1 (of 24) IBUS 302: International Finance Topic 4-The Bid-Ask Spread and Cross-Exchange Rates Lawrence Schrenk, Instructor.

1 (of 24)

IBUS 302: International Finance

Topic 4-The Bid-Ask Spread and Cross-Exchange Rates

Lawrence Schrenk, Instructor

2 (of 24)

Learning Objectives

1. Explain the bid-ask spread.

2. Calculate cross-exchange rates.

3. Calculate cross-exchange bid-ask spread.▪

‘Cancelling Currencies’ I

Remember high school physics: A car is traveling 20 mile per hour and goes for 3

hours, how far has it gone?

You can cancel ‘units’ like algebraic variables to find the correct units of the answer.

3 (of 24)

miles20 × 3 hours = 60 miles

hour

‘Cancelling Currencies’ II

You can cancel currency units the same way:

If S($/£) = 1.4557, how many dollars do you get for £25.00?

Cancel pounds to get dollars.

4 (of 24)

$S($/£) = S

£

$1.4457 × £25.00 $36.1425

£

‘Cancelling Currencies’ III

If S($/£) = 1.4557 and S(£/€) = 0.8852, what is S($/€)?

Cancel pounds to get dollars for euros.

5 (of 24)

$ £ $1.4457 × 0.8852 1.2797

£ € €

6 (of 24)

Bid-Ask Spread

7 (of 24)

Bid-Ask Spread

Definition: ‘Bid Price’, ‘Ask Price’ Bid price = price to buy Ask price = price to sell

Definition: ‘Spread’ Spread = Ask – Bid

Notation Bid Sb( ) Ask Sa( )

Terminology

S($/£) = 1.7768 ▪

Big Figure: 1.7700 Little Figure: 0.0068 ‘Points’ (or ‘Pips’)

One point is 0.0001 (0.01%) 12 points is 0.0012 (0.12%)

Spread in ‘points’, e.g., a spread of ‘6 points’. 1.7762-68 ▪

8 (of 24)

9 (of 24)

The ‘Market Maker’

Buy and Sell Order not Automatically Matched

Role of Dealers and Inventory Ask price > Bid price

Traders need to sell higher than they buy The spread compensates for costs and risk

commission/brokerage fee

10 (of 24)

Managing InventoryS($/£) = 1.7768

Big Figure: 1.7700 Little Figure: 0.0068

69

68

67

66

65

64

63

62

Average Raise Inventory Lower Inventory

63-68 64-69 62-67

The Spread

Dealer Costs: Order Processing Costs Inventory Holding Risks Information Costs of Market Making

Determinants of Spreads: Exchange Rate Volatility (Market Uncertainty) Trading Volume Number of Dealers (Market Competition) Order Sizes

11 (of 24)

Spread Characteristics

Narrower New York and London More Competition

Wider High Volatility or Exchange Crisis Rarely Traded Currencies

NOTE: The quoted FX rates are usually the ask/selling prices

12 (of 24)

Wholesale vs. Retail

Wholesale Interbank Trading Foreign exchange dealers in different banks in

major financial centers Spread normally 10 points (0.1%)

Retail Corporate Customers Larger Spread

13 (of 24)

Dealer Revenues

Most wholesale, standard-size transactions are for $10m or more, so the spread generates profits even though it is very low

A 1 point spread on dollars to pounds S($/£) = 1.90 $10m x £0.0001/$ = £1000 per point Or about $1,900 per point

NOTE: A £ point ≠ $ point.

14 (of 24)

15 (of 24)

Bid Ask

S($/£) $1.9072 $1.9077 American

S(£/$) £0.5241 £0.5243 European

Bid, Ask, American, European

BidAmerican = 1/AskEuropean

BidEuropean = 1/AskAmerican

16 (of 24)

Cross-Exchange Rates

17 (of 24)

Cross-Exchange Rates

‘Currency against currency’ trade is a non-dollar to non-dollar trade

Cross-exchange rate: the exchange rate between two non-dollar currencies

You can find the cross exchange rate ‘through’ the US dollar.

18 (of 24)

Reading the FX Table

Cross-Rates ▪

Directly Traded Cross Rates

Directly Traded Cross Rates Market Quotation Sufficient Volume and Liquidity Expanded in 1980s and ’90s Cross-rates must be internally consistent.

No Arbitrage Triangular Arbitrage EXAMPLES: Euro and Non-Euro European

Currencies, EUR/JPY, AUD/JPY

19 (of 24)

Derived Cross Rates

Derived (or Implied) Cross Rates Many currencies pairs are less actively traded Traded through another currency Calculation

‘Vehicle’ Currency More than half of all trades are against $ Lower transactions costs in $ trades €, ¥ also function as lesser vehicle currencies

20 (of 24)

21 (of 24)

Cross-Exchange Rate Formulae: Method 1

How many euro's for one pound? Method 1

Notes: Both are in American terms. The first currency (€) goes into the denominator (bottom) The second currency (£) goes into the numerator (top)NOTE: By ‘first currency’, I mean the first currency in the spot formula, i.e., X, in S(X/Y).

American TS e$/ rmS( / ) =

S($

s

American

££

T/ )€

€ erms

22 (of 24)

Method 1: Example Find S(¥/€)–How many yen for a euro?

If S($/€) = 1.4497 and S($/¥) =0.009228

Notes: Both are in American terms. The first currency (¥) goes into the denominator (bottom) The second currency (€) goes into the numerator (top)

American Terms

American Ter

S $/ 1.449¥

7S( / ) = 157.0980

S($/ ) 0.00

€€

¥ 9228ms

23 (of 24)

Cross-Exchange Rate Formulae : Method 2 How many euro's for one pound? Method 2

Notes: One in American terms; one in European terms The first currency (€) is in European terms. The second currency (£) is in American terms. The order of multiplication does not matter.NOTE: By ‘first currency’, I mean the first currency in the spot formula, i.e., X, in S(X/Y).

S(€/£) = S $/£ × S(€/$)

$ € €

Ame

= S

rican Terms × Euro

×

pean Term

S = S = S(€/£) £ $ £

s

24 (of 24)

Cross-Exchange Rate Formulae : Method 2 Find S(¥/€)–How many yen for a euro?

if S($/€) = 1.4497 and S($/¥) =0.009228

Notes: The first currency is in European terms. The second currency is in American terms. The order of multiplication does not matter. NOTE: When dealing in yen there can be rounding error.

S(¥/€) = S $/€ × S(¥/$) = 1.4497 × 108.3650 = 157.0

American Terms

967

× European T erms

25 (of 24)

Bid-Ask Cross-Exchange Rates

Using Method 2 Multiply two bids to get a bid. Multiply two asks to get an ask.

Example:

b b bS (¥/€) = S $/€ × S (¥/$)

American Terms × European TermsbS (¥/€) = 1.4497 × 108.3650 = 157.0967