Demystifying Forex Quotes and Triangular Arbitrage

VN:F [1.9.22_1171]please wait...Rating: 5.0/5 (1 vote cast)Quickbits Section: Read & Learn I have always seen that most of the students always find it very difficult to understand bid/ask rate derivation and triangular arbitrage in Forex Market. This is my attempt to give them some tricks which may prove really handy during quick revision for exam. Quote Convention: CFA Institute uses two conventions for Forex Quotes Currency A: Currency B OR Currency A/Currency B . For instance INR:USD will mean INR per unit of USD. Let’s take one more example, In the quotation 1 .2 USD/EUR, the USD is the price currency and the EUR is the base currency. The price of one euro (base currency) is 1 .2 USD (the price currency) so 1.2 is the price of one unit of the base currency in terms of the other. Trick to remember:  Try to remember it this way:- if 1.2 USD/EUR is given treat it as 1.2 USD = 1 Euro i.e. just replace ‘:’ sign or ‘/’ sign with ‘=’ sign. You will be amazed to note that in real-life quotes are given exactly the opposite way but for CFA exam purpose you can remember it the way we have discussed. Direct vs Indirect Quotes: In a Direct quote, base currency is always a domestic currency while the opposite case is called Indirect Quote. For instance, in above example 1.2 USD/EUR is Direct Quote for a European trader (Euro being base currency) however it is also an Indirect Quote for US trader. Bid / Ask Rate: Bid Rate is the rate at which TRADER will want to BUY currency FROM YOU. So in other words it is the rate at which YOU will SELL the currency to the TRADER. Ask Rate is the rate at which TRADER will want to SELL currency TO YOU. So in other words it is the rate at which YOU will BUY the currency FROM the TRADER. Trick to remember: Quotes are always given by traders and hence you need to consider them from trader’s point of view. Bid is always less than Ask. Try to remember it this way, if you are a business man (trader) you will buy at lower and sell at higher rate in order to earn profit.  Hence Bid = Buy (for Trader) which is always less than Ask = Selling price (for trader).   Cross Currency Rates: Cross Rate is the currency exchange rate between two currencies, both of which are not the official currencies of the country in which the exchange rate quote is given in. This phrase is also sometimes used to refer to currency quotes which do not involve the U.S. dollar, regardless of which country the quote is provided in.   Conversion from Bid to Ask Cross Rate: Let’s say you  are presented with INR/USD quote of 62.50/7. This means that (INR/USD)Bid rate is  62.50 and (INR/USD) ask rate is 62.57. Now if you are asked to quote USD/INR  Bid/Ask rate then you need to simply inverse the opposite rates. For instance: USD/INR bid rate = 1/(INR/USD)ask rate and the same way USD/INR ask rate = 1/(INR/USD) bid rate. Hence in this case the quote will be USD/INR = 0.01598/600 Triangular Arbitrage: let’s say you are given three bid-ask quotes as given below 1) a/b 2) b/c 3) a/c (each letter above represents unique currency. Further, suppose even if last one is c/a you can easily convert it to a/c by taking new bid = 1/ask & new ask =1/bid. Remember that finally we should have 1 * 2 = 3 format i.e. a/b * b/c = a/c format) Step-1 Find cross currency rate from 1 & 2 quote. As i have mentioned above if 1 * 2 = 3 then a/c bid-ask quotes are simply bid1 * bid2 – ask1*ask2 Step 2: Now compare your calculated quote (step1) with the given quote (3)....