§ 2 Spot Quotations

Among all market trading critera the price is essential for trader's profit or loss.The price prevailing in foreign exchange market is exchange rate.It is the price of one currency expressed in terms of another currency.Just as the interest rate is determined by money supply and money demand in the domestic money market，money value in relation to foreign currencies is mostly determined by supply and demand in foreign exchange market.A statement of willingness to buy or sell at an announced rate is called a foreign exchange quotation or quote.For most currencies in foreign exchange markets，all trades take place using one convention.

In FX market，currencies are traded in the form of currency pairs.In practice，FX pip is used to associate trading.Pip stands for“price interest point”.A FX pip is one unit utilized to denote value changes for currency pairs.It refers to the smallest incremental price move of a currency.One pip is 0.0001 in case of all the currencies excluding Japanese Yen.That is，1 pip is one unit of the 4th decimal point.Most major currencies on the FX market are priced in four decimal places，with 1 pip being one unit of the 4th decimal point.An important exception is the Japanese Yen（JPY）which is priced in second decimal place，with 1 pip being one unit of the 2nd decimal point.That is，for JPY one pip is 0.01.As currency rates do not change a lot the changes are brought out in pips.

The quantity of FX trades among banks are usually very large and because of that investors may profit even from only small price movements.

In 2005，Barclays Capital broke convention by quoting spot exchange rates with six decimal places on their electronic dealing platform.The contraction of spreads（the difference between the buy and sell prices）necessitated finer pricing and gave the banks the ability to win transactions on multibank trading platforms where all banks may otherwise have been quoting the same price.A number of other banks have now followed this system.Tick size（0.00001）is thus applied to stand for the smallest possible change in price.

2.1 Direct Quotation vs.Indirect Quotation

The participants of foreign exchange market could be classified into two tiers：the interbank（or wholesale market），and the client（or retail market）.Quotations are expressed 5 or 6 decimal places in interbank quotations while usually expressed in 4 decimal places in retail market.In the retail market，quotes are most often given as the home currency price of the foreign currency.It is called direct quotation.An indirect quote is foreign currency price of one unit of domestic currency.When one buys foreign currency from a bank，she usually gets direct quotation，i.e.，how much domestic currency she needs to pay for each unit of foreign currency.A quotation becomes direct/indirect quotations depending on who is using this quote.For example，if one Chinese goes to a local bank to buy some US dollars，bank offers 7.0626 yuan for each dollar.1 USD＝7.0626 CNY is direct quotation for this Chinese.With the same quote the bank offers，however，it is an indirect quotation for any customer from the United States.When foreign exchange trade does not involve in any domestic currency，direct/indirection quotation does not apply.

In retail market of China，banks previously had to price the over-the-counter yuan-dollar rate within 3％ of the central bank's midpoint.Since July 2014，banks in China could freely set exchange rates for over-the-counter transactions.Different banks may offer different prices.One could find current exchange rates banks offer by checking their websites，for example，the following links provide offers of top market markers in China’s interbank market.

2.2 European Quotation vs.American Quotation

Direct/indirection quotation can be very confusing because it changes depending on which country the trader is from.The professional interbank market，instead，has standardized its quotation system：European style and American.

2.3 Currency Pairs

Because that a foreign exchange rate is the price of one currency expressed in terms of another currency，the value of a currency is determined by its comparison to another currency.All foreign exchange trades involve the simultaneous buying of one currency and selling of another，thus quotes are given as currency pairs.Currency pair means the quotation and pricing structure of the currencies traded in the foreign exchange market.One currency pair shows how many units of quote currency（variable currency or reference currency）for one unit of base currency（fixed currency）.Currency pairs normally have the base currency as the first currency to be listed and is equal to one.The second currency is the quote currency.It is usual to take the “heavier” currency as the base.For example，in currency pair USD/CNY＝6.8659，USD is the base currency while CNY is the quote currency.It means one USD costs 6.8659 CNY，or the Chinese quoted price of each dollar is 6.8659.Most major currencies on the FX market are priced in four decimal places（pip）while some FX trading platforms online display changes as small as 1/10 pip（tickle）.Some currency pairs such as EUR/USD is displayed down to the 5th decimal，while some such as EUR/JPY is displayed down to the 3rd decimal.

Traders in foreign exchange market always purchase and sell a fixed amount of the base currency in exchange of the amount of the quote currency.When the quoted price increases，the base currency is appreciating against the quote currency，or，the quote currency is depreciating against the base currency.But the percentage appreciation of base currency is not equal to percentage depreciation of quote currency.

Take USD/CNY for instance，the magnitude of percentage appreciation or depreciation for the base currency USD is measured as follows：

Given that on 3rd Jan.2007，USD/CNY＝7.8160；and on 3rd Jan.2017，USD/CNY＝6.6915.Percentage change in USD exchange rate is（6.6915－7.8160）÷7.8160×100％≈－14.39％.The negative value indicates USD depreciation.One can say that for the past 10 years，USD has depreciated against CNY by 14.39％.It also means that for the past 10 years，CNY has appreciated against USD.The appreciation percentage can be found out by first converting the existing quotations so that CNY becomes the base currency.Hence，on 3rd Jan.2007，CNY/USD＝1÷7.8160≈0.1279；and on 3rd Jan.2017，CNY /USD＝1÷6.6915≈0.1494.Percentage is calculated as（0.1494－0.1279）÷0.1279×100％≈16.84％.For the past 10 years，CNY has appreciated against USD by 16.84％.In this case，the percentage depreciation of USD is 14.39％；while the percentage appreciation of CNY is 16.84％.

2.4 Cross Currency and Cross Currency Arbitrage

1） Dollar and Cross Currency

possible combination from

of the United States economy.This convention facilitates trading.For a set of N currencies, there

are potentially combinations.Applying the USD quotation reduces

USD.U.S.dollar by far is the world's most actively traded currency due to the size and the strength

According to BIS statistics, more than 80% of foreign exchange trading is conducted against

Because that only the most economically and politically stable and liquid currencies are demanded in sufficient quantities，there are many official currencies that are used all over the world.But there only a handful of currencies that are traded actively in the foreign exchange market.the 7 most traded currencies（in the order for base currency in currency pair）are USD，EUR，JPY，GBP，AUD，CAD，CHF .As currencies must be traded in pairs，7 currencies mathematically make currency pairs.Using only the USD quotation reduces possible combination to 7－1＝6.

Currency vendor provides quotes for only the most liquid currencies，exchange rate between currencies other than USD is normally calculated as the cross rates using the quotes for major currencies.A cross currency is when a currency quote that is without USD as one of its components.The most conventionally quoted cross currency pairs are the EUR/GBP，EUR/CAD and EUR/AUD according to the overall liquidity record of foreign exchange market makers.

Cross currency pairs are not as actively traded as pairs that include USD and cross rate is a bilateral exchange rate calculated from two other bilateral exchange rates.

For example，there is not much exchange between Cambodia and Georgia，one can hardly find any market maker offer direct exchange rate between these two currencies.If one Cambodian plans to travel to Georgia，she needs to spend Cambodian Riels to buy some U.S.dollars and then with these dollars，she further exchanges for Georgian Lari.The exchange rate between Cambodian Riel（KHR）and Georgian Lari（GEL）could then be derived from actual exchange rate between KHR and USD and between USD and GEL.Given USD/KHR＝4022 and USD/GEL＝2.6354，the cross rate between Cambodian Riel（KHR）and Georgian Lari（GEL）is GEL/KHR＝USD/KHR÷USD/GEL＝4022÷2.6354＝1526.14.Each Georgian Lari thus costs 1526.14 Cambodian Riels at this given time.In practice，if one Georgian plans to travel Siem Reap in Cambodia，she does not need to go all the way to exchange for Cambodian Riel，because U.S.dollars is widely used in tourism fields in Cambodia.

2） Cross Currency Arbitrage

As exchange rates offered by different banks are not always agree with each other，one may find some arbitrage opportunity.The act of exploiting an arbitrage opportunity resulting from a pricing discrepancy among three different currencies in the foreign exchange market is called cross currency arbitrage.（also referred to as triangular arbitrage or three-point arbitrage.）Cross currency arbitrage eventually keeps exchange rates in line with each other and with risk-free interest rates.

As stated in Chapter 2，foreign exchange market is dominated by large commercial banks.Each bank offers exchange rate according to its liquidity and inventory need.It is therefore possible that banks may offer different exchange rates.Market participants may take advantage of this pricing discrepancy by carrying out the 3-step strategy as shown in Figure 3-3.

Suppose that Citibank in New York offers EUR/USD＝1.2223；Barclays Bank in London offers GBP /USD＝1.8410；Dresdner Bank in Frankfurt offers GBP /EUR＝1.5100.Once the market participant spots the above information，she could execute 3 trades demonstrated in Figure 3-3 to realize the arbitrage opportunity.She first borrows dollars from Citibank and exchanges dollars for pounds with Barclays bank；then she sells pounds to Dresdner bank for euros；at last，she converts euros into dollars and repays her debt to Citibank.This arbitrage renders her 2538 dollars if starts with 1 million dollars.

Generally，a triangular arbitrage strategy involves 3 exchanges：

① Exchange the initial currency for a second，

② Exchange the second currency for a third，

③ Convert the third currency into the initial currency.

During the second trade，the arbitrageur locks in a zero-risk profit from the discrepancy that exists when the market cross exchange rate is not aligned with the implicit cross exchange rate.

Rule of thumb：given 3 currencies pairs， X/Y＝α ， Z/Y＝β ， Z/X＝γ ，there are 3！＝3×2×1＝6 possible transactions.Should α×γ≠β ，Table 3-3 gives arbitrage strategy as：

If put into figure arbitrage strategy is summed as follows：

Although arbitrage opportunities in FX market is less frequent than some other profit-making opportunities，it is a key element in maintaining liquidity of market whenever arbitrageurs bring prices across markets into balance.“According to the law of one price-a foundation of modern finance-arbitrage activity should ensure that prices of identical assets converge，lest unlimited risk-free profits may arise，” economist Paolo Pasquariello noted in a study on financial market dislocations .

The use of triangular arbitrage can be an efficient way to profit whenever the parity law is violent.But the fierce competition in FX market can correct price discrepancies very rapidly leaving few arbitrage opportunities，small and very short-lived（as short as seconds or milliseconds）.Adopting arbitrage strategies nowadays need artificial systems to monitor the market closely to spot the opportunities.

As technology improved，asymmetric information may be reduced.Market participants are better informed by various media.Once different exchange rates are offered，almost every trader can sense the discrepancy.Take Figure 3-3 for instance，when dealers all rush into the first step，there is increased demand for pounds and increased supply of dollars，pounds would cost more dollars，it will rise from GBP /USD＝1.8410 to a higher level.In the second step，when many traders give up pounds for euros，the demand and supply analysis suggests that each pound cost less euros，exchange rate will drop down，lower than GBP /EUR＝1.5100.At last，when many traders use euros to buy dollars，dollar appreciates against euro，EUR/USD＝1.2223 cannot hold any more.The whole dynamic process indicates that the size of the arbitrage profit will soon be reduced .The process，however，does not always stop whenever the arbitrage profit is eliminated due to the over-react，which may push exchange rate to the over direction away from equilibrium and new arbitrage opportunities arise.Thus，there are trades all the time. aKCpNaQ4qyXhQVOZ9qLGDcoH2O5DjIvpl0yRPhsXBxuwcEMzE9/PhAImHwy6txXM