2.1 Understanding Spot Exchange Rates

Spot exchange rates are the current market prices at which currencies are traded for immediate delivery, forming the foundation for all other FX transactions and pricing.

Definition and Characteristics:

  • Definition: The spot exchange rate is the price at which one currency can be exchanged for another for immediate delivery (typically settlement in two business days)

  • Key Characteristics:

    • Reflects current market conditions and expectations

    • Constantly changing based on supply and demand

    • Serves as the reference for forward rates and other derivative pricing

    • Most actively traded FX instrument by transaction count

  • Immediate Delivery Convention:

    • T+2 settlement for most currency pairs

    • T+1 for USD/CAD and USD/MXN

    • “Immediate” is a convention, not instantaneous

    • Delivery typically through payment systems (CLS, Fedwire, etc.)

Quoting Conventions:

  • Direct Quote:

    • Domestic currency units per unit of foreign currency

    • Example: In US, USD/JPY = 110.00 means 1 USD = 110 JPY

    • Most countries quote USD as base currency (except UK, Commonwealth, Eurozone)

  • Indirect Quote:

    • Foreign currency units per unit of domestic currency

    • Example: In US, EUR/USD = 1.1000 means 1 EUR = 1.1000 USD

  • Major Currency Pairs:

    • EUR/USD: Euro vs. US Dollar (most traded pair)

    • USD/JPY: US Dollar vs. Japanese Yen

    • GBP/USD: British Pound vs. US Dollar

    • USD/CHF: US Dollar vs. Swiss Franc

    • USD/CAD: US Dollar vs. Canadian Dollar

    • AUD/USD: Australian Dollar vs. US Dollar

    • NZD/USD: New Zealand Dollar vs. US Dollar

Bid-Ask Spreads:

  • Structure:

    • Bid: Price at which dealer buys base currency

    • Ask/Offer: Price at which dealer sells base currency

    • Spread = Ask – Bid (dealer’s profit margin)

  • Factors Affecting Spreads:

    • Currency pair liquidity (major pairs: 1-2 pips, minors: 3-10 pips, exotics: 10-50+ pips)

    • Market volatility (higher volatility = wider spreads)

    • Time of day (liquid hours = narrower spreads)

    • Trading volume and liquidity (higher volume = narrower spreads)

    • Counterparty credit and relationship

    • Trade size and execution method

  • Cross-Currency Spreads:

    • Derived from major pair spreads

    • Wider than major pair spreads due to computational component

    • Varies with liquidity of the component pairs

Reading FX Quotes:

  • Example: EUR/USD 1.1050/1.1053

    • Bid: 1.1050 (dealer buys EUR at this price)

    • Ask: 1.1053 (dealer sells EUR at this price)

    • Spread: 0.0003 (3 pips)

  • Example: USD/JPY 110.20/110.23

    • Bid: 110.20 (dealer buys USD at this price)

    • Ask: 110.23 (dealer sells USD at this price)

    • Spread: 0.03 (3 pips, second decimal is pip)

  • Interpreting Quotes:

    • If you buy EUR/USD, you are buying EUR and selling USD

    • If you sell EUR/USD, you are selling EUR and buying USD

    • Quotes show the dealer’s perspective, not the client’s perspective

2.2 Spot Rate Determination and Theories

Exchange rates are determined through the interaction of supply and demand in the FX market, influenced by various economic, financial, and behavioral factors.

Market-Based Determination:

  • Supply and Demand Dynamics:

    • Demand for a currency comes from buyers, investors, and central banks

    • Supply comes from sellers, borrowers, and central banks

    • Balance determines the exchange rate

    • Flows reflect trade, investment, and speculation

  • Factors Affecting Currency Demand:

    • Demand for exports (importers need to buy foreign currency)

    • Investment demand (foreign investment requires local currency)

    • Speculative demand (betting on appreciation)

    • Reserve demand (central banks accumulating reserves)

  • Factors Affecting Currency Supply:

    • Demand for imports (importers sell domestic currency)

    • Outbound investment (domestic investors buying foreign assets)

    • Speculative supply (betting on depreciation)

    • Central bank selling reserves

Exchange Rate Determination Theories:

  • Purchasing Power Parity (PPP):

    • Absolute PPP: Exchange rate equals the ratio of price levels

    • Relative PPP: Exchange rate changes equal the inflation differential

    • Formula: ΔE = Ï€_domestic – Ï€_foreign

    • Limitations: Transport costs, trade barriers, non-traded goods

    • Long-term tendency, not short-term precision

  • Interest Rate Parity (IRP):

    • Covered Interest Rate Parity: Forward rate determined by interest rate differential

    • Uncovered Interest Rate Parity: Expected spot rate determined by interest rate differential

    • Formula: F = S × (1 + i_domestic) / (1 + i_foreign)

    • Important for forward pricing and carry trade profitability

    • Deviations can be exploited through arbitrage

  • Balance of Payments Approach:

    • Current account balance affects currency demand/supply

    • Capital account flows influence exchange rates

    • Overall balance of payments (including official reserves) determines pressure

    • Long-term relationship between trade imbalances and currencies

  • Monetary Model:

    • Exchange rate determined by relative money supplies

    • Real output affects money demand

    • Flexible prices and full employment assumptions

    • Formula: E = (M_domestic/M_foreign) × (Y_foreign/Y_domestic)

    • Provides a long-term framework

  • Portfolio Balance Model:

    • Exchange rates determined by asset market equilibrium

    • Investors allocate wealth across domestic and foreign assets

    • Relative returns and risks drive allocation

    • Includes stock and bond market influences

Empirical Evidence on Exchange Rate Determination:

  • Short-Term Difficulties:

    • Exchange rates are difficult to forecast in the short term

    • Models have limited predictive power

    • Random walk often beats economic models

  • Medium-Term Factors:

    • Interest rate differentials matter

    • Growth differentials and productivity matter

    • Current account balances influence

  • Long-Term Tendencies:

    • PPP tends to hold over the long run

    • Real exchange rates trend toward equilibrium

    • Structural factors determine long-term trends

2.3 Cross-Rate Calculations

Cross-rate calculations involve determining exchange rates between two currencies when neither is the US dollar, using the USD as the intermediary currency.

Understanding Cross Rates:

  • Definition: A cross rate is the exchange rate between two currencies that are not the official currency of the country where the quote is provided, typically calculated using the US dollar as the intermediary

  • Importance:

    • USD is the vehicle currency for most FX transactions

    • Cross rates extend trading beyond USD pairs

    • Provides liquidity for less common currency pairs

    • Essential for international trade and investment

Basic Cross-Rate Calculations:

  • Same Base Currency:

    • If both quotes have the same base currency (USD)

    • Example: USD/JPY = 110.00 and USD/CHF = 0.9200

    • Cross rate: CHF/JPY = 110.00 / 0.9200 = 119.5652

  • Same Quote Currency:

    • If both quotes have the same quote currency (USD)

    • Example: EUR/USD = 1.1000 and GBP/USD = 1.3000

    • Cross rate: EUR/GBP = 1.1000 / 1.3000 = 0.8462

  • Different Base and Quote Currencies:

    • Example: EUR/USD = 1.1000 and USD/JPY = 110.00

    • Cross rate: EUR/JPY = 1.1000 × 110.00 = 121.00

Bid-Ask Cross Rate Calculations:

  • Bid Rate Calculation:

    • Calculate the bid for the cross currency pair

    • Use appropriate bid and ask rates for the component pairs

    • Generally: Cross bid = Bid for base / Ask for quote

  • Ask Rate Calculation:

    • Calculate the ask for the cross currency pair

    • Use appropriate bid and ask rates for the component pairs

    • Generally: Cross ask = Ask for base / Bid for quote

  • Example: EUR/GBP Bid-Ask

    • EUR/USD: 1.1050/1.1053

    • GBP/USD: 1.3000/1.3003

    • EUR/GBP Bid = 1.1050 / 1.3003 = 0.8498

    • EUR/GBP Ask = 1.1053 / 1.3000 = 0.8502

Triangular Arbitrage:

  • Definition: Profiting from discrepancies between three exchange rates

  • Process:

    1. Convert Currency A to Currency B

    2. Convert Currency B to Currency C

    3. Convert Currency C back to Currency A

  • Arbitrage Condition:

    • The cross rate should equal the product of the two component rates

    • If not, arbitrage opportunity exists

    • For example: EUR/USD × USD/JPY should equal EUR/JPY

  • Example of Triangular Arbitrage:

    • EUR/USD = 1.1000 (buy EUR, sell USD)

    • USD/JPY = 110.00 (buy USD, sell JPY)

    • Implied EUR/JPY = 1.1000 × 110.00 = 121.00

    • Actual EUR/JPY = 121.05

    • Arbitrage: Buy EUR/USD, buy USD/JPY, sell EUR/JPY

    • Small profits quickly eliminated

Common Cross-Rate Pairs:

  • EUR/JPY: Most actively traded cross (Euro-Japanese Yen)

  • EUR/GBP: Euro-British Pound (important in Europe)

  • EUR/CHF: Euro-Swiss Franc (Eurozone-Switzerland)

  • GBP/JPY: British Pound-Japanese Yen (volatile pair)

  • AUD/JPY: Australian Dollar-Japanese Yen (carry trade proxy)

  • NZD/JPY: New Zealand Dollar-Japanese Yen (carry trade proxy)

  • Emerging Market Crosses: CNY crosses, INR crosses, and others

2.4 Spot Market Applications

Spot FX markets serve various practical applications for different types of participants.

Commercial Transactions:

  • Import/Export Payments:

    • Importers buy foreign currency to pay suppliers

    • Exporters sell foreign currency from customer payments

    • Timing considerations and settlement dates

    • Spot transactions for immediate needs

  • Foreign Investments:

    • Convert capital for international investments

    • Transfer profits and dividends

    • Manage international cash positions

    • Currency conversion for M&A

Investment Transactions:

  • Portfolio Currency Conversion:

    • Convert domestic currency to invest in foreign assets

    • Convert foreign currency proceeds back to domestic

    • Manage portfolio currency exposure

    • Currency overlay strategies

  • Currency Positioning:

    • Position in a currency for investment purposes

    • Speculate on currency movements

    • Hedge currency exposure

    • Implement FX views

Arbitrage Opportunities:

  • Triangular Arbitrage:

    • Exploiting cross-rate discrepancies

    • Very short-lived opportunities

    • Requires sophisticated systems and execution

    • Profit margins are small

  • Covered Interest Arbitrage:

    • Exploiting interest rate differentials

    • Forward contract used to lock in future exchange rate

    • Risk-free profit when IRP is violated

    • Important for market efficiency

Practical Considerations in Spot Trading:

  • Counterparty Selection:

    • Credit assessment and limits

    • Relationship and service quality

    • Pricing competitiveness

    • Execution capabilities

  • Execution Methods:

    • Direct dealing with a bank

    • Electronic platforms (multi-bank, single-dealer)

    • Algorithmic execution

    • Telephone dealing (declining)

  • Settlement and Administration:

    • Confirmations and matching

    • Settlement instructions

    • Documentation and record-keeping

    • Compliance and regulatory requirements

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