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Treasury & Fund Management

Mohammad Ali Jinnah University


Fall 2012
Mr. Eraj Hashmi

Tel: +92 21 2430532 | Fax: +92 21 2430748 | bma@bmacapital.com | www.bmacapital.com

Eraj Hashmi

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bid-ask spread
Banks

generally do not charge commissions on foreign currency transactions. Instead, they make their profit

from the bid-ask spread. The spread is the difference between the bid and the ask. The bid price is the price a dealer is willing to pay to buy a currency. If you are selling the currency, you will receive this price. The ask price is the price a dealer is willing to take to sell a currency. If you are buying the currency, you will pay the ask price.
Example: A

Assume the following quotes:

bid of 1.6625 USD/GBP ask of 1.6635 USD/GBP the direct (U.S. quote) percentage spread.

An

Calculate (1.6635

1.6625) / 1.6635 = 0.0006 = 0.06%

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Explain how spreads on foreign currency quotations can differ as a result of market conditions, bank/dealer positions, and trading volume
Market conditions affect currency spreads because the bid-ask spread on foreign currency quotations increases as exchange rate volatility (uncertainty) increases

Market conditions

Greater trading volume

Greater trading volume leads to narrower spreads (and vice versa).

Bank and currency dealer positions

Bank and currency dealer positions do not directly affect the size of foreign currency spreads. If a dealer wants to reduce her holdings, she will usually adjust the midpoint of the spread rather than the spread itself.

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Money Ma direct and indirect methods of foreign exchange quotations


Direct Direct foreign exchange quotations are in domestic currency per unit of foreign currency. They are from the perspective of the counter currency. For example, in the quotation AUD:USD = 0.60, the base currency is AUD and the counter currency is the USD. The quote is a direct quote to a U.S. investor. It tells him the cost of one AUD in his domestic currency. This quote may also appear as USD/AUD = 0.60. Indirect Indirect quotations are in the foreign currency per unit of the domestic currency. They are from the perspective of the base currency. The quote AUD:USD = 0.60 is an indirect quote to an Australian investor.

To convert a direct quote to an indirect quote, or vice versa, you simply take the reciprocal of the one that you are given. For example, in Japan, a direct quote of 125/$ is equivalent to an indirect quote of 1 / (125/$) = 0.0080$/. Just use the 1/x key on your calculator to turn the indirect quote 1.25 /$ into the direct quote of 0.0080/$. To convert a direct quote to an indirect quote, or vice versa, you simply take the reciprocal of the one that you are given.
Tel: +92 21 2430532 | Fax: +92 21 2430748 | bma@bmacapital.com | www.bmacapital.com

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Calculate and interpret currency cross rates, given two spot exchange quotations involving three currencies.
Example: The spot exchange rate between the Swiss franc (CHF) and the USD is 1.7799 CHF/USD, and the spot exchange rate between the New Zealand dollar (NZD) and the U.S. dollar is 2.2529 NZD/USD. Calculate the CHF/NZD spot rate. Answer: In Switzerland, the direct exchange rate is: 1.7799 CHF/USD / 2.2529 NZD/USD = 0.79005 CHF/NZD

Example:

Given the following bid-ask spreads, calculate the SF/DKK bid ask spread:
SF/$ bid-ask 1.3096 1.4528 DKK/$ bid-ask 2.4365 2.5843 Answer: Set up a bid-ask matrix using: SF/$ bid-ask 1.3096 1.4528 DKK/$ bid-ask 2.4365 2.5843 (1.3096 SF/$) / (2.5843 DKK/$) = 0.50675 SF/DKK Eraj Hashmi
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(1.4528 SF/$) / (2.4365 DKK/$) = 0.59627 SF/DKK


Tel: +92 21 2430532 | Fax: +92 21 2430748 | bma@bmacapital.com | www.bmacapital.com

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Calculate and interpret currency cross rates, given two spot exchange quotations involving three currencies. (2nd Slide)
A

Pakistani dealer gives a quote of 8.00 bid / 8.10 ask (PKR/AED) and a Dubai dealer quotes the AED at 2.00

bid / 2.1 ask (THB/AED). What is the PKR/THB bid and ask from the perspective of a Pakistani dealer? This result is determined as follows: Step 1: Invert THB quote. First, we need to invert the THB quotes to make the currency units AED/THB. Then, when we multiply by the PKR/AED quote we will have the correct PKR/THB units. (Remember that when you take the reciprocal of a quote, the bid becomes the ask and vice versa. So, for the bid we take the given ask) Bid: 1.00000 / 2.10000THB/AED = 0.47619AED/THB Step 2: Calculate PKR/THB bid-ask Prices. Bid: 8.00000PKR/AED 0.47619AED/THB = 3.80952PKR/THB, or 3.81PKR/THB. Ask: 8.10000PKR/AED 0.50000AED/THB = 4.05000PKR/THB, or 4.05PKR/THB. Thus, the PKR/THB bid-ask is: 3.81PKR/THB - 4.05PKR/THB
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Ask: 1.00000 / 2.00000THB/AED = 0.50000AED/THB

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Calculate and interpret the spread on a forward foreign currency quotation and explain how spreads on forward foreign currency quotations can differ as a result of market conditions, bank/dealer positions, trading volume, and maturity/length of contract
Assume that the USD/GBP six-month forward rate is quoted at a bid of 1.63843 and an ask of 1.64073. From a U.S. dealers perspective, calculate the bid-ask spread.

Answer:
In this case the spread is simply 0.0023 USD/GBP = 1.64073 1.63843. Just as with spot market foreign currency spreads, spreads in the forward foreign currency market increase with greater exchange rate volatility and decrease when trading volume is higher. Spreads tend to increase with the term of the forward contract, and forward currency spreads are typically greater than spot currency spreads

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Money Ma forward discount or premium


Forward Discount

What Does Forward Discount Mean? In a foreign exchange situation where the domestic current spot exchange rate is trading at a higher level then the current domestic futures spot rate for a maturity period. A forward discount is an indication by the market that the current domestic exchange rate is going to depreciate in value against another currency.
Forward Premium Read more: http://www.investopedia.com/terms/f/forwarddiscount.asp#ixzz06SipMPhc What Does Forward Premium Mean? When dealing with foreign exchange (FX), a situation where the spot futures exchange rate, with respect to the domestic currency, is trading at a higher spot exchange rate then it is currently

The forward discount or premium on a foreign currency can be calculated as an annualized percentage differential between the spot rate and the forward rate: Forward discount = forward rate spot rate = negative number

Forward premium = forward rate spot rate = positive number


Tel: +92 21 2430532 | Fax: +92 21 2430748 | bma@bmacapital.com | www.bmacapital.com

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