Page 52 - DMGT549_INTERNATIONAL_FINANCIAL_MANAGEMENT

Unit 3: Foreign Exchange Market and Exchange Rates

Notes
!
Caution The width of Bid-ask Spreads in forex transactions depends fundamentally on
transaction costs and risks. Also, in some countries governments set Bid and ask prices for
foreign exchange at levels that assume some monopoly profits for authorised dealers
(who are generally government owned banks) in their own countries.

Spreads and Pips

The difference between the Bid Price and the Ask Price is called a spread. If a foreign exchange
dealer were to look at the following quote: EUR/USD = 1.3700/05, the spread would be 0.0005 or
5 pips, also known as points. The pip is the smallest amount a price can move in any Currency
quote.

Example: All foreign exchange dealers are interested in making a profit out of each
transaction. Therefore, when a dealer in India tries to sell foreign Currency he will try to get as
high a price as is possible for every unit of foreign Currency sold. But when the dealer is buying
foreign Currency, his aim will be to get the most reasonable price for every unit of the foreign
Currency he buys.
A dealer in New Delhi may give the following quotation:
US $1 = ` 43.3000-43.7300
£1 = ` 69.9200-71.3100
This means that the dealer will buy dollars from the exporter at US $1 = ` 43.3000 and sell dollars
to an importer at US $1 = ` 43.7300. Similarly, he will buy pounds at £1 = ` 69.9200 but sell
pounds at £1 = ` 71.3100. The lower rate in the quotation is the Bid (buy) rate while the higher
rate is the ask (selling) rate. The difference between the banks’ Bid and ask rate is the spread. The
spread fluctuates in accordance with the level of stability in the market, the Currency in question
and the volume of the business.
Spread can be expressed in percentage as:
Percentage spread = Ask Price – Bid Price/Ask Price x 100

= 43.7300 – 43.3000/43.7300 x 100
= .9833
Generally, in transactions among dealers, only the last two digits are quoted and the rest is
understood. This is done to save time.

Example: A foreign exchange trader gives the following quotes for the Euro Spot, one
month, three months and six months to a US based treasurer
$0.02368/70 4/5 8/7 14/12

Calculate the outright quotes for one, three and six months forward.
Solution:
1st Month: Since first (buy quote) is less than the second (sell quote) Currency is trading at a
premium. Hence points are added to the Spot rate.
3rd Month: Since first (buy quote) is greater than the second (sell quote) Currency is trading at
a discount. Hence points are deducted from the Spot rate.

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