Spot Foreign Exchange
What is a Spot Rate?
When transacting in Foreign Exchange every deal has to have a value date. Spot is the most common value date used in foreign exchange and every fx transaction is based off a spot rate. Market convention says that the spot value date is the date two working days after the transaction date. As there are two currencies (currency pair) in every trade a good working day requires the financial centre for both currencies to be open for business. For example if you were trading Great British Pound against the United States Dollar (Currency Pair GBP/USD) the spot value date would be two working days time. If there is a public Holiday in London or New York the spot value date would be pushed back by a day. The most common example of value date adjustment is weekends. A trade placed on friday will be value dated for tuesday.
As with most rules there is an exception. The Canadian Dollar. Because of their close geographic proximity the spot value date for United States Dollar/Canadian Dollar (also known as Dollar CAD currency pair USD/CAD) trades is one good working day.
Tod and Tom
With the advent of technology it became possible to settle fx trades before the spot date. Trades booked for same day value are booked for value today or Tod. Trades booked value tomorrow are known as value Tom.
As Tod and Tom trades are booked before the spot value date there should be a forward points adjustment to reflect interest costs or benefits incurred. There will be more on forwards points in later editions.
Base Currency / Terms Currency
There are two currencies involved in an fx trade. This is known as a currency pair. The first currency in the pair is known as the base currency. The second is the terms currency. This concept is simple now but will become more complicated as we continue our fx journey.
Direct and Indirect Currencies
The United States Dollar is the international benchmark currency.
What does this mean exactly?
As the financial markets emerged and global markets moved away from precious metal benchmarks such as silver trade dollars and gold sovereigns. It became apparent that a currency would have to become the benchmark. The Greenback was the obvious choice due to the strength of the US economy and the stability that this gave to the USD and the volume of International trade then generated by the USA.
A direct currency pair uses the USD as the base currency and the second currency as the terms currency.
England and many of the commonwealth countries were still on pre-decimal currencies and it was far easier to express an exchange rate as 1 pound = x USD rather than expressing the USD in terms of shillings and pence.
An indirect currency pair uses the home currency as the base and USD as the terms currency.
As mentioned above, England and many of the british commonwealth currencies are indirect currencies. The other key indirect currency is the European Euro.
Converting Currency Amounts
To convert a Base Currency amount into Terms Currency you multiply the Base Currency amount by the exchange rate.
To convert a Terms Currency amount into Base Currency you divide the Terms Currency amount by the exchange rate.
In the professional market participants (market makers) will put up their best bid & offer. This is known as a two way price. Wholesale currency trading used to be carried out through a live broker market but is increasingly handled by electronic broker services and trading portals.
The bid is where the market maker buys the base currency.
The offer is where the market maker sells the base currency.
For example a quote of 0.7250/0.7255 would mean that the best bid in the market is 0.7250 and the best offer in the market is 0.7255.
A customer (price taker) could sell the base currency to the market maker at 0.7250 or buy from the market maker at 0.7255. Please note the best bid & offer prices will in most cases be offered by different market makers.
A rate for a currency pair which does not include the USD is known as a cross rate. We use simple algebra to eliminate the USD from the equation.
When crossing a Direct with an Indirect currency.
Multiply on the same side of the spread.
example: Derive an NZDJPY cross rate from its component rates
The NZDUSD quote is 0.6780 0.6785
The USDJPY quote is 105.08 105.18
to calculate NZDJPY we multiply on the same side of the spread
NZDJPY Bid = 0.6780 x 105.08 = 71.24
NZDJPY Offer = 0.6785 x 105.18 = 71.36
Therefore an NZDJPY quote would be 71.24 71.36
When crossing an Indirect with an Indirect currency.
Divide on the opposite side of the spread.
example: Derive an AUDGBP cross rate from its component rates
The AUDUSD quote is 1.0680 1.0685
The GBPUSD quote is 1.5855 1.5860
AUDGBP Bid = 1.0680 / 1.5860 = 0.6734
AUDGBP Offer = 1.0685 / 1.5855 = 0.6739
Therefore an AUDGBP quote would be 0.6734 0.6739
note if you were in England or Europe the rate would be expressed as GBPAUD or the inverse of the above.
GBPAUD BID = 1.5855 / 1.0685 = 1.4838
GBPAUD Offer = 1.5860 / 1.0680 = 1.4850
When crossing a Direct with a Direct currency
Divide on the opposite side of the spread