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The Spot Market

• Spot Rate Quotations


• The Bid-Ask Spread
• Spot FX trading
• Cross Rates
Spot Rate Quotations
• Direct quotation
– the U.S. dollar equivalent
– e.g. “a Japanese Yen is worth about a penny”
• Indirect Quotation
– the price of a U.S. dollar in the foreign
currency
– e.g. “you get 100 yen to the dollar”
Spot Rate Quotations
USD equiv USD equiv Currency per Currency per
Country Friday Thursday USD Friday USD Thursday

Argentina (Peso) 0.3309 0.3292 3.0221 3.0377

Australia (Dollar) 0.7830 0.7836 1.2771 1.2762

Brazil (Real) 0.3735 0.3791 2.6774 2.6378

Britain (Pound) 1.9077 1.9135 0.5242 0.5226

1 Month Forward 1.9044 1.9101 0.5251 0.5235

3 Months
Forward 1.8983 1.9038 0.5268 0.5253

6 Months
Forward 1.8904 1.8959 0.5290 0.5275

Canada (Dollar) 0.8037 0.8068 1.2442 1.2395

1 Month Forward 0.8037 0.8069 1.2442 1.2393

3 Months
Forward 0.8043 0.8074 1.2433 1.2385

6 Months
Forward 0.8057 0.8088 1.2412 1.2364
Spot Rate Quotations

USD equiv USD equiv Currency per Currency per


Country Friday Thursday USD Friday USD Thursday
Argentina (Peso) 0.3309 0.3292 3.0221 3.0377
Australia (Dollar) 0.7830 0.7836 1.2771 1.2762
The direct quote for
Brazil (Real) 0.3735 0.3791 2.6774 2.6378 British pound is:
Britain (Pound) 1.9077 1.9135 0.5242 0.5226
£1 = $1.9077
1 Month Forward 1.9044 1.9101 0.5251 0.5235
3 Months
Forward 1.8983 1.9038 0.5268 0.5253
6 Months
Forward 1.8904 1.8959 0.5290 0.5275
Canada (Dollar) 0.8037 0.8068 1.2442 1.2395
1 Month Forward 0.8037 0.8069 1.2442 1.2393
3 Months
Forward 0.8043 0.8074 1.2433 1.2385
6 Months
Spot Rate Quotations

USD equiv USD equiv Currency per Currency per The indirect quote
Country Friday Thursday USD Friday USD Thursday for British pound
Argentina (Peso) 0.3309 0.3292 3.0221 3.0377 is:
Australia (Dollar) 0.7830 0.7836 1.2771 1.2762 £.5242 = $1
Brazil (Real) 0.3735 0.3791 2.6774 2.6378
Britain (Pound) 1.9077 1.9135 0.5242 0.5226
1 Month Forward 1.9044 1.9101 0.5251 0.5235
3 Months
Forward 1.8983 1.9038 0.5268 0.5253
6 Months
Forward 1.8904 1.8959 0.5290 0.5275
Canada (Dollar) 0.8037 0.8068 1.2442 1.2395
1 Month Forward 0.8037 0.8069 1.2442 1.2393
3 Months
Forward 0.8043 0.8074 1.2433 1.2385
6 Months
Spot Rate Quotations

USD equiv USD equiv Currency per Currency per Note that the
Country Friday Thursday USD Friday USD Thursday direct quote is the
Argentina (Peso) 0.3309 0.3292 3.0221 3.0377 reciprocal of the
Australia (Dollar) 0.7830 0.7836 1.2771 1.2762 indirect quote:
Brazil (Real) 0.3735 0.3791 2.6774 2.6378
Britain (Pound) 1.9077 1.9135 0.5242 0.5226
1 Month Forward 1.9044 1.9101 0.5251 0.5235
3 Months
Forward 1.8983 1.9038 0.5268 0.5253
1
6 Months
Forward 1.8904 1.8959 0.5290 0.5275 1.9077 =
Canada (Dollar) 0.8037 0.8068 1.2442 1.2395
.5242
1 Month Forward 0.8037 0.8069 1.2442 1.2393
3 Months
Forward 0.8043 0.8074 1.2433 1.2385
6 Months
The Bid-Ask Spread
• The bid price is the price a dealer is willing
to pay you for something.
• The ask price is the amount the dealer
wants you to pay for the thing.
• The bid-ask spread is the difference
between the bid and ask prices.
The Bid-Ask Spread
• A dealer could offer
– bid price of $1.25 per €
– ask price of $1.26 per €
– While there are a variety of ways to quote that,
• The bid-ask spread represents the
dealer’s expected profit.
The Bid-Ask Spread

big figure small figure

Bid Ask
S($/£) 1.9072 1.9077
S(£/$) .5242 .5243
• A dealer would likely quote these prices as 72-
77.
• It is presumed that anyone trading $10m
already knows the “big figure”.
Cross Rates
• Suppose that S($/€) = 1.50
– i.e. $1.50 = €1.00
• and that S(¥/€) = 50
– i.e. €1.00 = ¥50
• What must the $/¥ cross rate be?
$1.50 €1.00 $1.50
× =
€1.00 ¥50 ¥50
$1.00 = ¥33.33
$0.0300 = ¥1
Triangular Arbitrage

Suppose we observe
these banks posting $
these exchange rates.
Barclays
Credit Lyonnais
S(¥/$)=120
S(£/$)=1.50

¥ Credit Agricole
First calculate any implied £
cross rate to see if an
arbitrage exists. S(¥/£)=85

£1.50 $1.00 £1.00


× =
$1.00 ¥120 ¥80
Triangular Arbitrage
As easy as 1 – 2 – 3:
$
1. Sell our $ for £, Barclays
2. Sell our £ for ¥, Credit Lyonnais
S(¥/$)=120 3 1
3. Sell those ¥ for $. S(£/$)=1.50
2

¥ Credit Agricole
£
S(¥/£)=85
Triangular Arbitrage
Sell $100,000 for £ at S(£/$) = 1.50
receive £150,000
Sell our £150,000 for ¥ at S(¥/£) = 85
receive ¥12,750,000
Sell ¥12,750,000 for $ at S(¥/$) = 120
receive $106,250
profit per round trip = $106,250 – $100,000 = $6,250
Triangular Arbitrage
Here we have to go “clockwise” to
make money—but it doesn’t
matter where we start.
$
Barclays
Credit Lyonnais
S(¥/$)=120 2 3 S(£/$)=1.50
1

¥ Credit Agricole
£
S(¥/£)=85
If we went “counter clockwise” we would be the source of arbitrage profits, not the
recipient!
Triangular Arbitrage
• As a quick spot method for triangular arbitrage, write the three rates out with
a different denominator in each:
– 1.3285 CHF / USD
– 0.00851 USD / JPY
– 88.20 JPY / CHF
• If there is parity:
CHF USD JPY
  =1
USD JPY CHF

– If this is greater, or less than, 1 an arbitrage opportunity exists.


– An answer < 1 means that one of the component rates (fractions) is too low. An
answer > 1 mean that one of the rates is too high.
– If the total is less than one, assume that any of the fractions is too low, e.g. CHF/USD.
This would imply that CHF is too low (overvalued vs USD) or USD is too high
(undervalued vs CHF); this tells us to either buy the undervalued or sell the
overvalued currency.
The Forward Market
• A forward contract is an agreement to buy
or sell an asset in the future at prices
agreed upon today.
Forward Rate Quotations
• The forward market for FX involves
agreements to buy and sell foreign
currencies in the future at prices agreed
upon today.
• Bank quotes for 1, 3, 6, 9, and 12 month
maturities are readily available for forward
contracts.
• Non Deliverable Forwards
Forward Rate Quotations
• Consider the example from above:
for British pounds, the spot rate is
$1.9077 = £1.00
While the 180-day forward rate is
$1.8904 = £1.00
• What’s up with that?
USD
equiv USD equiv Currency per Currency per
Country Friday Thursday USD Friday USD Thursday
Argentina
(Peso) 0.3309 0.3292 3.0221 3.0377
Australia
(Dollar) 0.7830 0.7836 1.2771 1.2762
Brazil (Real) 0.3735 0.3791 2.6774 2.6378 Clearly the market
Britain participants
(Pound) 1.9077 1.9135 0.5242 0.5226 expect that the
1 Month pound will be
Forward 1.9044 1.9101 0.5251 0.5235
worth less in
3 Months dollars in six
Forward 1.8983 1.9038 0.5268 0.5253
months.
6 Months
Forward 1.8904 1.8959 0.5290 0.5275
Canada
(Dollar) 0.8037 0.8068 1.2442 1.2395
1 Month
Forward 0.8037 0.8069 1.2442 1.2393
3 Months
Forward 0.8043 0.8074 1.2433 1.2385
6 Months
Forward 0.8057 0.8088 1.2412 1.2364
Forward Rate Quotations
• Consider the (dollar) holding period return of
a dollar-based investor who buys £1 million
at the spot and sells them forward:
gain $1,890,400 – $1,907,700 –$17,300
$HPR= = =
pain $1,907,700 $1,907,700

$HPR = –0.0091

Annualized dollar HPR = –1.81% = –0.91% × 2


Forward Premium
• The interest rate differential implied by
forward premium or discount.
• For example, suppose the € is appreciating
from S($/€) = 1.25 to F180($/€) = 1.30
• The 180-day forward premium is given by:
F180($/€) – S($/€) 360 1.30 – 1.25
f180,€v$ = × = ×2 = 0.08
S($/€) 180 1.25
Long and Short Forward
Positions
• If you have agreed to sell anything (spot or
forward), you are “short”.
• If you have agreed to buy anything
(forward or spot), you are “long”.
• If you have agreed to sell FX forward, you
are short.
• If you have agreed to buy FX forward, you
are long.
Payoff Profiles
profit If you agree to sell anything in the future at a set
price and the spot price later falls then you gain.

S180($/¥)
0

F180($/¥) = .009524
If you agree to sell anything in the future at a set
price and the spot price later rises then you lose.

loss Short position


Payoff Profiles
profit
short position
Whether the payoff
profile slopes up or down
depends upon whether
you use the direct or
indirect quote:

0 F (¥/$) = 105 or
S180(¥/$)180
F180($/¥) = .009524.
F180(¥/$) = 105

-F180(¥/$)
loss
Payoff Profiles
profit
short position

S180(¥/$)
0

F180(¥/$) = 105
When the short entered into this forward
contract, he agreed to sell ¥ in 180 days at
-F180(¥/$)
loss F180(¥/$) = 105
Payoff Profiles
profit
short position

15¥

S180(¥/$)
0
120
F180(¥/$) = 105
If, in 180 days, S180(¥/$) = 120, the short will make
a profit by buying ¥ at S180(¥/$) = 120 and
-F180(¥/$)
loss delivering ¥ at F180(¥/$) = 105.
Payoff Profiles
profit Since this is a zero-sum game, the long position
F180(¥/$) payoff is the opposite of the short. short position

S180(¥/$)
0

F180(¥/$) = 105

-F180(¥/$) Long position


loss
Payoff Profiles
profit
The long in this forward contract agreed to BUY
-F180(¥/$)
¥ in 180 days at F180(¥/$) = 105
If, in 180 days, S180(¥/$) = 120, the long will
lose by having to buy ¥ at S180(¥/$) = 120
and delivering ¥ at F180(¥/$) = 105.
S180(¥/$)
0
120
F180(¥/$) = 105
–15¥
Long position
loss

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