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##### Subject 1. Foreign Exchange Spot Markets
The currency exchange rate convention used in this reading is P/B.

• B is the base currency.
• P is the price of the base currency.

For example, a USD/GBP rate of 1.5 indicates that one GBP is priced at 1.5 USD.

Dealers (e.g., banks) do not normally charge a commission on their currency transactions, but they profit from the spread between the buying and selling rates on both spot and forward transactions. Quotes are always in pairs: the first rate is the buy, or bid, price (for a dealer); the second is the sell, or ask, offer (for a dealer).

• The ask rate is always higher than that bid rate, so the dealer can make a profit.
• The counterparty that asks for a two-sided price quote has the option, not the obligation, to deal at either the bid or ask price quoted to them.
• The bid-ask spread a client receives from a dealer is usually wider than the bid-ask spread a dealer receives from the interbank market. The dealer can use the interbank market to offset its position and get out of the risk exposure.

Sometimes the term pip is used to describe a spread. A pip is the smallest price change that a given exchange rate can make. Since most major currency pairs are priced to four decimal places, the smallest change is that of the last decimal point - for most pairs this is the equivalent of 1/100th of one percent, or one basis point.

The size of the bid-ask spread quoted to dealers' clients depends on three factors:

• The bid-ask spread in the interbank market for the pair. This factor depends on a few factors: the currency pair involved, the time of day, and the market volatility.
• The size of the transaction.
• The dealer-client relationship.

Triangular Arbitrage

A cross rate is the exchange rate between two countries computed from each country's exchange rate against a third country.

Example

The rate between Japanese JPY and the USD is JPY/USD = 80.0512 - 80.1230 and the rate between EUR and the USD is EUR/USD = 0.7920 - 0.7932. The quote between JPY and EUR will JPY/EUR = 80.0512/0.7932 = 100.9218, and 80.1230/0.7920 = 101.1654.

Note that in calculating the cross rates you should always assume that you have to sell a currency at the lower (or bid) rate and buy it at the higher (or ask) rate, giving you the worse possible rate.

Exchange traders are continuously alert to the possibility of taking advantage, through currency arbitrage transactions, of exchange rate inconsistencies in different money centers. These transactions involve buying a currency in one market at a lower price and simultaneously selling it in another at a higher price. As a result, the value of the bought currency will rise, while the value of the sold currency will fall. Such activities tend to keep exchange rates uniform in the various markets.

For example, suppose the following bid-ask quotes:

Market | Price Currency | Base Currency | Bid | Ask
New York | USD | GBP | 1.5712 | 1.5748
Toronto | CAD | USD | 1.0268 | 1.0312
London | CAD | GBP | 1.5617 | 1.5823

An astute trader would sell USD for CAD in Toronto, use the CAD to acquire GBP in London, and sell the GBP in New York. Specifically, the trader would:

• Begin in New York with USD1 million.
• Acquire CAD 1,026,800 for USD 1,000,000 in Toronto.
• Sell these CAD for GBP 648,928.8 in London (1,026,800 / 1.5823).
• Sell these GBP in New York for USD1,019,597 (648,928.8 x 1.5712).
• Get a profit of USD 19,597 with no investment and risk!

Absence of arbitrage requires the bid price is always lower than the ask price, no matter it is a dealer's quote, interbank quote, or implied cross rate quote.

Learning Outcome Statements

calculate and interpret the bid-ask spread on a spot or forward foreign currency quotation and describe the factors that affect the bid-offer spread;

identify a triangular arbitrage opportunity and calculate its profit, given the bid-offer quotations for three currencies;

CFA® 2023 Level II Curriculum, Volume 1, Module 8

User Comment
Oksanata I think he should use 1.5748, not 1.5617 to sell these GBP in New York, shouldn't he?
malcolm56 I would think he would use 1.5712 since he's selling GBP into the bid price, but I agree that 1.5617 doesn't seem to make sense.
Oksanata if the dealer wants to sell his GBP in NY he should enter the market as Seller, i.e. use ASK price to sell his GBPs (1.5748)..for 1.5712 he would be able to buy GBPs in NY, not sell...isn't it so, Malcolm56?
ArekKlauza This is because he is selling in NY market, and the prices in that market are 1.5712 | 1.5748. He gets less \$ using the lower rate (1.5712)
Remember the tip to get always the worst possible rate for me (and the best for the dealer).
Oksanata I got it! the thing to always keep in mind is base currency or price currency, For example, in New York GBP (base currency) is bought for \$1.5712 and is sold for \$1.5748, so if I want to sell GBP I have to take \$1.5712 for them.
sanyukta Oksanta I think you are right. The biggest think to keep in mind is perspective. For me I ask myself is it in the perspective of the dealer or the trader, bearing in mind that the price quoted are that of the dealers. The exercise here is in the perspective of the trader. Therefore where he has the base currency and wants to acquire the price currency, he will get this at the buy rate (a dealer would be buying from him) and where he has the price currency and wants to get the base currency, he will us the ask rate (a dealer would be selling to him).
Thanks for making me think this through guys. I hope my logic helps you too.
guest Because you are a client, if the currency needs to multiply something, always multiply the smaller one. If the currency needs to divide something, always divides the bigger one. Clients are always at a disadvantageous position compared with the dealers.
bspence Another way to think about it is up-the-bid-and-multiply and down-the ask-and-divide. So for example, EUR/USD (1.1748 - 1.1750) to convert Euro to USD we are going down the equation so down-the ask-and-divide, therefore 10,000 Euro / 1.1750 = \$8,510.64. And in the opposite direction, if we want to convert USD to Euro we're going up the equation, up-the-bid-and-multiply, so \$10,000 * 1.1748 = 11,748 Euro.