DIRECT Quotes: How much does it cost us to buy a particular currency (treated like a commodity)

In the U.S:   1 DM costs $.5765 = e.

INDIRECT Quotes are units of FOREX per $.

$ 1 = DM 1.7346 = 1/e

 Transactions Costs:
 1) Brokers and Agents charge commissions.
 2) Major Money Center Banks charge a BID-ASK Spread.
       The BID-ASK SPREAD
        One D-Mark = $.6000-40
         This means that for large purchases, a Dealer will buy DM for $.6000 and sell DM for $6040.
         The Spread is $.0040,

The Percentage Spread is the Spread divided by the Asking Price or $.0040/$.6040 = .66%
Percentage Spreads vary directly with exchange volatility and indirectly with trading volume.

Most quotes and trades go through the U.S. Dollar - especially lightly-traded currencies.
Thus to move from the Thai Baht to the Greek Drachma, one would probably sell Baht, Buy $, then Sell $ and Buy Drachma. One would pay TWO Bid-Ask Spreads.

FORWARD RATE: The Exchange Rate A Dealer Quotes Today for Delivery on some Future Date.
        WSJ usually publishes prevailing 30-, 90-and 180-day Forward Rates.
        The Dealer and the Customer (Buying or Selling) form a Binding Contract.
         The Dealer Profits from a Bid-Ask Spread.
This Spread is larger than the Spot Spread. This is because Forward Rates are More Volatile and Trades are less Frequent than Spot. There is also greater Risk that a Customer May DEFAULT on a Contract.

The Dealer Hopes to Reduce Its Own Currency Risk Through OFFSETTING TRANSACTIONS - matching LONG and SHORT Forward Contracts.

The Customer is Usually HEDGING some Currency Risk.

Examples of a Forward Hedge:

A German Supplier extends Trade Credit to a U.S. Importer, for 1 million Deutsche Marks, payable in 30 days. The Importer is thus SHORT D-Marks and is worried about the DM Appreciating against the Dollar. The Importer could contract to buy the DM at the 30-day Forward Rate.

or if a U.S. Exporter extends Trade Credit to a German Customer, expecting to be Paid in DM in 90 days. The Exporter is thus LONG the DM, and is worried about the DM depreciating. The Exporter could contract to Sell the DM at the 90-day Forward Rate.

A Less Common Alternative:

The Money-Market Hedge (I often call this a "spot hedge" as it involves hedging using the spot market.

The Importer, who is SHORT (Owes) the German Unit, could BUY DM on the Spot Market, and leave the FOREX in an interest-bearing D-Mark account until the trade credit loan is repaid.

The Exporter, who is LONG (is Owed) the German Unit, could BORROW D-Marks from a German Bank and Convert the Bank Loan Proceeds into Dollars at the Spot Rate. The Trade-Credit Loan Repayment would be used to pay off the DM Bank Loan.

As Money-Market And Forward Hedges are Competing Strategies:
1. Hedgers will Choose the Least Costly Hedge.
2. Arbitrageurs will help insure that each type of hedge costs about the same.

Three Factors Largely Determine the choice of hedging tools.
1. The Difference in Interest Rates between the two Currencies' Home Countries.
2. The Discount or Premium that the Forward Rate is Trading to Spot.
3. Transactions Costs, Differences in Borrowing and Lending Rates, Taxes, and Barriers to Capital Flows.
(We will assume there are none)

We usually assume that the Spot Rate and the two Interest Rates determine the Forward Rate.   Sometimes the text implies that interest rates or the spot exchange will adjust to a "off-base" forward rate.  This may happen to a slight degree or in rare instances, but mostly it is the forward rate that "depends" on the spot rate and the relative interest rates.  This is because the forward market is not anywhere as liquid (or large) as the spot market and the loan markets.

INTEREST RATE PARITY EQUATION:

f₁ = e_o (1+r_h )/(1+r_f)    r_h=home currency interest rate,  r_f=foreign currency interest rate

If the U.S. rate is 4.5% (annualized), the German rate is 2.5%, and the spot rate is DM=$.60, then the one year forward rate should be $.611 - the Forward Rate is roughly at a 1% premium to the Spot Rate.

What if IRP was violated? What if the Spot and Forward rates were the same?    The main thing to remember is that the forward rate (at 60 cents) is cheaper than it should be.

In the case of a  Hedger:
The Importer, who is short D-Marks, would buy DM on the forward market.  Use these to pay off the DM debt when the debt comes due.
The Exporter, who is long D-Marks, would use a Money-market hedge: Sell DM at $.60 on the spot market (that is borrow DM from a bank at 2.5%.  Immediately convert the loan proceeds into dollars (which is what you will eventually want), hold the dollars in a 4.5% interest-bearing account.   Use the eventual payment from the German customer to pay off the bank loan.

In the case of the Arbitrageur, who starts from a neutral position,  would Borrow DM at 2.5%, Convert to Dollars at $.60 and place in a 4.5% Dollar account. Hedge the Currency Risk by buying DM Forward at $.60. Result: Risk-Free Profit of two percent on borrowed funds

The relationship between the forward and the spot rates is thus not in a stable situation here - primarily because no one is selling DM at the Forward Rate; The Arbs and the Importers are all buying at the forward rate and this buying should push "f"  up to that exchange rate predicted by the IRP equation..