INBU 4200 INTERNATIONAL FINANCIAL MANAGEMENT

Lecture 5

Topic: Quoting Currencies

Defining The Foreign Exchange Market The Foreign Exchange Market Performs Three Important

Functions:

(1) Generates rates of exchange. The ratio of one currency to another. These determine costs and returns to global businesses.

(2) Facilitates the conversion of one currency into another. Through the buying and selling of currencies. Allows global firms to move in and out of foreign currency as needed.

(3) Offers contracts to manage foreign exchange exposure. These hedging contracts allow global firms to offset foreign currency

exposures. Thus, they can concentrate on their core business.

Who Provides These Important FX Functions? Large global banks (e.g., HSBC, UBS, Citibank) acting

on behalf of: Their “external” clients” (primarily global firms)

Acting in a broker capacity at the request of their clients. Meeting foreign currency business needs of their clients, including Exporters, importers, multinational firms, hedge funds, etc…

Global banks also trade for their own “internal” bank accounts to generate profits for their banks. Acting in a “dealer” (i.e., trader) capacity Taking positions in currencies to make a profit.

In meeting the needs of their clients and their own internal trading, these global banks “establish” the “tone” of the market.

This is through the “market maker” function, whereby they: Quote prices to other parties and Commit to buying and selling currencies at their quoted

prices.

Making the Market in FX The market maker function of any global bank

involves two primary activities: (1) Willingness of the market maker to provide the

market with “on-going” (i.e., continuous) two way quotes upon request: (1) Provide a price at which they will buy a currency (2) Provide a price at which they will sell a currency

This function provides the market with transparency (2) Willingness of the market maker to actually buy

and/or sell at the prices they quote: Thus the market maker offers “firm” prices into the market!

This function provides the market with liquidity.

How Do Market Makers Quote Currencies? We already know from a previous discussion of two

possible ways of quoting currencies: European Terms Quote:

Number of foreign currency units per 1 U.S. dollar. 119 yen to the dollar

American Terms Quote: U.S. dollars and cents per 1 unit of the foreign currency $1.3100 to one Euro

Which quote is used? American terms quoted currencies historically related to non-

decimal currencies (i.e., the pound, Australian and New Zealand dollar).

Also by government decision, i.e., the Euro. ECB decided to quote the currency in American terms.

The majority of the world’s currencies are quoted in European terms, while the majority of the world’s major currencies are quoted in American terms.

ISO Currency Designations All foreign currencies are assigned an International

Standards Organization (ISO) abbreviation. E.g., USD; JPY; GBP; EUR; CNY; HKD; MXN; AUD; ZAR For individual countries please see:

http://www.oanda.com/site/help/iso_code.shtml Since the exchange rate is simply the ratio (i.e.,

value) of one currency against another, market makers express this relationship using the two currencies’ ISO designations.

For Example: USD/JPY USD/MXN EUR/USD GBP/USD EUR/JPY (this is a cross rate)

Base and Quote Currency Since a foreign exchange quote is simply the

ratio of one currency to another, a “complete” market maker quote must have two ISO designations (e.g., EUR/USD or USD/JPY): The first ISO currency quoted is called the base

currency. The second ISO currency quoted is called the quote

currency. For examples above:

EUR/USD: EUR is the base currency and USD is the quote currency.

USD/JPY: USD is the base currency and JPY is the quote currency.

Bid and Ask Quotes Recall that a market maker always provides the

market with two prices, both a buy and sell quote (or price) for the currency.

For Example: EUR/USD: 1.2102/1.2106 The first number quoted by the market maker is the

market maker’s buy price ($1.2102). It is called the market maker’s bid quote (or buy price) The second quoted number is the market marker’s sell

price ($1.2106). It is called the market maker’s ask quote (or sell price) Note: The bid quote is always lower than the ask

quote.

What Currency is The Market Maker Buying and Selling? Given the example: EUR/USD: 1.2102/1.2106,

which currency is the market maker selling and which currency is the market maker buying? Answer: Market makers are always quoting prices

at which they will buy or sell the base currency (against the quote currency).

So in the above example: The market maker will buy euros for $1.2102

This is the bid price for euros. The market maker will sell euros for $1.2106

This is the ask price for euros.

Another FX Quote Example Assume the following USD/JPY: 110.12/110.20

Note: Now the base currency is the dollar and the quote currency in the yen, thus

The market maker will buy dollars at ¥110.12 This is the bid price for dollars.

The market maker will sell dollars at ¥110.20 This is the ask price for dollars.

Note Again: Regardless of the type of quote (American terms or European terms), the ask price is always higher than the bid.

Summary thus far and “Pips” Recall that the currency that is located in the front of the ISO pair (e.g.,

EUR/USD) is called the base currency. You should assign a value of 1 to it.  For example, if you see a market maker

ask price for the EUR/USD of 1.2811, that means that if you were to buy one Euro (the base currency) you are going pay $1.2811. Or if you see a market maker bid price for the USD/JPY of 120.10 that means if you were to sell one dollar (the base currency) you are going to get 120.10 for it.

When the bid and ask prices are moving up, that means that the base currency is getting stronger and the quote currency is getting weaker.

Currencies are usually quoted to four decimal places, such as the Euro/US Dollar trading at 1.2400/1.2403, with the last decimal place referred to as a point or "pip". A pip for most currencies is 0.0001 of an exchange rate; the one exception is

the USD/JPY quote in which each pip is equal to 0.01. Currency changes and currency spread (between bid and ask prices)

are measured, and reported in “pips.” So for the EUR/USD quote, 1.2400/1.2403 this represents a spread of 3 pips and if the EUR bid goes from 1.2400 to 1.2410, this represents a change in the euro (strengthening) of 10 pips.

Viewing the Quote from Other than the Market Maker Assume you are a corporate client and you receive

the following GBP/USD quote from a market maker bank: 1.8020/1.8050

Assume you need to buy pounds from the market maker. What would you pay (in dollars) for each pound? You would pay the ask price, or $1.8050 for each pound

Assume you wanted to sell pounds to the market maker. What would you get (in dollars) for each pound sold? You would get the bid price, or $1.8020 for each pound.

Viewing the Quote from Other than the Market Maker: Another Example Assume you are a corporate client and you receive the

following USD/JPY quote from a market maker bank: 112.50/112.75 Recall: now the base currency is the dollar.

Assume you want to buy dollars from the market maker. What would you pay in yen for each dollar? You would pay the ask price, or 112.75 for each dollar.

Assume you want to sell dollars to the market maker. What would you get in yen for each dollar sold? You would get the bid price, or 112.50 for each dollar.

Remember: The market maker is always buying or selling the base currency (against the quote currency).

Let’s Look at Real Time Currency Quotes Go to the following web-site:

http://www.fxstreet.com/nou/graph/streamingchart.asp At this site, go to:

Live Currency Rates (U.S. Dollar/Major currencies) Observe ISO quotes (look at EUR/USD and USD/JPY). Observe bid and ask quotes. Observe what currency and at what price the market maker is buying

or selling (base currency). Observe what price you (a non-market maker) would buy or sell the

base currency to the market maker. Observe changes in bid and ask quotes.

If these are going up, the base currency is strengthening and the quote currency is weakening. Reverse is true if these are going down.

Note: Reported change in the currency (base currency) is the bid price change in “pips” from the previous day.

Another site: http://www.forextrading.com/

How are Some Currencies Quoted? Euro: EUR/USD Swedish Krona: USD/SEK British Pound: GBP/USD Norwegian Kroner: USD/KOR Australian Dollar: AUD/USD Israeli Shekel: USD/ILS New Zealand Dollar: NZD/USD Danish Krone: USD/DKK

Russian Ruble: USD/RUB Yen: USD/JPY Malaysian Ringgit: USD/MYR Swiss Franc USD/CHF Korean Won: USD/KRW Canadian Dollar: USD/CAD Indian Rupee: USD/INR Mexican Peso: USD/MXN Philippine Peso: USD/PHP Hong Kong Dollar: USD/HKD Argentina Peso: USD/ARS Singapore Dollar: USD/SGD Brazilian Real: USD/BRL South African Rand: USD/ZAR Thai Baht: USD/THB

Note: American terms quoted currencies use the foreign currency as the base currency and European terms quoted currencies use the U.S. dollar as the base currency.

FX Spreads to Market Maker Banks Recall, that all market makers provide both a bid (i.e., buy)

and an ask (i.e., sell) quote for a currency. The difference between the bid and ask price is the spread to the

market maker. This represents the market maker’s “profit” from executing a

“round” transaction (i.e., an equal buy and sell for a currency). Assume the following GBP/USD quote: 1.7921/1.7929

What is the spread in pips? Answer: 9 – 1 = 8 pips

What is the spread to the market maker on a “round” transaction (assume 10 million pound transactions)? Ask $1.7929 x £10,000,000 = $17,929,000 (price to sell pounds) Bid $1.7921 x £10,000,000 = $17,921,000 (price to buy pounds) Spread (Commission) = $ 8,000 (on round transaction)

Observations About Bid/Ask Spreads Bid/ask spreads increase with exchange rate volatility. Bid/ask spreads decrease with increases in market

maker competition. Bid/ask spreads larger in retail market than in wholesale

(i.e., interbank) market. Wholesale market: global bank to global bank Retail market: bank to customer (client of bank)

Bid/ask spreads will differ slightly among market markets. As market makers attempt to adjust their positions.

Typical spreads for major currencies are 2 to 4 pips.

Quotes According to Delivery Time Period Spot Quote: Quote for “immediate” transactions.

Actual delivery will take place at the end of 2 business days. Saturday and Sunday are not business days There may be a one day delivery depending upon the location

(e.g., between Canada and the U.S., or within Europe).

Forward Quote: Quote for more than 3 business day transactions. Actual delivery to take place at the end of 3 business

days or more from now.

Forward Foreign Exchange Market and Rates This market involves contracting today for the future

purchase or sale of foreign exchange. Forward rates are quoted today by market makers. As with spot rates, forward rates are two way quotes, or bid

and ask prices. Bid at which they will buy the base currency in the future. Ask at which they will sell the base currency in the future.

Forward rates can be: Worth more than the spot rate (premium) Worth less than the spot rate (discount) Equal to the spot rate (flat)

Examples of Spot and Forward RatesSeptember 8, 2004 February 6, 2006 American Terms

U.K. (Pound) $1.7867 $1.7471 1 month forward $1.7818 $1.7472

European Terms Japan (Yen) 109.30 118.60

1 month forward 109.13 119.02

Was the pound selling at a forward discount or premium in 2004 and 2006? What about the yen?

Sources of spot and forward quotes:

http://online.wsj.com/public/us and http://www.ozforex.com/cgi-bin/spotrates.asp

Review and Illustration of FX Quote For a review and illustration of the foreign

exchange quote process please link to the following on my web site: Foreign Exchange Illustration.

This illustration will work you through the quote and base currency and the bid and ask price as set by market makers.

It will also demonstrate the meaning of these quotes from the client side of the transaction