International Corporate Finance Study Guide

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...