University of Sydney
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Introduction
This week, we will:
learn about the mechanics of the spot exchange market.
understand various ways in which exchange rates can be quoted, and study how the
exchange markets themselves operate.
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Exchange Rate: Definition
Definition
An exchange rate is the amount of a currency that one needs in order to buy one unit of another
currency, or it is the amount of a currency that one receives when selling one unit of another
currency.
An example of an exchange rate quote is 0.8 USD per CAD (which we will usually denote
as ‘USD/CAD 0.8’): you can, for instance, buy a CAD by paying USD 0.80.
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Naming Convention
In the above, we have combined currency names following the conventions in physics:
EUR/USD means euros per dollar, just as ‘km/h’ means kilometers per hour.
This is the most logical convention. For instance, if you exchange 3 million USD into EUR
at a rate of 0.8 EUR per USD, the result is 2.4 million EUR – a number of euros.
This fits with our notation:
USD 3 million× EUR/USD 0.8 = EUR 2.4 million
This may seem self-evident.
BUT pros do it differently.
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Naming Convention (contd.)
In the convention typically adopted by traders, bankers, and journalists, EUR/USD is not
the dimension of the quote but the name of the exchange rate: it is the value of the euro,
expressed in dollars, not its dimension.
▶ The pros write ‘EUR/USD = 1.2345’, whereas we write ‘St = USD/EUR 1.2345’.
▶ That is, the dimension the trader asks for is USD/EUR, the inverse of what they
write—but they do not mean a dimension, they mean a name.
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Naming Convention (contd.)
In all examples in this lecture, we use dimensions.
To harden yourself, stare at the following entries for a full minute:
Currency Name Value
EUR/USD USD/EUR 0.75
EUR/GBP GBP/EUR 0.60
USD/CHF CHF/USD 1.05
The telltale difference is that the dimension is immediately followed (or, occasionally,
preceded) by the number.
In FINC5090, we will work with dimension, i.e., USD/EUR = 1.2345 should be
understood as 1 EUR = 1.2345 USD.
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Quotation Convention
It is even more crucial that you understand how exchange rates are quoted.
▶ Which currency should be used as the nume´raire?
▶ Buying money with money is different from our standard convention of buying
goods and services.
▶ With exchange transactions, you need to agree on which money is being bought or
sold.
▶ There would be no ambiguity if one of the currencies were your home currency.
▶ A purchase then means that you obtained foreign currency and paid in home
currency, the way you would do it with your other purchases too.
▶ A sale means that you delivered foreign currency and received home currency.
▶ If neither currency is your home currency, then you need to establish which of the
two acts as the home currency.
Among pros, the currency in which the price is expressed is called the quoting currency,
and the currency whose price is being quoted is called the base currency or reference
currency.
We have just noted that pros denote a rate as base/quoting (or, better, base:quoting)
while its dimensions are quoting/base. A different issue is whether the quoting currency is
the home or the foreign one.
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FINC5090 Convention: Home Currency per Unit of Foreign Currency
Once we agree on which country is, or acts as the home country, we can agree to quote
exchange rates as the price in units of home currency (HC) per unit of foreign currency
(FC). That is, we quote the rate as HC/FC throughout this course, meaning that one unit
of FC is worth n HC units (dimension HC/FC).
As we shall see,
Expressing prices in HC is the convention for financial assets.
▶ Thus, standard finance results hold: the current market value is the expected future
value (including interest earned), discounted at a rate that takes into account the
risk.
Some people do it differently and state that, with one unit of home currency, they can
buy M = 1/N units of foreign currency (FC/HC).
▶ Confusing. Why?
▶ Under the alternative quotation, confusingly, the current value would be determined
by the inverse of the expected inverse of future value, multiplied by unity plus the
required return.
The direct (HC/FC) quoting convention used to be standard in continental Europe, and is
called the direct quote, or the right quote. In the United States, a price with dimension
USD/FC is called American terms.
The alternative is called the indirect or left quote (i.e., FC/HC) or, in the United States,
European terms.
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The Indirect Quoting Convention: A Historical Perspective
One group of people using mostly indirect quotes are professional traders in the United
States.
Between 1944 and the mid-1980s, each and every exchange deal went through the USD.
▶ For instance, a German needed to buy CHF, the DEM would first be converted into
USD, and these dollars were then exchanged for CHF.
▶ When New York traders talk to, say, their German counterparts, both must talk the
same language, quotewise.
▶ Both Germans and Americans actually preferred to quote in terms of DEM/USD
rather than USD/DEM, for the simple reason that the official parities, set by the
German government, were expressed in DEM/USD.
▶ More generally, U.S. professionals use the exchange-rate convention as quoted in
the other country.
⋆ Japan uses direct quotes, so a US trader will quote JPY/USD (HC/FC) to
Japanese counterparts.
⋆ UK uses indirect quotes, so a US trader will quote USD/GBP (FC/HC) to
UK counterparts.
The UK (and commonwealth countries like Australia and New Zealand) use indirect
quotation because GBP once was the World’s reserve currency.
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Bid and Ask Rates
When you deal with foreign currency, you will discover that you pay a higher price at the
time of purchase than when you sell one currency for another.
▶ For example, for dollar–rouble deals the currency booth in your hotel will quote two
numbers, say RUB/USD 35–36.
▶ This means that if you sell USD for RUB, you receive RUB 35, while if you wish to
buy USD you will have to pay RUB 36.
The rate at which the bank will buy a currency from you is called the bid rate: they bid
(i.e., they announce that they are willing to pay) RUB 35 per dollar.
The rate at which the bank will sell a currency to you is the ask rate (they ask RUB 36
per dollar).
No bank will allow you to buy low and then immediately resell at a profit without taking
any risk.
Just remember that you buy at the bank’s ask rate, and you sell at the bank’s bid rate. In
theory, there could still be room for a situation ‘bid rate = ask rate’, which offers no such
arbitrage opportunities.
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Bid and Ask Rates (contd.)
Yet the real-world situation is invariably ‘bid rate < ask rate’: banks want to make some
money from foreign-currency transactions.
Another way to think of this difference between the ask and the bid rates is that the
difference contains the bank’s commission for exchanging currencies.
The difference between the buying and selling rates is called the spread, and you can think
of the bank’s implicit commission as being equal to half the spread.
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Primary Rates versus Cross Rates
As of 1945 and until well into the 1980s, all exchange rates in the wholesale segment were
against the USD. They were and are called primary rates, while any rate not involving the
USD would be called a cross rate and would traditionally be regarded as just implied by
the primary rates.
The primary rates are in the first column (FC/USD) or the bottom line (USD/FC).
The rest of the table is obtained by division or multiplication: GBP/EUR = GBP/USD ×
USD/EUR, for example. Each of the resulting new rows or columns is a set of quotes in
HC/FC (row) or FC/HC (column). 12 / 28
Primary Rates versus Cross Rates (contd.)
Why, among pros, there were, until the 1980s, just primary rates?
▶ There were several reasons.
▶ Official parities were against the USD; there was no official parity (in the sense of
being defended by any central bank) for rates against other currencies.
▶ The USD market had the lowest spreads, so all real-world transactions would
effectively be done via the dollar anyway. The cross-rate would just be the rate
implied by the two primary rates used in the transaction.
▶ In pre-electronic days, it would be quite laborious to keep track of n(n−1)
2
entries,
where n equals the number of currencies. So rather than quoting cross rates all the
time, banks just showed primary quotes and then computed cross rates if and when
needed.
Due to technology advancements and an increase in cross volume transactions, we now
see explicit quotes for some of the cross rates.
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Inverting Exchange Rates in the Presence of Spreads
The rule is that the inverse of a bid quote is an ask quote, and vice versa.
To conceptualize this, consider an Indian investor who wants to convert her CAD into
USD and contacts her house bank, Standard Chartered.
▶ Being neither American nor Canadian, the bank has no natural preference for either
currency and might quote the exchange rate as either USD/CAD or CAD/USD.
▶ The Indian bank would make sure that its potential quotes are perfectly compatible.
▶ If it quotes from a Canadian viewpoint, the bank gives a CAD/USD quote, which
says how many CAD the investor must pay for 1 USD, for instance, CAD/USD 1.5.
▶ If it uses the U.S. perspective, the bank gives a USD/CAD quote, which says how
many USD the U.S. investor gets for 1 CAD, 0.66667.
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Inverting Exchange Rates in the Presence of Spreads (contd.)
The bank’s alternative ways of quoting will be fully compatible if
S
CAD/USD
bid,t =
1
S
USD/CAD
ask,t
S
CAD/USD
ask,t =
1
S
USD/CAD
bid,t
To fully understand this, recall that the ask is the higher of the two quotes.
But if you invert two numbers, the inverse of the larger number will, of course, be smaller
than the inverse of the smaller number.
Because the inverse of a larger number is a smaller number, the inverse ask must become
the bid, and vice versa.
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Inverting Exchange Rates in the Presence of Spreads (contd.)
One corollary is that in countries like the United Kingdom, where the reverse or indirect
quote is used, the rate relevant when you buy is the lower of the two, while the higher
quote is the relevant rate when you sell.
Thus, it is important to be aware of what the foreign currency is, and what convention is
being used for quoting the exchange rate.
Again, it is always easier and more convenient to have foreign currency in the denominator.
That way, the usual logic will work: banks buy low and sell high.
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How Exchange Markets Work
Unlike stock and futures markets, the forex market is an unorganized market.
▶ Consists of a wholesale tier, an informal network of banks and currency brokerages.
At any point in time, wholesale exchange markets on at least one continent are active so
that the worldwide exchange market is open twenty-four hours a day.
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How Exchange Markets Work (contd.)
Until the 1990s, .
▶ Most interbank dealing was done over the telephone.
▶ Most conversations were tape-recorded, later confirmed by mail, telex, or fax.
▶ Reuters, which was already omnipresent with its information screens, and EBS6
have now built computer networks that allow direct trading and which now largely
replace the phone market.
▶ The way the computer systems are used depends on the role the bank wants to
play. We make a distinction between deals via (i) market makers, (ii) auction
platforms, or (iii) brokers.
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Market Makers
If a market-making credit agreement between two banks has been signed,
▶ Either party undertakes to provide a two-way quote (bid and ask) when solicited by
the other party.
▶ This is done without even knowing whether that other party intends to buy or
rather sell.
▶ Such a quote is binding: market makers undertake to effectively buy or sell at the
price that was indicated.
There are limits to the market makers’ commitments to their quotes.
▶ First, potential customers should decide almost immediately whether to buy
(“mine”), or to sell (“yours”), or not to deal.
▶ Second, if the intended transaction exceeds a mutually agreed level laid down in the
prior credit agreement – market makers can refuse.
▶ Third, the credit agreement also provides a limit to the total amount of open
contracts that can be outstanding between the two banks at any moment; if the
limit is reached, no more deals are allowed.
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Market Making: Implications
What are the implications for market-making for the size of the bid-ask spread and the
maximum order size?
The lower the volume in a particular market, the higher the spread.
▶ During holidays, weekends, or lunch breaks, spreads widen.
▶ Spreads are also higher during periods of uncertainty, including at the open and
close of the market each day.
Maximum order quantities for normal quotes follow a similar pattern.
▶ A market maker is prepared to handle large lots if the market is liquid (thick) or the
volatility is low.
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Market Making: Explanations Behind Implications
All these phenomena are explained by the risk of market making.
If a customer has “hit” a market maker, the latter normally wants to get rid of that new
position quickly.
▶ But in a thin or volatile market, the price may already have moved against the
market maker before he or she was able to close out.
▶ Thus, the market maker wants a bigger commission as compensation for the risk
and puts a lower cap on the size of the deals that can be executed at this spread.
For the same reason, quotes for an unusually large position are wide too.
▶ Getting rid of a very large amount takes more time, during which anything could
happen.
▶ At the retail end of the market, in contrast, the spread increases for smaller
transactions.
▶ This is because 100 small transactions, each for USD 100,000, cost more time and
effort than one big transaction of USD 10m.
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Market Making: Trade Size and Quoted Prices
Notice how the maximum amounts and the spreads relate to each other, presumably both
reflecting liquidity and volatility.
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Market Making: Order Size vs. Spread (contd.)
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Brokers
Another way of shopping around in foreign exchange markets is through currency brokers.
On behalf of a bank or company, the broker would call many market makers and identify
the best counterpart.
Roughly half of the transaction volume in the exchange market used to occur through
brokers.
Nowadays, brokers are mainly used for unusually large transactions, or “structured” deals
involving, say, options next to spot and/or forward; for bread-and-butter deals, their role is
much reduced.
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Markets by Location and by Currency
In April 2007, the daily volume of trading on the exchange market and its satellites –
futures, options, and swaps—was estimated at more than USD 3.2 trillion. This is:
▶ 45 times the daily volume of international trade in goods and services.
▶ 80 times the United States’s daily GDP.
▶ 230 times Japan’s GDP.
▶ 400 times Germany’s GDP.
▶ 7,500 times the world’s official development-aid budget.
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Markets by Location and by Currency (contd.)
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Markets by Delivery Date
The exchange market consists of two core segments: the spot exchange market and the
forward exchange market.
The spot market is the exchange market for quasi-immediate payment (in home currency)
and delivery (of foreign currency).
▶ We denote this spot rate by St , with t referring to the current time.
The forward market is the exchange market for payment and delivery of foreign currency
at some future date, say, three months from now.
▶ We denote this forward rate by Ft,T , with T referring to the future delivery date.
▶ The most active forward markets are for 30, 90, 180, 270, and 360 days, but
nowadays, bankers routinely quote rates up to ten years forward and occasionally
even beyond ten years.
Worldwide, spot transactions represent less than 50% of the total foreign exchange market
volume.
The forward market, together with the closely related swap market, makes up over 50% of
the volume.
About 3% of total trade consists of currency-futures contracts (a variant of forward
contracts traded in secondary markets) and currency options.
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Next Week
We will study some of the important concepts in economics:
▶ The law of one price.
▶ Arbitrage.
▶ Interest rate parity
▶ Purchasing power parity.