THE SPOT MARKET

The foreign exchange markets revolve around spot (that, is the FX spot market). For now, let’s abstract from bid–ask spreads (to which we return later) and remember what we said earlier about prices: “Every price is a ratio of quantities.” With this in mind, and recognizing that you have to quote the price of one currency in terms of another, the convention for quoting the spot exchange rate between, say, U.S. Dollars (USD) and Swiss Francs (CHF) is written USD|CHF (said “Dollar–Swiss”) and identifies the number of Swiss Francs per Dollar. Sounds backward, doesn’t it? USD|CHF or “Dollar-Swiss” means “Swiss per Dollar.” Don’t blame me; I didn’t make this up! We sometimes see this as USD|CHF 1.2500 or USD|CHF S = 1.2500 Written differently, as an explicit ratio of quantities When we quote USD|CHF (or any currency pair), we recognize the first currency, in this case the U.S. Dollar, as the “underlying” asset, that is, the thing that is being traded. The second currency, CHF, is the one that identifies the units in which the price of the underlying currency is being quoted; in other words, it indicates the number of units of that currency that is equal to (i.e., trades for) one unit of the underlying currency. In this example, Dollar-Swiss quotes the price of one USD in terms of CHF. In the professional or interbank market, to buy Dollar-Swiss (USD|CHF) means to buy Dollars with Swiss Francs (or more pedantically, to buy Dollars and pay for them with Swiss Francs or, said slightly differently, to buy Dollars CHF USD 1 2500 1 . 84 FOREIGN EXCHANGE and to sell Swiss Francs, which you recall, although it sounds like two trades, characterizes one single transaction). Understanding this, then, informs us exactly what my colleague who was “buying Dollar-Yen” was doing. He was buying USD with JPY (or buying United States Dollars and selling Japanese Yen). Of course, you can buy Dollars with Yen, but you could also buy Dollars with Swiss Francs or any number of other currencies. Returning to USD|CHF, someone on our FX desk once told me that you can think about any spot quote like “USD|CHF 1.2500” in the following way: Separating the “USD|” from the “CHF 1.2500,” replacing the “|” with a “1,” and putting an “=” between the terms gives: USD 1 = CHF 1.2500 Of course, there is no reason (other than convention) to quote this exchange rate in terms of “Swiss Francs per Dollar.” As mentioned earlier, we could (although we generally don’t in the interbank market) quote CHF|USD. This would simply be the reciprocal or multiplicative inverse of 1.2500, namely, .8000. If 1.25 Swiss Francs trade for 1 U.S. Dollar, then USD .8000 should trade for 1 Swiss Franc. What would USD|JPY S = 111.00 mean? It would mean that 111 Japanese Yen trade for 1 U.S. Dollar. Put another way, it takes 111 Yen to buy 1 Dollar. Alternatively, 1 U.S. Dollar will buy 111.00 Japanese Yen. There is already one point of possible confusion, that is, how far out (i.e., how many decimal places) should FX be quoted. With USD|CHF, we quoted out four decimal places, while with USD|JPY we quoted out only two decimal places. As a general guide, keep in mind the number 8. Between USD|CHF and CHF|USD, we would quote both out four decimal places (making a total of eight figures beyond the decimal points); by this gauge, when we quote USD|JPY, we go out only two decimal places, so, if we were to consider JPY|USD, we would have to go out six decimal places with this quote (again, making a total of eight numbers quoted beyond the decimal points). Yen is one of the primary exceptions, though; most currency pairs are quoted out four decimal places regardless. The fact that Japanese Yen is an exception, though, can come in handy for instructional purposes. As a general rule of thumb, if you are looking at an unfamiliar page or table of FX quotes, start by locating the exchange rate between U.S. Dollars and Japanese Yen; this provides an excellent point of orientation. If the number is between, say, 80 and 300, you can bet that it’s Yen per Dollar or The Foreign Exchange Spot Market 85 USD|JPY; on the other hand, if it starts with a .0-something, it’s Dollars per Yen or JPY|USD. The Major Spot Quotes Given the five major currencies, we summarize their standard interbank quoting conventions with the four quotes below (accompanied by representative spot values): USD|CHF 1.2500 USD|JPY 111.00 EUR|USD 1.2500 GBP|USD 1.8000 The first two quotes (USD|CHF and USD|JPY) are similar in some sense and the second two quotes (EUR|USD and GBP|USD) are similar in some sense. Let’s stop for a minute and think about these. One of these pairs is called an American quote and the other pair is considered a European quote. Take a minute and guess which is which. (For the record, conjectures on this are almost always wrong!) The first two quotes have in common the fact that the underlying asset is the U.S. Dollar. The second pair of quotes have in common the fact that the prices are quoted in terms of U.S. Dollars. To keep these labels straight, ask yourself, in terms of what units are Americans used to seeing prices quoted? U.S. Dollars, of course. For that reason, the bottom pair (Euro- Dollar and Sterling-Dollar) are American quotes. EUR|USD 1.2500 means that Euro 1 = USD 1.2500 (or that the price of 1 Euro is 1.25 U.S. Dollars). GBP|USD 1.8000 means that Pound Sterling 1 = USD 1.8000 (or the price of 1 Pound is 1.80 U.S. Dollars). An American who is contemplating taking a vacation to Rome or London would have to ask, “How many of my Dollars would I have to pay to get one of those Euros or to get one of those Pounds?” This is clearly viewed from the American perspective. Having said that, can we rationalize the first set of quotes above as European quotes? If a Swiss family were to plan a vacation to Disneyland (the real Disneyland—none of this Euro Disney stuff), they would have to ask themselves, “How many of our Swiss Francs will we need to buy Dollars?” To my knowledge, they do not take Swiss Francs in Disneyland. This is clearly the European perspective. What about USD|JPY? Obviously this currency pair has nothing to do with Eu- 86 FOREIGN EXCHANGE rope (indicating the exchange rate between an Asian currency and a North American currency), but it is still referred to as a European quote. The logic behind the name of this convention (that is, the convention with the U.S. Dollar as the underlying currency) goes back to the end of World War II—after which most of the major European currencies (with the exception of the British Pound) were quoted in this manner versus the U.S. Dollar (e.g., USD|DEM or Dollar-Deutsche Mark, USD|ITL or Dollar-Italian Lira, USD|FRF or Dollar-French Franc, USD|ESP or Dollar-Spanish Peseta). USD|JPY follows the quoting convention that was used for most of the European currencies and is labeled accordingly. European quotes are also sometimes known as “banker’s quotes” (as this, historically, was the interbank norm). There are other designations for FX quotes, but they simply involve more jargon. You may hear people talk about base currency and counter or quote currency; with USD|CHF, the Dollar is the base and the Swiss Franc is the quote or countercurrency. You may also hear about “direct quotes” and “indirect quotes”; these require raising the issue of foreign and domestic (that I proposed to avoid at the start); I will not use this terminology at all, as I do not find it helpful and consider it confusing at best. SPOT EXERCISE #1 1. What is the name of the exchange rate quoting convention (i.e., American or European) between U.S. Dollars and Canadian Dollars if we quote USD|CAD? 2. What would it mean if USD|CAD S = 1.2000 3. If USD|CAD S = 1.2000, what would CAD|USD S = ? 4. What is the name of the exchange rate quoting convention between Australian Dollars and U.S. Dollars if we quote AUD|USD? 5. What would it mean if AUD|USD S = .7500 Nicknames Many of the currency pairs are referred to using nicknames. As mentioned, GBP|USD is known as “Cable”; USD|CHF is sometimes referred to as “Swissy”; AUD|USD is “Aussie”; NZD|USD is “Kiwi”; and so on. An entertaining site containing the nicknames in local vernacular for the Euro (with translations) can be found (under Slang Words) at http://en.wikipedia.org/wiki/Euro.