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)

Cancelling Currencies II You can cancel currency units the same way: If S($/£) = , how many dollars do you get for £25.00? Cancel pounds to get dollars. 4 (of 24)

Cancelling Currencies III If S($/£) = and S(£/) = , what is S($/)? Cancel pounds to get dollars for euros. 5 (of 24)

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 BidS b ( ) AskS a ( )

Terminology S($/£) = Big Figure: Little Figure: Points (or Pips) One point is (0.01%) 12 points is (0.12%) Spread in points, e.g., a spread of 6 points (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 Inventory S($/£) = Big Figure: Little Figure: Average Raise Inventory Lower Inventory

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($/£) $ $1.9077American S(£/$) £0.5241£0.5243European Bid, Ask, American, European Bid American = 1/Ask European Bid European = 1/Ask American

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 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).

22 (of 24) Method 1: Example Find S(¥/)–How many yen for a euro? If S($/) = and S($/¥) = Notes: Both are in American terms. The first currency ( ¥) goes into the denominator (bottom) The second currency ( ) goes into the numerator (top)

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).

24 (of 24) Cross-Exchange Rate Formulae : Method 2 Find S(¥/)–How many yen for a euro? if S($/) = and S($/¥) = 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 (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: