EECS 1530 Lecture Notes - Lecture 39: Foreign Exchange Risk, Commercial Bank, Opportunity Cost
21 Jun 2018
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EECS 1530 Lecture 39 Notes
Introduction
Factors That Affect the Spread
Assume that a commercial bank’s prevailing quote for wholesale transactions involving
the euro is $1.0876/78.
This means that the commercial bank is willing to pay $1.0876 per euro
Alternatively, it is willing to sell euros for $1.0878.
The bid/ask spread in this example is therefore Bid=ask spread ¼ $1:0878 $1:0876
$1:0878 ¼ about: 000184 or: 0184%
The spread on currency quotations is influenced by the following factors: Spread ¼ f
order costs; þ Inventory costs; þ Competition; Volume; Currency risk þ
Order costs.
Order costs are the costs of processing orders; these costs include clearing costs and the
costs of recording transactions.
Inventory costs.
Inventory costs are the costs of maintaining an inventory of a particular currency.
Holding an inventory involves an opportunity cost because the funds could have been
used for some other purpose.
If interest rates are relatively high, then the opportunity cost of holding an inventory
should be relatively high.
The higher the inventory costs, the larger the spread that will be established to cover
these costs
Competition
The more intense the competition, the smaller the spread quoted by intermediaries.
Competition is more intense for the more widely traded currencies because there is
more business in those currencies.
Document Summary
Assume that a commercial bank"s prevailing quote for wholesale transactions involving the euro is . 0876/78. Holding an inventory involves an opportunity cost because the funds could have been used for some other purpose. The more intense the competition, the smaller the spread quoted by intermediaries. Competition is more intense for the more widely traded currencies because there is more business in those currencies. The establishment of trading platforms that allow mncs to trade directly with each other is a form of competition against foreign exchange dealers, and it has forced dealers to reduce their spread in order to remain competitive. A commercial bank"s prevailing quote for wholesale transactions involving the euro is. This means that the commercial bank is willing to pay . 0876 per euro. Alternatively, it is willing to sell euros for . 0878. The bid/ask spread in this example is therefore bid=ask spread :0878 :0876.
