Economics

Question 1

Currency Notation

Answer 1

USD/GBP 1.5650

• Meaning 1 GBP converts to 1.5650 USD
  
  • USD = Price currency
  • GBP = Base currency

Question 2

Bid-Ask (Bid-Offer) Spreads

Answer 2

• ‘Bid-offer’ and ‘Bid-ask’ mean the same thing
• Example quote: USD/EUR 1.3245 (Bid) /1.3249 (Offer)
• The bank making the quote bids for the base currency on the left and offers it on the right
• In this example the bank is willing to pay USD 1.3245 to buy one Euro and will sell one Euro for USD 1.3249
• YOU WILL ALWAYS GET THE WORST DEAL!!! (less)
• The spread in this example is quoted as 4 pips
  
  • The offer is always higher than the bid
  • The spread represents the profit to the dealer
  • There will be a bid-ask quoted by dealers to their clients, and a bid-ask quoted to the dealer in the interbank market

Question 3

Factors affecting the spread size

Answer 3

1. Bid-offer spread in the interbank market
2. Size of the transaction – larger transaction, wider spread
3. Relationship between dealer and client – dealer may narrow spread to win further business

!! Credit risk of the client has minimal impact due to the short settlement cycle !! T+2

!! Size of the dealer’s inventory in relation to desired position will NOT affect the spread

Question 4

Bid-offer spread in the interbank market depends on:

Answer 4

1. Currency pair involved: Less liquid, wider spreads
2. Time of day: More liquid when all markets are open
3. Market volatility: More volatility, more risk, wider spreads

Question 5

Calculating currency cross rates

Answer 5

Question 6

Calculate Spread

Answer 6

Question 7

Cross exchange rates with bid-offer spreads

Answer 7

Question 8

Triangular Arbitrage

Answer 8

1. Calculate cross rate for AUD/CHF and compare to quote
2. Sell the overvalued and buy the undervalued
3. Usually you will start and end with the USD, i.e. sell USD to buy the overvalued currency so you can then sell it for the undervalued

Question 9

Triangular arbitrage using bid-offer spread

Answer 9

1. Calculate cross rate for AUD/CHF and compare to quote
2. Sell the overvalued and buy the undervalued
3. Usually you will start and end with the USD, i.e. sell USD to buy the overvalued currency so you can then sell it for the undervalued