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International Finance

International Finance. Exchange Rates Bill Reese. Learning Objectives. In this unit we will learn: How to interpret direct and indirect exchange rates How to determine cross-rates How rates are quoted How to calculate the bid-ask spread. Basic Terms. Spot Rate

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International Finance

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  1. International Finance Exchange Rates Bill Reese

  2. Learning Objectives • In this unit we will learn: • How to interpret direct and indirect exchange rates • How to determine cross-rates • How rates are quoted • How to calculate the bid-ask spread

  3. Basic Terms • Spot Rate • The price of a currency in terms of another currency for a trade today • Forward Rate • Price agreed upon today for a trade to be executed at a specified future date (30, 60, 90, 180 or 360 days)

  4. Basic Terms • Direct quote • American quote • Domestic currency/foreign currency • Dollars needed to buy one unit of foreign currency • $/€

  5. Basic Terms • Indirect quote • European quote • Foreign currency/domestic currency • Units of foreign currency needed to buy one dollar • €/$

  6. Quotes • Currency is a commodity • Bananas • $0.5/pound = 2 lbs. for a dollar • Price of dollar = €.813 • Price of a euro = $1.23

  7. Quotes • Currency in denominator is the one being priced • .813 €/$ • 1.23 $/€

  8. Quotes • You have dollars and want euros $ → € • Selling dollars • Buying euros • You have euros and want dollars € → $ • Selling euros • Buying dollars

  9. Quotes • You have $5.00. How many euros is it worth if XR is 1.23 $/€? • Multiply or divide? • Direct quote: $5 x 1.23 $/€ • Note that $ won’t cancel out • Must invert • Indirect quote or divide

  10. Quotes • $5 ÷ 1.23 $/€ = $5 x 1/1.23 €/$ = $5 x .813 €/$ = €4.065

  11. Quotes • Suppose you have €30 and want dollars? • €30 x 1.23 $/€ = $36.90 • Note how €s cancel out in numerator and denominator

  12. Cross Rates • Cross exchange rate • One foreign currency per unit of another foreign currency 1.23 $/€ and 1.81 $/£ • Cross-rate between euro and pound

  13. Cross Rates • Multiply to cancel out $ 1.23 $/€ x 1.81 $/£ Can’t do it – must divide or invert 1.23 $/€ ÷ 1.81 $/£ = 1.23 $/€ x 1/1.81 $/£ = 0.68 £/€

  14. Cross Rates • If you want €/£ • Take reciprocal • 1/0.68 £/€ = 1.47 €/£

  15. Bid and Ask • There are two XRs • Bid: price dealer will pay you for your currency • Rate if you want to sell • Ask: price dealer will sell you units of a currency for • Rate if you want to buy • Ask > Bid

  16. Bid and Ask • Indirect quotes • Ask: 1.29 SF/$ • Bid: 1.28 SF/$ • Direct quotes • Ask: .78125 $/SF • Bid: .7752 $/SF • Bid in $ = Ask in SF • Bid in SF = Ask in $

  17. Bid and Ask • Example • Ask: .0091 $/¥ • Bid: .0090 $/¥ • $150 to convert to yen • Buy yen at price of .0091 $/¥ • Or sell dollars at price of 1/.0091 ¥/$ • $150 ÷ .0091 $/¥ = ¥16,483.5

  18. Bid and Ask • Change your mind – convert back • Sell yen at price of .0090 $/¥ • Or buy dollars at price of 1/.0090 ¥/$ • ¥16,483.5 x .0090 $/¥ = $148.35

  19. Bid and Ask • $150 → $148.35 • Lost $1.65 • Lost 1.1% of $150 you started with • Bid-Ask Spread Spread = Ask – Bid Ask = (.0091 - .0090)/.0091 = 1.1%

  20. Bid and Ask • Spread • Transaction cost for round-trip transaction • Decreases with greater amounts of currency • Increases with less frequently traded currency

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