INBU 4200 INTERNATIONAL FINANCIAL MANAGEMENT

1
INBU 4200 INTERNATIONAL FINANCIAL MANAGEMENT

• Lecture 5
• Topic Quoting Currencies

2
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.

3
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.

4
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.

5
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 worlds currencies are quoted
  in European terms, while the majority of the
  worlds major currencies are quoted in American
  terms.

6
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)

7
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.

8
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 makers buy price (1.2102).
• It is called the market makers bid quote (or buy
  price)
• The second quoted number is the market markers
  sell price (1.2106).
• It is called the market makers ask quote (or
  sell price)
• Note The bid quote is always lower than the ask
  quote.

9
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.

10
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.

11
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.

12
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.

13
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).

14
Lets Look at Real Time Currency Quotes

• Go to the following web-site
• http//www.fxstreet.com/nou/graph/streamingchart.a
  sp
• 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/

15
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.

16
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 makers 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)

17
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.

18
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.

19
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)

20
Examples of Spot and Forward Rates

• September 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

21
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