Exchange Rates:

The value of a currency is determined by its comparison to another currency. The first currency
of a pair is called the "base currency", and the second currency is called the "terms currency"
(or "quote currency"). The currency pair indicates how much of the terms currency is needed to
purchase one unit of the base currency.
 EUR/USD: 1.2; 1 Euro gives you 1.2 USD
 USD/CAD: 1.1; 1 USD gives you 1.1 CAD
 GBP/USD: 1.6; 1 GBP gives you 1.6 USD
Spot Exchange Rate
Spot exchange rate (or FX spot) is the current rate of exchange between two currencies. It is the
rate at which the currencies can be exchanged immediately.
According to the definition, delivery is theoretically immediate; however, conventions of
currency markets allow for up to two days for settlement of a transaction.
Bid:
The rate at which the quoting party is willing to buy the COMMODITY CURRENCY( or sell the
TERMS CURRENCY).
Offer:
The rate at which the quoting party is willing to sell the COMMODITY CURRENCY(or buy the
TERMS CURRENCY).
For example, if the USD/INR ‘BID’ is 45.25, that means the quoting party is willing to buy dollars
(the COMMODITY CURRENCY) from you, and in return sell you 45.25 rupees per dollar that he
buys.
Forward Exchange Rate
Forward exchange rate is the exchange rate at which a party is willing to enter into a contract
to receive or deliver a currency at some future date.
Currency forwards contracts and future contracts are used to hedge the currency risk. For
example, a company expecting to receive €20 million in 90 days can enter into a forward
contract to deliver the €20 million and receive equivalent US dollars in 90 days at an exchange
rate specified today. This rate is called forward exchange rate.
Forward exchange rates are determined by the relationship between spot exchange rate and
interest or inflation rates in the domestic and foreign countries.
Direct Quote
Direct quote is the convention of expressing currency exchange in terms of units of domestic
currency per unit of foreign currency.
It is 'direct' in the sense that a resident knows the price of the foreign currency straight away.
What is a direct quote for a domestic resident is an indirect quote for the resident of the
foreign country. An indirect quote is the exact opposite of the direct quote.
Formula
A direct quote can be converted to indirect quote by the following formula:
Direct Quote=1Indirect Quote
When a currency exchange rate is expressed in terms of bid-ask spread instead of a mid-quote,
the direct bid becomes the indirect ask and direct ask becomes the indirect bid as explained in
Example 3.
Examples
Example 1: A US resident converted US$20,000 to £12,800. What is the direct quote for the
exchange rate prevalent at the time the transaction was made?
Answer: US dollar is the domestic currency while British pound is the foreign currency. In direct
quote since exchange rate is expressed in terms of domestic currency per unit of foreign
currency, direct quote between US dollar and British pound would be $1.5625 per £ (calculated
by dividing $20,000 by £12,800).
$1.5625/£ is an indirect quote for the British resident.
Example 2: Exchange rate between US dollar and Swiss franc is 0.92 Swiss francs per US dollar.
Answer: It is direct quote for Swiss resident because from Switzerland perspective it is quoted
as units of domestic currency per unit of foreign currency. An indirect quote would be US$1.087
per Swiss franc (=1/0.92).
Example 3: Exchange rate between US dollars and Canadian dollar is US$1.0211/C$ -
US$1.0213/C$. Find the indirect quote for a US resident.
Solution: When exchange rates are expressed as bid − ask quotes, a reciprocal of the bid rate in
direct quote becomes the ask quote in indirect quote, and the reciprocal of the ask rate in
direct quote becomes the bid rate in indirect quote.
Indirect quote for exchange rate between US dollar and Canadian dollar for US resident would
be C$0.9791/US$ - C$0.9793/US$, where C$0.9791/US$ = 1/(US$1.0213/C$), and C$0.9793 =
1/(US$1.0211/C$).
Indirect Quote
Indirect quote is the reporting of foreign exchange rate in terms of units of foreign currency per
unit of domestic currency. For a resident of the United States intending to buy/sell British
pounds, it means exchange rates expressed in British pounds per unit of US dollar.
Formula
An indirect quote is the inverse of the direct quote.
When the foreign exchange rate is expressed as a mid-quote, the following formula can be used
to calculate the indirect quote:
1
Indirect Quote =
Direct Quote
Where the foreign exchange rate is expressed in terms of bid and ask spread, indirect quote can
be calculated by finding the inverse of both prices and switching their positions. It means that
the direct bid becomes the indirect ask and the direct ask becomes the indirect bid. Direct
quote of (x − y) would become indirect quote of (1/y − 1/x).
Examples
Example 1: An Australian resident converted 500,000 AUD to 45,139,200 JPY. Find the indirect
quote for the Australian resident.
Solution
For an Australian resident, Australian Dollar (AUD) is the domestic currency while Japanese Yen
(JPY) is the foreign currency. Indirect quote expresses foreign currency in terms of one unit of
domestic currency. Indirect quote in this situation would be 90.2784 JPY/AUD (45,139,200 JPY
per 500,000 AUD).
Relevant direct quote would be 0.011077 JPY/AUD (=1/(90.2784 JPY/AUD)).
Example 2: EUR/USD exchange rate is 1.3391 − 1.3392. This is the direct quote for a resident of
the European Union.
Since the exchange is quoted as bid-ask, we find reciprocals of both prices and switch their
positions to get the relevant indirect quote.
Indirect exchange rate between Euro and US dollar for the European resident would be (0.7467
− 0.7468). The new bid is 0.7467 calculated as the inverse of the direct ask (1.3392), while
0.7468 is the new ask and is calculated as the inverse of the direct bid (1.3391).
Practice Problem:
Suppose the direct quote for the pound sterling in NY is 2.2220-30.
a) What is the direct quote for dollars in London?
b) Compute the percentage bid-ask spread in NY.

Bid Ask Spread

Bid-ask spread (also called bid-offer spread) is the excess of the price at which a financial
market participant is willing to sell a financial instrument (the ask or the offer) over the price at
which he is willing to buy it (the bid).
Bid-ask spread is the mechanism by which dealers in the quote driven markets are
compensated.
Market bid-ask spread equals the excess of the best ask (the lowest ask) over the best bid (the
highest bid. Though every participant in a quote-driven market has his own bid and ask prices,
the market bid-ask spread is different from individual bid-ask spreads.
Bid-ask spread depends on market liquidity and volatility of the relevant financial instrument
(i.e. stock, currency, bonds, etc.)
Formula :Bid-Ask Spread = Ask Price − Bid Price
Market Bid-Ask Spread = Best Ask Price − Best Bid Price
Ask/offer price (or ask) is the price at which the dealer sells and bid price (or bid) is the price at
which he purchases it.
Examples
Example 1: Stock Bid-Ask Spread
Low-cap stocks are normally traded on quote-driven markets. Best bid/best ask (market bid
ask) for Tesla Motors, Inc. (TSLA) on NASDAQ as on 18 July 2012 is $118.28/$118.49. This gives
us a bid ask spread of $0.28 [= $118.49 − $118.28].
This means if you have 100 shares of Tesla, you can sell them for $11,828 [= $118.28 × 100],
however, if you want to purchase 100 more shares of Tesla, you will have to pay $11,849 [=
$118.49 × 100].
Example 2: Currency Bid-Ask Spread
Forexica sells Euro at 1.3093€/$ and purchases it at 1.3089€/$. Find the bid-ask spread.
1.3093 is the sale price, so it is the ask. 1.3089 is the purchase price, and hence the bid. This
gives us a bid-ask spread of 0.0004 [= 1.3093 − 1.3089] or 4 pips. In foreign currency markets
this 4th decimal is called one pip.
Example 3: US Treasuries Bid-Ask Spread
US treasuries bid-ask quotes are expressed in terms of multiples of 1/32s.
Bid-ask quote for a $1,000 US bond that carries 6% coupon rate and matures in 15 years is
103.16 − 28. It means the dealer is willing to buy the bond for $1035 [= (103 + 16/32)/100 ×
$1,000]. He is willing to sell the same bond for $1,037.5 [= (103 + 24/32)/100 × $1,000].
Interest Rate Parity
Interest rate parity is a theory proposing a relationship between the interest rates of two given
currencies and the spot and forward exchange rates between the currencies. It can be used to
predict the movement of exchange rates between two currencies when the risk-free interest
rates of the two currencies are known.
Interest rate parity theory assumes that differences in interest rates between two currencies
induce readjustment of exchange rate. However, exchange rates are determined by several
other factors and not just the interest rate differences, therefore interest rate parity theory
cannot predict or explain all movements in exchange rates. But it does serve as a useful guide
nonetheless.
Interest rate parity theory is based on assumption that no arbitrage opportunities exist in
foreign exchange markets meaning that investors will be indifferent between varying rate of
returns on deposits in different currencies because any excess return on deposits in a given
currency will be offset by devaluation of that currency and any reduced return on deposits in
another currency will be offset by appreciation of that currency.
Covered interest rate parity exists when forward contract rates of currencies can be used to
prove that no arbitrage opportunities exist. If forward exchange quotes are not available the
interest rate parity exists but it is called uncovered interest rate parity.
Covered interest rate parity may be presented mathematically as follows:

Where iquot is the interest free rate of return on deposits of quote currency, ibase is that rate
for base currency and n are the number of years until the date of forward rate.
If exchange rate is quoted as USD/EUR i.e. Euros per 1 US Dollar, the USD is the base currency
and EUR is the quote currency.
Interest rate parity can be used to estimate forward rates between two currencies by
rearranging the above equation to:
Example
Suppose mid-market USD/CAD spot exchange rate is 1.2500 CAD and one year forward rate is
1.2380 CAD. Also the risk-free interest rate is 4% for USD and 3% for CAD. Check whether
interest rate parity exist between USD and CAD?
Solution:

Since the two values are approximately equal, therefore interest rate parity exists.
Purchasing Power Parity
Purchasing power parity (PPP) is an economics theory which proposes that the exchange rate of
any two currencies will remain equal to the ratio of their respective purchasing powers.
Purchasing power of a currency is measured as the amount of the currency needed to buy a
selected product or basket of goods commonly available in different countries.
Purchasing power parity theory states that, in the long run, the price paid for a product in two
countries using different currencies will be same after the exchange rate differences have been
accounted for. This itself is based on the law of one price i.e. price of a given commodity is
same no matter what currency is used to purchase it.
It also suggests that a change in purchasing power of the two currencies will induce
readjustment of the exchange rate towards new equilibrium point.
Purchasing power parity assumes similar market conditions and absence of costs such as
transportation and duties etc.
Let's say we have two currencies A and B. Then,

Purchasing power of a currency is a function of inflation which means that high rate of
inflation of one currency relative to another will reduce the purchasing power of the currency
and vice versa. This means that the exchange rate between two currencies will change in
proportion to the ratio of inflation rates between the two currencies as shown in the following
equation:

Where iquot is the inflation rate of quote currency, ibase is the inflation rate for base
currency and n are the number of years until the date of forward rate.
Let's say the exchange rate is quoted as USD/GBP i.e. GBP per 1 USD. In this case the USD is the
base currency and GBP is the quote currency.
The above equation may be rearranged to obtain the following formula for the estimated
of forward exchange rate:
Forward Rate=Spot Rate×(1+iquot1+ibase)n
Example
For the sake of simplicity we are going to ignore the bid-ask spread in the following example.
The price of a standardized basket of goods is 18,000 USD or 13,000 GBP. Let us test whether
purchasing power parity exists if the current USD/GBP exchange rate is 1.3800 USD.
The estimated exchange rate as per PPP is 1.3846 [=18,000/13,000], which is quite near the
1.3800 meaning that PPP exists. This example is just for understanding purpose only. Real life
spot rates may be quite different than the rate estimated using PPP because currency exchange
rates are determined by a number of market conditions.
Cross Currency Rates:
Executing a foreign exchange transaction between the major international currencies is usually
straightforward, as most banks will be trading and making a price between all the major
currencies. However, for less common currencies, many banks will not run books and therefore
rates are not always quoted or easily available.
In order to establish the appropriate rate of exchange, the cross-rate between the two
currencies has to be calculated. This works by translating the first currency into a common
currency (often the US Dollar) and then translating the common currency into the second
currency. This then determines the cross-rate between the two currencies.
All foreign exchange rates are quoted base currency/variable currency – in other words, an
amount of the variable currency in exchange for one unit of the base currency. So for USD/CAD,
the US Dollar is the base currency and the rate quoted will be the amount of Canadian Dollars
for one US Dollar.
In most cases, the base currency will be US dollars for both currencies and this will enable the
cross-rate to be calculated quite easily. However, for some currencies, the FX market
convention is that the US Dollar is the variable currency, such as in the trade GBP/USD when
the pound becomes the base currency and the amount of dollars varies.
Finally we must remember that for all foreign exchange trades, the dealer can quote two
numbers – the first is the bid rate (the rate at which the trader will buy the currency), the
second is the offer rate (the rate at which the trader will sell the currency). The dealer always
wants more currency if selling units of the base currency than will be given away if currency is
being provided for units of the base currency. The difference is the margin and is one of the
sources of profit to the dealer.

Calculating cross-rates where there is a common base currency quoted for both currencies

Where there are two currencies Y and Z both of which are quoted against X, the two exchange
rates are X/Y and X/Z and the cross-rates will be:

 Y/Z=X/ZX/Y

 and Z / Y = X / Y X / Z

Example

To calculate the cross-rate between the Canadian Dollar (CAD) and the South African Rand
(ZAR), using the US Dollar as the common currency. Let us assume that the Canadian Dollar and
Rand are quoted as:

 USD / CAD = 1.58850 1.58880

 USD / ZAR = 11.0500 11.1250

The first number is the rate at which the bank sells the currency being quoted against the US
dollar and the second is the rate at which the bank buys the currency being quoted against the
US dollar. So the cross rates can be calculated as:

 CAD / ZAR = USD / ZAR USD / CAD

 ZAR / CAD = USD / CAD USD / ZAR

For CAD/ZAR – to buy a variable amount of ZAR per 1 CAD:

 Bid = 11.05000 1.58880 = 6.955 - the bank buys CAD and sells ZAR

 Offer = 11.12500 1.58850 = 7.003 - the bank sells CAD and buys ZAR

 So CAD/ZAR = 6.955 / 7.003

For ZAR/CAD – to buy a variable amount of CAD per 1 ZAR:

 Bid = 1.58850 11.12500 = 0.1428 - the bank buys ZAR and sells CAD

 Offer = 1.58880 11.05000 = 0.1438 - the bank sells ZAR and buys CAD

 So ZAR/CAD = 0.1428 / 0.1438

As you might expect these rates are the reciprocal of the CAD/ZAR rates.

Calculating cross-rates where the common currency is the base currency in one pair and the
variable currency in the other

Once again there are two currencies Y and Z both of which are quoted against X, but the
exchange rates are Y/X and X/Z, not X/Y and X/Z so the cross-rates are:

 Y/Z=Y/X x X/Z

 And Z / Y = 1 Y / X x X / Z

Example

To calculate the cross-rate between Sterling (GBP) and the Mexican Peso (MXN), using the US
Dollar (USD) as the common currency. Let us assume that rates are quoted as follows:

 GBP / USD = 1.43130 / 1.43160

 USD / MXN = 9.02000 / 9.03000

 GBP / MXN = GBP / USD x USD / MXN

 MXN / GBP = 1 GBP / USD x USD / MXN

For GBP/MXN – to buy a variable amount of MXN per 1 GBP:

 Bid = 1.43130 x 9.02000 = 12.91 - the bank buys GBP and sells MXN

 Offer = 1.43160 x 9.03000 = 12.93 - the bank sells GBP and buys MXN

 So GBP/MXN = 12.91 / 12.93

For MXN/GBP – to buy a variable amount of GBP per 1 MXN:

 Bid = 1 1.43160 x 9.03000 = 0.07735 - the bank buys MXN and sells GBP

 Offer = 1 1.43130 x 9.02000 = 0.07746 - the bank sells MXN and buys GBP

 So MXN/GBP = 0.07735 / 0.07746

Example:

Assume you are a trader with Deutsche Bank. From the quote screen on your computer
terminal, you notice that Dresdner Bank is quoting €0.7627/$1.00 and Credit Suisse is offering
SF1.1806/$1.00. You learn that UBS is making a direct market between the Swiss franc and the
euro, with a current €/SF quote of .6395. Show how you can make a triangular arbitrage profit
by trading at these prices. (Ignore bid-ask spreads for this problem.) Assume you have
$5,000,000 with which to conduct the arbitrage. What happens if you initially sell dollars for
Swiss francs? What €/SF price will eliminate triangular arbitrage?
Solution:
To make a triangular arbitrage profit the Deutsche Bank trader would sell $5,000,000 to
Dresdner Bank at €0.7627/$1.00. This trade would yield €3,813,500= $5,000,000 x .7627. The
Deutsche Bank trader would then sell the euros for Swiss francs to Union Bank of Switzerland at
a price of €0.6395/SF1.00, yielding SF5,963,253 = €3,813,500/.6395. The Deutsche Bank trader
will resell the Swiss francs to Credit Suisse for $5,051,036 = SF5,963,253/1.1806, yielding a
triangular arbitrage profit of $51,036.
Example:
The current spot exchange rate is $1.95/£ and the three-month forward rate is $1.90/£. Based
on your analysis of the exchange rate, you are pretty confident that the spot exchange rate will
be $1.92/£ in three months. Assume that you would like to buy or sell £1,000,000.
a. What actions do you need to take to speculate in the forward market? What is the
expected dollar profit from speculation?
b. What would be your speculative profit in dollar terms if the spot exchange rate actually
turns out to be $1.86/£.
Solution:
a. If you believe the spot exchange rate will be $1.92/£ in three months, you should buy
£1,000,000 forward for $1.90/£. Your expected profit will be:
$20,000 = £1,000,000 x ($1.92 -$1.90).
b. If the spot exchange rate actually turns out to be $1.86/£ in three months, your loss from
the long position will be:
-$40,000 = £1,000,000 x ($1.86 -$1.90).