Spread – the Difference Between Buying and Selling Price

Chapter 2: An Introduction to Exchange Rates

Spread – The difference between buying and selling price

Spot Foreign Exchange Market – involved with the exchange of currencies held in different currency denominated bank accounts. Deposits are transferred from sellers’ to buyers’ accounts, with instructions to exchange currencies. Delivery, or “value,” from the electronic instructions is “immediate” – usually in one or two days. This distinguishes the spot market from the forward market, which involves the planned exchange of currencies for value at some date in the future.

Spot Exchange Rate – the number of units of one currency per unit of another currency, where both currencies are in the form of bank deposits. The spot exchange rate is determined in the spot market by the supplies of and demands for currencies being exchanged in the gigantic, global interbank foreign exchange market.

SWIFT – Society for Worldwide International Financial Telecommunications. This computer-based communications system links banks and brokers in just about every financial center. The banks and brokers are almost in constant contact, with activity in one financial center or another 24 hours a day. The efficiency of the spot foreign exchange market is revealed in the extremely narrow spreads between buying and selling prices. These spreads can be smaller than 1/10 of a percent of the value of a currency exchange, and are therefore about 1/50 or less of the spread faced on banknotes by international travelers.

Interbank Trading – Banks trade directly with each other, and all participating banks are market-makers which means that banks quote buying and selling prices to each other. The calling bank does not call to specify whether they wish to buy or sell, or how much of the currency they wish to trade. Bank A calls Bank B for a quote of “their market.” This is known as an open-bid double auction.  The interbank foreign exchange market can be characterized as a decentralized, continuous, open-bid, double-auction market.

Foreign Exchange Brokers  - Limit orders are placed. The broker attempts to match the bank’s purchase order with sell orders. Unlike the market-making banks with interbank trading, brokers deal for others, showing callers their best rates and charging a commission to buying and selling customers. The indirect broker-based market can be characterized as a quasi-centralized, continuous, limit-book, single-auction market.

Why do many travelers carry traveler’s checks rather than just domestic and foreign bank notes? Why are they relatively inexpensive?

Banks face lower risk of theft of traveler’s checks and companies that issue them (American Express, Visa, MasterCard etc.) will quickly credit the banks that accept their checks. Issuers of travelers’ checks also enjoy the use of the money paid for the checks before they are cashed. The banks selling the checks to customers do not face an inventory cost; payment to the check issuing company such as AMEX by a check-selling bank is made only when a customer is purchasing the checks. These benefits to the check issuers keep the buying-selling spread down.

Dealer – a person who buys and/or sells for its own account.

Broker – a person who buys and/or sells for the accounts of other people and is an agent for them.

What risks are taken by foreign currency dealers, especially those who engage in small retail transactions? What is a bid/asked price? What is a spread?

The ask price is the inter-bank selling rate and the bid price is the inter-bank buying rate. The retail spread is wider than the interbank spread. The primary risk lies within fluctuations in foreign currency rates.

Why are the spreads for currency exchanged with travelers by retail currency dealers so expensive?

The banknote market used by travelers involves large spreads because generally only small amounts are traded, although the same amount of paperwork is required as with the bigger commercial transactions. Also, each bank and currency exchange must hold many different currencies to be able to provide customers with the currencies they want, and these notes do not earn interest. This involves an opportunity cost of holding currency inventory as well as a risk from short-term changes in exchange rates. Banks also have to take costly security precautions to prevent against robberies, especially when moving from branch to branch or country to country.

CHIPS (Clearing House Interbank Payments System) – a computerized mechanism through which banks hold US dollars to pay each other when buying or selling foreign exchange. The system is owned by the large NY-based clearing banks and it handles hundreds of thousands of transactions per day.

Continuous Linked Settlement (CLS)  - a newer settlement system designed to reduce settlement risk, which was spurred on by concern over the possible vulnerability of the international financial system to extreme outside events. Allow member banks to debit and credit escrow accounts simultaneously (debits and credits are linked continuously with no intervening delays between them). The virtue of a continuously linked system is that it prevents situations where a bank pays for a currency before receiving it, and then finds out the bank that was to provide the currency has become bankrupt.

Fedwire  - a system also used for settlement of domestic transactions.

Note:

Transaction costs in the form of bid–ask spreads on exchange rates are important because they can greatly influence returns on short-term foreign investments. They also provide the potential for large revenues for banks and represent a cost to businesses.

Chapter 3: An Introduction to Exchange Rates

What is a forward currency exchange and how is it accomplished? How does it differ from a spot market currency exchange although using some of the same mechanisms?