ibus 302: international finance
Post on 23-Feb-2016
19 Views
Preview:
DESCRIPTION
TRANSCRIPT
1 (of 24)
IBUS 302: International FinanceTopic 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 mileshour
‘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)
$ £ $1.4457 × 0.8852 1.2797£ € €
7 (of 24)
Bid-Ask Spread Definition: ‘Bid Price’, ‘Ask Price’
Bid price = price to buy Ask price = price to sell
Definition: ‘Spread’ Spread = Ask – Bid
Notation Bid Sb( ) Ask Sa( )
TerminologyS($/£) = 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
6968676665646362
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 AskS($/£) $1.9072 $1.9077 American
S(£/$) £0.5241 £0.5243 European
Bid, Ask, American, European BidAmerican = 1/AskEuropean
BidEuropean = 1/AskAmerican
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.
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$/ rmS( / ) = S($
sAmerican
££
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 TermsAmerican Ter
S $/ 1.449¥ 7S( / ) = 157.0980S($/ ) 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
top related