Network of financial institutions and brokers in which individuals, businesses, banks, and governments buy and sell the currencies of different countries The liquidity of the market provides businesses with access to international markets for goods and services by providing foreign currency necessary for transactions worldwide
The bid price is the price at which the market is willing to buy a particular currency The ask price is the price at which the market is willing to sell a particular currency Convert From/ToDollarPoundFFrancDMarkYen Dollar Pound FFranc DMark Yen
1. Direct quote: $.6149/DM 2. Indirect quote (reciprocal rate): DM1.6263/$ = 1/ Bid rate = $.6149/DM (price bid by broker to purchase DM) Ask rate = $.6273/DM =1/1.594 (price asked by broker to sell DM) Spread = $.0124 = transaction cost
Objectives ◦ Minimize cost of funds ◦ Improve liquidity ◦ Reduce risks ◦ Improve return on investment Cash inflows and outflows Beginning cash balance Collections Disbursements Ending cash balance Investing surplus cash Covering cash shortage Ending cash required
Compare direct rates to cross rates to identify attractive exchange opportunities: ◦ Direct rate to convert £ to DM = DM2.607/£ ◦ Cross rate DM/£ using $: Convert £ to $ ($1.665/£) and then convert $ to DM (DM1.594/$): ($1.665/£) * (DM1.594/$ )= DM2.654/£ ◦ This particular cross rate of £ to $ to DM is more attractive than converting £ directly to DM.
Bilateral arbitrage opportunity: Assume you can convert your $ into € with a broker in New York and then convert each € with a broker in Frankfurt for $1.346: New YorkFrankfurt $ / € € /$ € /$$1.346/ € _____ $1 € * $1.346/ € $1.0002
New York FrankfurtZurich € /$ CHF1.326/€ $1.016/CHF $1 € * CHF1.326/€ CHF.9854 * $1.016/CHF $ Foreign exchange market efficiency – Foreign exchange rates reflect all publicly available information