INTERNATIONAL FINANCE

Mechanics

The Foreign Exchange

•  Cancel currency units •  If $/Eur = 1,20, how many $ do you get for 1,000 Eur?

•  Cancel EUR and you are left with $

Cancel one

1.20 $

EUR ⎛

⎝ ⎜

⎞

⎠ ⎟ ! 1000 EUR = $1,200

•  If ($/£) = 1.50 and (£/€) = 0.8560

•  Cancel the nexus currency to get the crossed one.

Cancel one to get another

1.50 $ £ ⎛

⎝ ⎜

⎞

⎠ ⎟ ! 0.8560

£ € ⎛

⎝ ⎜

⎞

⎠ ⎟ = 1.284

$ € ⎛

⎝ ⎜

⎞

⎠ ⎟

•  Bid price = Price to buy •  Ask price = Price to sell •  Spread = Ask – Bid

–  Sell expensive buy cheap •  Big figure (1.50) and small figure (20)

–  ($/£) = 1.5020 •  1 Basis point : 0,01% •  Spread in points : 6 Basis points or 0,06%

–  1.5020-15026 –  Remember 1$ basis point is not 1£basis point: 1 MM $ * £0.0001/$ =

£100 per basis point or 1.5020 $ / £ * £100 = 150.2 $ per basis point.

Terms to remember

•  ($/£) = 1.5018 Mid market

–  Market average bid-offer : 16-20 –  Need to raise inventory : 17-21

•  More attractive bid, less attractive offer –  Need to lower inventory : 15-19

•  More attractive offer, less attractive bid

When buy and when sell

•  Spread include: –  Profit –  Costs:

•  Order Processing cost •  Inventory cost •  Holding cost

–  Other: •  Trading volume (Higher volume usually narrower spread) •  Market competition (Higher competition usually narrower spread) •  Exchange rate volatility (Higher volatility usually wider spread) •  Liquidity (Lower liquidity usually wider spread) •  Order size (Larger order size usually wider spread)

Need to take into account

•  BidAmerican = 1/AskEuropean •  BidEuropean = 1/AskAmerican

•  So: –  ($/£) Bid 1.5016 Ask 1.5020 American –  (£/$) Bid 0,6657 Ask 0,6659 European

Buy cheap Sell expensive

American versus European

•  Exchange rate between 2 non-$ currencies “through” the $

•  Cross-rate must be consistent: –  No arbitrage –  Triangular arbitrage

•  Helps when two crossed exchange currencies are less actively traded

•  More usual trades against $, though have become more active ¥ and €

Cross-exchange rate

•  2 different calculation possibilities: –  American / American:

–  American x European:

Cross-exchange rate

(€/£) = $/£( )

($/€) American Terms American Terms

(€/£) = $/£( ) ! (€/$) American Terms ! European Terms

= $ £

⎛

⎝ ⎜

⎞

⎠ ⎟ !

€ $

⎛

⎝ ⎜

⎞

⎠ ⎟ =

€ £

⎛

⎝ ⎜

⎞

⎠ ⎟ = (€/£)