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1 (of 24) IBUS 302: International Finance Topic 4-The Bid-Ask Spread and Cross-Exchange Rates Lawrence Schrenk, Instructor

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2 (of 24) Learning Objectives 1. Explain the bid-ask spread. 2. Calculate cross-exchange rates. 3. Calculate cross-exchange bid-ask spread.

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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)

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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. 4 (of 24)

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Cancelling Currencies III If S($/£) = 1.4557 and S(£/) = 0.8852, what is S($/)? Cancel pounds to get dollars for euros. 5 (of 24)

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6 (of 24) Bid-Ask Spread

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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 ( )

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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 8 (of 24)

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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

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10 (of 24) Managing Inventory S($/£) = 1.7768 Big Figure: 1.7700 Little Figure: 0.0068 69 68 67 66 65 64 63 62 Average Raise Inventory Lower Inventory 63-68 64-6962-67

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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)

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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)

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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)

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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)

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15 (of 24) Bid Ask S($/£) $1.9072 $1.9077American S(£/$) £0.5241£0.5243European Bid, Ask, American, European Bid American = 1/Ask European Bid European = 1/Ask American

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16 (of 24) Cross-Exchange Rates

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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.

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18 (of 24) Reading the FX Table Cross-Rates

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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)

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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)

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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).

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22 (of 24) 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)

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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).

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24 (of 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.

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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:

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