Page 53 - DMGT549_INTERNATIONAL_FINANCIAL_MANAGEMENT

International Financial Management

Notes 6th 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.
In outright terms these quotes would be expressed as mentioned below:

Maturity BID (Buy) Ask (Sell) Spread
US $ per 1 Euro
Spot rate $ 0.02368 $ 0.02370 .00002
1 Month $ 0.02372 $0.02375 .00003
3 Month $ 0.0236 $0.02363 .00003
6 Month $ 0.02354 $ 0.02358 .00004

Swaps

A Swap transaction (not to be confused with the Swap rate) is a double-leg deal, in which one
buys Spot Currency X selling Currency Y and simultaneously sells forward Currency X buying
Currency Y. Let us give an example to show the rationale of such a transaction. Assume that an
American investor has a future receipt in DM. In addition, assume that he thinks that German
bonds are presently a good investment. So he has dollar assets but does not hold cash in DM. In
plain words, he needs DM right now and cannot wait for the future receipt DM to come. One
solution would be to sell dollars and buy DM in the Spot Market. However, suppose he does not
wish to block money in a foreign exchange adventure for he cannot forecast the exchange value
of the future receipt. In this case he sells dollars against DM Spot getting his DM and buying his
bonds. Simultaneously he buys dollars forward against DM matching the value date of the
receipt. Upon expiration of the forward period, the investor cashes the receipt, pays back the DM
that he owes and gets his original dollars. Hence, he has been able to overcome the time Lag
problem.

Example: A trader may give the following quotations.

Spot 1-month 3-month 6-month
`/$ 43.3125/25 10/15 20/15 15/20
`/DM 22.9410/40 30/20 20/25 15/19
The trader will know whether the quotes represent a premium or discount on the Spot rate. This
can be determined in an easy way. If the first forward quote (i.e., buying rate) is smaller than the
second forward quote (i.e., the asking rate) then there is a premium. In such a case, points are
added to the Spot rate. However, if the first quote is greater than the second, then it is a discount
and points are subtracted from the Spot rate.

Self Assessment

Fill in the blanks:

4. A …………………… transaction is a double-leg deal, in which one buys Spot Currency X
selling Currency Y and simultaneously sells forward Currency X buying Currency Y.
5. The difference between the Bid Price and the Ask Price is called a …………………… .

6. The width of Bid-ask Spreads in forex transactions depends fundamentally on transaction
costs and …………………….
7. The …………………… is the smallest amount a price can move in any Currency quote.

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