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FIN 476. The Spot Market for FOREX. Foreign Exchange Market. currencies (FOREX) are traded in a highly liquid, global market. as the FOREX market is global, it is a 24 hour market, with a new major trading centre somewhere always open.
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FIN 476 The Spot Market for FOREX
Foreign Exchange Market • currencies (FOREX) are traded in a highly liquid, global market • as the FOREX market is global, it is a 24 hour market, with a new major • trading centre somewhere always open • the major participants in the FOREX market are large commercial banks • who buy and sell currencies: • to meet customers needs for currencies • for proprietary trading reasons
The FOREX market can be broken down into two basic parts: • Spot Market • Forward Market • We will look at the spot market right now. • The spot market is the market for immediate exchange of currencies. • “Immediate” is actually a misnomer, actual delivery of currencies which • have been traded occurs through an electronic transfer between bank • accounts two working days after the deal is made. • It is in the spot market that the current exchange rate (the spot rate) • Is determined
Currency Dealers • the large, commercial banks employ currency dealers • it is these people who set exchange rates in response to supply and demand • that they see coming in through orders they receive • a dealer quotes prices at which he or she is willing to transact • the prices are posted electronically, so that the quote is disseminated • around the world to other dealers • a quote actually involves four things: a bid price, an ask price, • a bid depth and an ask depth
Price Quotes • the bid and ask (or offer) prices are the price at which the dealer is • willing to buy and sell the currency, respectively • the depths are the amounts of currency up to which the dealer • guarantees the price quotes • Example: if the depth is $10,000,000 then the price quote is valid • for transactions up to that amount. More than that and the price • would have to be negotiated. • For the bid and ask prices, it will always be the case that: • BID < ASK
the difference between the bid and ask (ask-bid) is the bid-ask spread • the spread is a major source of profits for dealers • dealers profit on every unit of currency they can buy and re-sell through • their quotes • they must set their quotes to try to maximize the volume of trade they • conduct, and also to balance supply and demand • Example: • On September 26, 2003 the quote between the British pound and • US dollar was: • 1.65960/66000 $US/£ This mean the bid price was 1.65960 $US/£ and the ask price was 1.66000 $US/£
Note that because the quote is $US/£, the prices are actually prices for • pounds. • To derive the prices for $US, you must first invert the prices, and then • note that the bid for the pound is the ask for the $US, and the ask for the • pound is the bid for the $US Bid for £ = 1.65960 $US/£ Ask for $US = = 0.60255 £/$US Ask for £ = 1.66000 $US/£ Bid for $US = = 0.60241 £/$US The same quote can be expressed as a quote for $US as: 0.60241/55 £/$US
Triangular Currency Arbitrage • currency prices are quoted in trading centres around the world by many • different dealers • What keeps these different dealers prices “in line” with each other? • if different dealers’ quotes are not consistent with each, then this • may give rise to an arbitrage opportunity • Consider traders in Bahrain, Tokyo and London (all of which are open • simultaneously at one point in the day), each quoting a different currency pair London: $US/€ Tokyo: ¥/$US Bahrain: ¥/€
Say you started with $US and sold them in London for €, then sold the € in Bahrain for ¥, then sold the ¥ in Tokyo for $US • If you end up with more $US than you started with, there is an • arbitrage opportunity • You could make riskless profits instantly. • This would be called triangular currency arbitrage. • Arbitrage opportunities should not exist (for more than a few moments). • This insures that quotes around the work are consistent with each other. London: $US/€ Tokyo: ¥/$US Bahrain: ¥/€