposits/loans tend to be the highest. The
possible reasons are:
 Less competition
 High operation costs
 The rates for loans are risk-adjusted.

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 Covered Interest Rate Arbitrage,
the Old Example

Spot exchange rate S($/£) = 1.25 $ /£

360-day forward rate F360($/£) = 1.22 $ /£

U.S. interest rate i$ = 7.10%

British interest rate i£ = 11.56%

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 Covered Interest Rate Arbitrage
with Bid-Ask Spreads
Spot exchange rate S b ($/£) = 1.25 $ /£
S a ($/£) = 1.26 $ /£
b
360-day forward rate F360 ($/£) = 1.22 $ /£
a
F360 ($/£) = 1.23 $ /£

U.S. interest rate i$b = 7.10%

i$ a = 8.5%

British interest rate i£b = 11.56%

i£ a = 14%

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 Covered Interest Rate Arbitrage
with Bid-Ask Spreads
Computations using the average of bid-ask prices:
F$b/ £  F$a/ £
2  i£b  i£a  1.225
1   1  (1  12.78%)  1
S$b/ £  S$a/ £  2  1.255
2
i$b  i$a
 10.08%   7.8%
2
Does it imply that a CIA opportunity exist?
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 Step 2: The Old Strategy
buy pounds £794
1
£794 = $1,000× Step 3:
S a ($ / £) Invest £794 at
ii££b = 11.56%
$1,000 In one year £794
i$ a will be worth
£885.40 =
Step 4: sell £794(1+ i£b )
Step 1: pounds forward
borrow $1,000
Step 5: Repay Less b
$1,080= £885.40  F360 ($ / £)
than $1,085!
your dollar loan
with $1,085=$
1000(1+ i$ a )
For each $1,000, you lose $5!
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 Step 2: Alternative Strategy
buy dollars
£800
Step 1:
b
1,000$= £800× S ($ / £) borrow £800
Step 5: Repay
$1,000 your pound loan
Step 3: with £912 =
i$ a
Invest $1,000 a
£800 ×(1+ i£ ) .
at i$ b

Step 4: sell Less than £912!

In one year $1,000 dollars forward
will be worth 1
$1,071=$1,000× 871£ ＝ $1,071× a
b
F360 ($ / £)
(1+ i$ )

For each £800, you lose £41!

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 Covered Interest Rate Arbitrage
with Bid-Ask Spreads
 In the above example, even though IRP appears to
violated by using the average prices, we do not
have an arbitrage opportunity due to the transaction
costs incurred in both the FX market and the
money market.
 As the result, the “violations of IRP” can persist.
 Recall that another reason for the observed deviations
from IRP is the capital control.

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