IBUS 302: International Finance

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

2. Learning Objectives • Explain the bid-ask spread. • Calculate cross-exchange rates. • Calculate cross-exchange bid-ask spread.▪

3. ‘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.

4. ‘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.

5. ‘Cancelling Currencies’ III • If S($/£) = 1.4557 and S(£/€) = 0.8852, what is S($/€)? • Cancel pounds to get dollars for euros.

6. Bid-Ask Spread

7. 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( )

8. 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 ▪

9. 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. Managing Inventory S($/£) = 1.7768 Big Figure: 1.7700 Little Figure: 0.0068 Average Raise Inventory Lower Inventory 63-68 64-69 62-67 69 68 67 66 65 64 63 62

11. 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

12. 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

13. 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

14. 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.

15. Bid, Ask, American, European • BidAmerican = 1/AskEuropean • BidEuropean = 1/AskAmerican Bid Ask S($/£) $1.9072 $1.9077 American S(£/$) £0.5241 £0.5243 European

16. Cross-Exchange Rates

17. 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. Reading the FX Table Cross-Rates ▪

19. 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

20. 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

21. 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).

22. 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)

23. 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).

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.

25. Bid-Ask Cross-Exchange Rates • Using Method 2 • Multiply two bids to get a bid. • Multiply two asks to get an ask. • Example: