Financial Concept

The bid - ask spread of a currency reflects, in general, the cost of transacting in that currency.

• It is calculated as the difference between the ask and the bid.

• For example, 1.2158 – 1.2148 = 0.001.

• The bid - ask spread can be converted into a percent to compare the cost of transacting among a number of currencies.

• The margin is calculated as the spread as a percent of the ask.

(Ask - Bid)/Ask * 100

• A cross-rate is an unobserved rate that is calculated from two observed rates.

• For example, the spot rate for the Canadian dollar is 1.3176 C$/$, and the spot rate on the euro is 1.2153 $/€. What is the Canadian dollar price of the euro (C$/€)?

• Note that (C$/$)·($/€) = C$/€.

• In this example, (1.3176)· (1.2153) = 1.6013 C$/€.

• Spatial Arbitrage refers to buying a currency in one market and selling it in another.

• Arbitrage opportunities exist if an observed rate in another market is not consistent with a cross-rate (ignoring transaction costs).

• Again, profit opportunities are likely to be arbitraged away quickly, meaning that cross-rates are, for the most part, consistent with observed rates.

• A exchange rate accounts for relative price changes, or in other words, for differences in inflation between the two nations. Real exchange rates indicate the purchasing power of a nation’s residents for foreign goods and services relative to their purchasing power for domestic goods and services. A real exchange rate is an index. Hence, we compare its value for one period relative to its value in another period, or the change in the index from one period to another.

• A nominal exchange rate indicates the rate of exchange between one nation’s currency with the currency of another nation.

• An effective exchange rate is a measure of the weighted-average value of a currency relative to a select group of currencies. Thus, it is a guide to the general value of...