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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

The Spot Market for FOREX

Foreign exchange market l.jpg
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

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  • 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 l.jpg
    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

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    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

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    • 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/£

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    • 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 l.jpg
    Triangular Currency Arbitrage actually prices for

    • 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: ¥/€

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    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: ¥/€