The trading of currencies takes place in foreign exchange markets whose major function is to facilitate international trade and investment. Foreign exchange markets, however, are shrouded in mystery. One reason for this is that a considerable amount of foreign exchange market activity does not appear to be related directly to the needs of international trade and investment.
Spot, forward, bid, ask prices:
There is an almost bewildering variety of foreign exchange markets abound in a number of currencies. In addition, there are diverse prices for these currencies. Virtually every major newspaper, such as THE WALL STREET JOURNAL or THE LONDON FINANCIAL TIMES, prints a daily list of exchange rates. These are expressed either as the number of units of a particular c4rrency that exchange for one U. S. dollar or as the number of U. S. dollars that exchange for one unit of a particular currency. Sometimes both are listed side by side.
For major currencies, up to four different prices typically will be quoted. One is the "spot" price. The others may be "30 days forward, " "90 days forward, " and " 180 days forward. " These may be expressed either in"European terms"(such,as the number of U. S. dollar per British Poundsterling) or in "American terms"(such as number of British Pouudsterling per U.S. dollar).
The spot price is what you must pay to buy currencies for immediate delivery ( two working days in the interbank market; over the counter, if you buy bank notes or travellers checks). The forward prices for each currency are what you will have to pay if you sign a contract today to buy that currency on a specific future date(30 days from now, and so on). In this market, you pay for the currency when the contract matures.
Why would anyone buy and sell for eign currency forward? There are some major advantages from having such opportunities available. For example, an exporter who has receipts of foreign currency due at some future date can sell those funds forward now,, thereby avoiding all risks associated with subsequent adverse exchange-rate changes. Similarly, an importer who will have to pay for a shipment of goods in foreign currency in, say, three months can buy the foreign exchange forward and, again, avoid having to bear the exchange-rate risk.
The exchange rates quoted in the financial press are not the ones individuals would get at a local bank. Unless otherwise specified, the published prices refer to those quoted by banks to other banks for currency deals in excess of $ 1 million. Even these prices will vary somewhat depending upon whether the bank buys or sells. The diffrence between the buying and selling price is known as the "bid/ask spread. " The spread partly reflects the banks ' costs and profit margins in transactions; however, major banks make their profits more from capital gains than from the spread.
The market for bank notes and the travellers checks is quite separate from the interbank foreign exchange market. For smaller currency exchanges, such as an individual going on vocation abroad might make, the spread is greater than in the interbank market. This presumbly reflects the larger average costs-including the exchange - rate risks that banks face by holding bank notes in denominations too small to be sold in the interbank market-associated with these smaller exchanges. As a result, individuals generally pay a higher price for foreign exchange than those quoted in the newspapers.
An example of the range of spot exchange rates available is presented in the table below, which shows prices for deutsche marks and sterling quoted with a one-hour period on November 28, 1983. There are two important points to notice. First, all except those in the first line are prices quoted in the interbank, market for transactions in excess of $1 million. The sterling prices have a bid/ask spread of only 0. 1 cent ( which is only about 0. 07 percent of the price, or $ 7 on $ 10, 000). On DM, the spread per dollars worth works out to be about half that on sterling ($ 4 on $ 10, 000).
Second, the prices quoted by local banks for small, or retail, transactions, which serve only as a guide and do not necessarily represent prices on actual deals, and involve a much larger bid/ask spread. These retail spreads vary from bank to bank, but are related to (and larger than) the interbank rates. In some cases, they may be of the order of 4 cents or less on sterling, though the price quoted in St. Louis involved average spreads of 8 cents on sterling. The latter represents a spread of about 5.5 percent ( about $550 per $10, 000). The equivalent spread for DM was 7 percent ( $700 per $10,000 transaction).
The spread on forward transactions will usually be wider than on spot, especially for longer maturities. Of course, like the spot spread, the forward spread varies with time of day and market conditions. At times it may be as low as 0.02 cents. No information is available for the size of spread on the forward prices typically offered on small transactions, since the retail market on forward transactions is very small.
