NPTEL International Finance Vinod Gupta School of Management , IIT. Kharagpur .

Module - 12 Foreign Exchange Quotations: Bid-Ask Spread

Developed by: Dr. Prabina Rajib Associate Professor Vinod Gupta School of Management IIT Kharagpur, 721 302 Email: prabina@vgsom.iitkgp.ernet.in

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Lesson - 12 Foreign Exchange Quotations: Bid-Ask Spread Highlights & Motivation:

The objective of the module is to understand the nuances with bid-ask spread associated with foreign exchange spot quotations. Different aspect of bid and ask rates are discussed in the session i.e, what is bid-ask rates, how banks use the bid-ask rates to change the inventory of the currency they hold, how bid-ask price in Indian spot market has changed significantly over the years and how demand and supply of a currency impacts the bid-ask spread.

Objectives:
In this session, the following aspects of spot bid-ask quotations are given. Bid-Ask rates (for both interbank and retail market). Bid-Ask spread in point form and percentage form. Spot market liquidity and Bid-Ask spread. Bid-Ask Spread and demand supply of currency Bid-Ask spread and arbitrage profit.

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12.1: Introduction
The spot quotations discussed in Session 11, were given as one rate i.e, USD/INR 42.75. However, in real life, like any market place, buyers and sellers give their buying and selling rate. Hence at a given point of time, there are two rates available.These two rates are known as bid and ask rates. As discussed in Session 4 (market participants in foreign exchange market), forex dealers give both bid rates and ask rates. Bid-ask rates are given by forex dealers who are willing to buy and sell forex at these rates. It is to be noted here that in a traditional market, the buyers and sellers are normally separate entities. For example, buyers and sellers of steel would be different. A buyer is an user of the steel while seller is the producer of the steel. However in a forex market buyers and sellers can be individual entities (exporters or importers) as well as a single entity buying and selling a currency simultaneously. The difference between these two rates is known as bid-ask spread. Different aspect of bid and ask rates are discussed in the session i.e, what is bid-ask rates, how banks use the bid-ask rates to change the inventory of the currency they hold, how bid-ask price in Indian spot market has changed significantly over the years and how demand and supply of a currency impacts the bid-ask spread.

12.2: Bid-Ask Rates:

Suppose State Bank of India (SBI), a dealer in forex, is quoting bid-ask EURO/INR of 76.5025 to 76.5048 for spot transaction at 11.15am on 29th August 20XX. Table 12.1: Bid-Ask rates Spot Rate by SBI Bid Euro/INR 76.5025

Ask 76.5048

In this quotation, Euro is the base currency while INR is variable/term/quote currency. Bid-ask price is always expressed in terms of base currency. The bid rate indicates that, SBI is willing to buy 1 Euro from the counterparty and pay INR 76.5025. The ask rate indicates that SBI is willing to sell (or give) 1 Euro to counterparty and accept (or receive) INR 76.5048. In other words, for every Euro SBI buys and sells, it makes a profit of INR 0.0013. Bid rate is always lesser than ask rate. While buying a currency, the traders pay a higher amount compared to selling the same amount of the currency. The bid-ask spread is what the bank/foreign exchange dealer profits.
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The following website (http://www.hifx.co.uk/marketwatch.aspx) gives the interbank forex rate on a real time basis. Table 12.2 shows a snapshot of the interbank quotation. In fact Table 12.2 is just an extension to Table 12.1. Let us understand, bid-ask concepts discussed in this section, in relation to the details given in Table 12.2. Table 12.2 Interbank forex Quotations http://www.hifx.co.uk/marketwatch.aspx Bid Ask Bid-ask spread 1.62536 1.62576 USD 0.00040/GBP 1.7703 1.7714 AUD 0.0011/GBP 0.01136 0.0114 JPY0.0016/USD 0.73665 0.73705 USD 0.0040/NZD 0.9145 0.9150 USD0.0005/AUD

GBPUSD GBPAUD JPYUSD NZDUSD AUDUSD

The quotations are for spot rates. While publishing quotations in any screen or over phone banks quote the base currency first. In GBPUSD the GBP is the base currency and USD is the variable/quote/term currency. Similarly, in GBPAUD, GBP is the base currency while AUD is the variable/quote/term currency. The bid and ask rates are from the banks perspective. In the first row given in Table 12.2, at a bid price of 1.62536, the bank would buy 1 unit of base currency and sell 1.62536 units of variable/quote/term currency. In other words, the bank will buy 1 GBP and pays 1.62536 of USD. At an ask price of 1.62576, the bank is willing sell/offer 1 GBP and receive 1.62576 of USD. If a company wants to sell 1mn GBP (the bank should buy 1mn GBP) and receive USD, then the company would pay 1mn GBP to bank and receive USD162536. If the company wants buy 1mn GBP (the bank to sell GBP), the company would pay USD162576. Bid Ask spread determines the profit for the bank. It is very important to understand at this point is, bid price is always lesser than ask price. Now if a company wants to buy or sell USD (as base currency), then which rates it would be able to do so. The bid-ask rate of 1.62536-162576 will not be directly applicable. The rate needs to be converted so that USD becomes the base currency and GBP becomes the variable/quote/term currency. If we merely reverse the rates i.e, (1/1.62536) and (1/1.62576), we get a bid-ask spread of (0.61524 - 0.61509).

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Table 12.3 Interbank Forex Quotations Bid Ask GBPUSD 1.62536 1.62576 USDGBP (Wrong) 0.61524 0.61509 USDGBP (Correct) 0.61509 0.61524 However, this is not feasible as the bid price > ask price. Hence the correct bid-ask spread is 0.61509 - 0.61524. The correct bid rate is (1/ask rate) and ask rate is (1/bid rate). Both the correct and wrong bid ask spread for USDGBP quotation is given in Table 6.3. With a bid-ask rate of 0.61509 - 0.61524, indicates that a company intending to buy 1mn USD, would pay GBP 61524 to the bank. A company intending to sell 1mn USD would receive GBP 61509 from the bank. The bank quoting the above rate is making a profit of GBP 15 for every 1 mn USD it buys and sells. Bid-ask spread represent the profit potential for the forex dealer while it the transaction cost for the company intending to buy/sell forex. Of course, the spread must cover other costs such as phone bills, internet charges, employees salary and bookkeeping charges etc. In fact, the same figures can be derived from Table 12.2. A company intending to sell 1mn USD, has to pay USD1.62576 and receive 1 GBP. If the company sells 1mn USD, he would receive GBP 615096. In fact the details given in Table 12.3 are not necessary to be calculated. It is given merely to understand the nuances of bid and ask spread. Table 12.4 shows the restated bid and asks spread for the quotations given in Table 12.2. In Table 12.4, the base currencies have been reversed.

Table 12.4 Restated forex quotations as given in Table 12.2 Bid 0.61509 0.5645 89.766 1.3567 1.0928 Ask 0.61524 0.5648 89.798 1.3574 1.0934 Bid-Ask spread GBP 0.00015/USD GBP0.0003/AUD JPY0.032/USD NYZ0.0007/USD AUD0.0006/USD

USDGBP AUDGBP USDJPY USDNYZ USDAUD

To summarize, a trader need to first identify the base currency in a currency quotations. Then focus on the bid-ask rate to determine the price he would pay/receive for any forex transaction.

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One important aspect which needs to be highlighted here is that the rates expressed in Table 12.2 and Table 12.3 are interbank rates. Interbank rates are the rates offered by forex dealers to each other. These rates are applicable to big-ticket players. However, if a small or medium sized corporate or an individual would like to buy or sell GBP, the bidask spread would widen. The following table, Table 12.5 details the rates a forex dealer may quote for interbank, corporate and retail trades. Table 12.5 Interbank and Retail forex Quotations Bid 1.62536 1.62527 1.62522 Ask 1.62576 1.62621 1.62681 Bid-Ask Spread USD 0.00040/GBP USD 0.00094/GBP USD 0.00159/GBP

GBPUSD (Interbank) GBPUSD (Corporate ) GBPUSD (Retail)

Now let us focus little more on the bid-ask spread. It indicates the profit a bank/forex dealer would get if it simultaneously buys and sells 1 unit of base currency. For example, the first row in Table 12.5 indicates that a bank would earn a profit of USD 0.00040 per every 1 unit of GBP it buys and sells. At times bid-ask spread is quoted in percentage terms. A banks/forex dealers spread ask bid is calculated as follows: spread = * 100 . bid For example, for the retail quotations given in Table 6.5, the spread is
1.62681 1.62522 *100 = 0.071% 1.62522 The bid-ask spread occupies a very important role in judging the liquidity in foreign exchange market. Better the liquidity, lesser the spread. In India, the foreign exchange market has evolved in a major way since last 10 years, after the introduction of FEMA 2000. The RBI report on Foreign Exchange Turnover published in October 2010 shows the changing bid-ask spread in the spot market. As per the RBI document The normal spot market quote has a spread of 0.25 paisa to 1 paise while swap quotes are available at 1 to 2 paise spread. A closer look at the bid-ask spread in the rupeeUS dollar spot market reveals that during the initial phase of market development (i.e., till the mid 1990s), the spread was high and volatile due to thin market with unidirectional behavior of market participants (Chart 3.3). In the later period, with relatively deep and liquid markets, bid-ask spread has sharply declined and has remained low and stable, reflecting efficiency gains. spread =

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Figure 12.1: Bid-Ask Spread in Spot Foreign Exchange Market Source: http://www.rbi.org.in Forex exchange dealers not only provide bid-ask quotations for spot trading, they also give bid-ask quotations for longer duration forwards quotations. Forwards quotations bidask spread is discussed in later sections.

12.3: Bid-Ask Spread and Demand Supply of

Forex dealers or banks from time to time expand or squeeze the bid-ask spread to manage the inventory position in a given currency. Normally forex dealers or banks make these quotes for a currency pair or some currency pairs. They are ready to buy and sell currencies at the quoted rate. For example, if a dealer is quoting 1.62536-1.63576 for GBPUSD, then the bank is willing to buy 1 GBP and pay USD1.62536 and willing to sell 1 GBP and receive USD1.62576. If a bank has more USD than it wants to hold, then the bank offers a higher bid price. For example the bank may quote USD1.63540 as bid price (instead of 1.62536). This means that the bank is willing to buy 1 Euro and give USD1.62540 compared to USD 1.62536. This would encourage many traders to sell Euro to the bank and in return receive higher USD.
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To reduce USD inventory, the bank may also increase the offer price. Instead of 1.62576, the bank may offer, 1.62579. This means that the bank requires the traders to pay USD 1.62579 instead of earlier payment of USD1.62576. This would dissuade the traders to sell USD to this bank. Table 12.6 Change in Quotations ( GBP USD rate) when a bank wants a change in inventory position of a currency Bid 1.62536 1.62540 1.62528 Ask 1.62576 1.62578 1.62671 Bid-Ask Spread USD 0.00040/GBP USD 0.00038/GBP USD 0.00043/GBP

GBPUSD Reduce USD inventory Reduce Euro Inventory

In a similar token, if the bank wants to hold less Euro, it would like to buy fewer euros and also sell more Euro. To achieve this, the bank would reduce the bid price as well as ask price. Table 12.6 highlights how banks would narrow/widen bid-ask spread to manage currency inventory. Hence, depending on their inventory position, foreign exchange dealers/banks may narrow or widen the spread. However, they are not absolutely free to quote any rate. Willy-nilly they have to maintain parity with other dealers for the same currency pair. Too much of difference in quotes among banks/dealers will lead to arbitrage profit i.e, thus forcing the rates to remain range bound. When we compare the first two columns of Table 12.6, it can be seen that with the new rates, the bid-ask spread has reduced for the forex dealer/bank. However, this is normally not the case. If a forex dealer/bank wants to reduce the USD inventory, they would not like to change the bid-ask spread but only shift the bid-ask midpoint. Table12.7 lists the bid-ask midpoint for the details given in Table 12.6.
Table 12.7: Shifting of Bid-ask midpoint without changing the bid-ask spread.

GBPUSD Reduce USD inventory (old) Reduce USD inventory (new)

Bid 1.62536 1.62540 1.62541

Ask 1.62576 1.62578 1.62581

Bid-ask Spread USD 0.00040/GBP USD 0.00038/GBP USD 0.00040/GBP

Mid Point 1.62556 1.62559 1.62561

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ask bid 2 Details given in second row of Table 12.7 shows that not only the bid and ask rates have changed but the spread has reduced. However, forex dealers will only change the bid and ask rates without changing the spread. The, third row indicates that the bid-ask rate has shifted to right without any change in bid-ask spread. The midpoint has changed from 1.62556 to 1.62561. As per the details given in third row, to reduce USD inventory, the bank would buy 1 GBP and pay USD 1.62541. It would sell and 1 GBP and receive USD1.62581.

Midpoint is calculated as midpo int = bid rate +

The bid-ask spread is also affected by large number of other factors. These are Liquidity/trading volume in the market Size of the transaction Number of players, time of the day etc Currency rate volatility.

In the United States, spreads tend to be narrowest in the New York morning-Europe afternoon period, when the biggest markets are open and activity is heaviest. Bid-ask spread is widest in the late New York afternoon, when European and most large Asian markets are closed.

Multiple choices questions and fill in the Blanks:

1. Assume that a bank's bid rate on Swiss francs is $0.45 and its ask rate is $0.47. Its bid-ask percentage spread is: i. about 4.44%. ii. about 4.26%. iii. about 4.03%. iv. about 4.17%. 2. The value of the Australian dollar (A$) today is $0.73. Yesterday, the value of the Australian dollar was $0.69. The Australian dollar ________ by _______%. i. depreciated; 5.80 ii. depreciated; 4.00 iii. appreciated; 5.80 iv. appreciated; 4.00

3. If bid-ask rate for USD/YEN is 111.2015 and 111.2035, then YEN/USD bid and ask rates are going to be _________ and __________.

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Short Questions:
4. The following exchange rates are available: i) Bank A: JPY120/USD ii) Bank B : CHF 1.6/USD iii) Bank C: JPY of 80/CHF Assume that a trader has CJF of 100mn. Can he do triangular arbitrage ? Is so what would be the profit in CHF.

5. What forex dealers quote using bid-ask spread? Why Bid-Ask spread 6. Can there be huge difference between the bid-ask spread for a given bank over a considerable period of time? 7. What is Bid-Ask midpoint? 8. How forex dealers change the bid-ask spread to manage their currency inventory?

References:
1. Spot Rates and Cross Rates, http://www.ukforex.co.uk/cgi-bin/interbank-spotrates.asp. 2. The Foreign Exchange Market, (Chapter 4), Multinational Business, Finance, Stone Hill et al. 10th Edition. 3. Exchange Rate data, http://www.rbi.gov.in 4. FOREIGN EXCHANGE RATES ON ALL RATES : PER UNIT http://www.eximin.net/forex_rates/fer_template.asp

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