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FIN 476. The Spot Market for FOREX. Foreign Exchange Market. currencies (FOREX) are traded in a highly liquid, global market. as the FOREX market is global, it is a 24 hour market, with a new major trading centre somewhere always open.

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fin 476

FIN 476

The Spot Market for FOREX

foreign exchange market
Foreign Exchange Market
  • currencies (FOREX) are traded in a highly liquid, global market
  • as the FOREX market is global, it is a 24 hour market, with a new major
  • trading centre somewhere always open
  • the major participants in the FOREX market are large commercial banks
  • who buy and sell currencies:
      • to meet customers needs for currencies
      • for proprietary trading reasons

The FOREX market can be broken down into two basic parts:

      • Spot Market
      • Forward Market
  • We will look at the spot market right now.
  • The spot market is the market for immediate exchange of currencies.
  • “Immediate” is actually a misnomer, actual delivery of currencies which
  • have been traded occurs through an electronic transfer between bank
  • accounts two working days after the deal is made.
  • It is in the spot market that the current exchange rate (the spot rate)
  • Is determined
currency dealers
Currency Dealers
  • the large, commercial banks employ currency dealers
  • it is these people who set exchange rates in response to supply and demand
  • that they see coming in through orders they receive
  • a dealer quotes prices at which he or she is willing to transact
  • the prices are posted electronically, so that the quote is disseminated
  • around the world to other dealers
  • a quote actually involves four things: a bid price, an ask price,
  • a bid depth and an ask depth
price quotes
Price Quotes
  • the bid and ask (or offer) prices are the price at which the dealer is
  • willing to buy and sell the currency, respectively
  • the depths are the amounts of currency up to which the dealer
  • guarantees the price quotes
    • Example: if the depth is $10,000,000 then the price quote is valid
    • for transactions up to that amount. More than that and the price
    • would have to be negotiated.
  • For the bid and ask prices, it will always be the case that:
        • BID < ASK

the difference between the bid and ask (ask-bid) is the bid-ask spread

  • the spread is a major source of profits for dealers
  • dealers profit on every unit of currency they can buy and re-sell through
  • their quotes
  • they must set their quotes to try to maximize the volume of trade they
  • conduct, and also to balance supply and demand
  • Example:
      • On September 26, 2003 the quote between the British pound and
      • US dollar was:
      • 1.65960/66000 $US/£

This mean the bid price was 1.65960 $US/£ and the ask price

was 1.66000 $US/£


Note that because the quote is $US/£, the prices are actually prices for

  • pounds.
  • To derive the prices for $US, you must first invert the prices, and then
  • note that the bid for the pound is the ask for the $US, and the ask for the
  • pound is the bid for the $US

Bid for £ = 1.65960 $US/£

Ask for $US =

= 0.60255 £/$US

Ask for £ = 1.66000 $US/£

Bid for $US =

= 0.60241 £/$US

The same quote can be expressed as a quote for $US as:

0.60241/55 £/$US

triangular currency arbitrage
Triangular Currency Arbitrage
  • currency prices are quoted in trading centres around the world by many
  • different dealers
      • What keeps these different dealers prices “in line” with each other?
      • if different dealers’ quotes are not consistent with each, then this
      • may give rise to an arbitrage opportunity
  • Consider traders in Bahrain, Tokyo and London (all of which are open
  • simultaneously at one point in the day), each quoting a different currency pair

London: $US/€

Tokyo: ¥/$US

Bahrain: ¥/€


Say you started with $US and sold them in London for €,

then sold the € in Bahrain for ¥,

then sold the ¥ in Tokyo for $US

  • If you end up with more $US than you started with, there is an
  • arbitrage opportunity
  • You could make riskless profits instantly.
  • This would be called triangular currency arbitrage.
  • Arbitrage opportunities should not exist (for more than a few moments).
  • This insures that quotes around the work are consistent with each other.

London: $US/€

Tokyo: ¥/$US

Bahrain: ¥/€