International Finance

The Spot Market for Foreign Exchange

Main issues

• The foreign exchange market

• Conventions for quoting the spot exchange rate

• Bid-ask spreads and transaction costs

• Arbitrage and the law of one price

The Foreign Exchange Market

What is the FX market?

• Decentralized, global, over-the-counter (OTC) market for exchanging currencies

• The largest financial market in the world

• Open nearly 24 hours — follows the sun:
  Sydney → Tokyo → London → New York

• Three questions:

  • How large is the FX market?
  • Who are the important participants?
  • Where is the market located?

Market size: daily turnover

Source: BIS Triennial Central Bank Survey (2025)

Turnover by currency pair

Source: BIS Triennial Central Bank Survey (2025)

USD is on one side of 89% of all trades (up from 88% in 2022). EUR/USD remains the most traded pair (20% of turnover). USD/CNY has risen to 3rd place (8.1%), overtaking USD/GBP. Some currency pairs barely trade — implications for hedging cost and NDF markets.

Turnover by geographic center

Source: BIS Triennial Central Bank Survey (2025)

UK (mainly London) handles ~38% of global FX turnover. Singapore surged to 3rd place (11.8%, up from 9.5%), overtaking several centers. The top 3 (UK, US, Singapore) account for 68% of global turnover. The FX market is not “in” any one country — it is a network of trading centers connected electronically.

Market participants

• Reporting dealers (banks): Make markets, warehouse risk, provide liquidity

• Other financial institutions: Asset managers, hedge funds, central banks, pension funds

• Non-financial corporations: Hedging commercial FX exposures

• Retail: Small fraction; mostly via online platforms

The market has shifted heavily toward electronic trading (EBS, Reuters Matching, multi-dealer platforms).

Turnover by instrument type

Source: BIS Triennial Central Bank Survey (2025)

Spot is ~31% of FX turnover (up from 28% in 2022). FX swaps (~42%) remain the workhorse for funding. Outright forwards ~18%. Options ~7%. The forward and swap market is still larger than the spot market.

Turnover by counterparty

Source: BIS Triennial Central Bank Survey (2025)

Other financial institutions (49%) and reporting dealers (47%) dominate. Non-financial customers are only 5% of turnover. Within “other financial,” non-reporting banks (23%), institutional investors (13%), and hedge funds/PTFs (8%) are the main players.

The spot market is only part of the picture

Instrument	Share of turnover
FX swaps	~42%
Spot	~31%
Outright forwards	~18%
Options & other	~8%

The forward and swap markets are larger than spot.

We cover forwards in Lecture 3, swaps in Lecture 6.

Spot vs. Forward Market

Two market segments

Spot market:

• Exchange of currencies for near-immediate delivery
• Settlement: T+2 for most pairs; T+1 for USD/CAD and USD/MXN

Forward market:

• Contract agreed today; delivery at a future date
• Standard tenors: 1M, 3M, 6M, 9M, 12M (and longer)
• OTC; customizable notional and maturity

We need to understand spot first — forward prices are derived from spot plus interest rates.

Quoting Spot Exchange Rates

Definition of the spot exchange rate

The spot rate \(S_t\) is the amount of home currency (HC) per one unit of foreign currency (FC):

\[S_t = \frac{\text{HC}}{\text{FC}}\]

Think of it as a price:

• “USD 100 per textbook” is the price of a textbook
• “USD 1.10 per EUR” is the price of one euro
• “NOK 11.50 per USD” is the price of one dollar

Direct vs. indirect quotes

Direct (natural) quote — our convention:

• HC/FC: “How much HC do I need to buy one FC?”
• Example (US perspective): USD/EUR = 1.10

Indirect quote:

• FC/HC: “How much FC do I get for one HC?”
• Example: EUR/USD = 1/1.10 = 0.909

Warning: Market convention is inconsistent. “EUR/USD = 1.10” means USD per EUR in practice. We always use HC/FC.

Live FX quotes: direct and indirect

Source: OANDA

Note how each pair appears twice (EUR/USD and USD/EUR). The quotes are inverses of each other. Bid is always less than ask. The last digit (superscript) shows sub-pip precision.

Cross rates: calculation

To find the cross rate between two non-USD currencies, go through USD:

\[\frac{\text{FC}_1}{\text{FC}_2} = \frac{\text{FC}_1}{\text{USD}} \times \frac{\text{USD}}{\text{FC}_2}\]

Example: Find CHF/GBP given CHF/USD = 0.88 and USD/GBP = 1.27

\[\text{CHF/GBP} = 0.88 \times 1.27 = 1.118\]

Why? USD is the vehicle currency — almost all FX transactions go through USD, even when neither party wants dollars. USD liquidity is the spine of the FX market.

Percentage changes: the asymmetry

The % appreciation of currency A against B does not equal the % depreciation of B against A.

Example:

• Today: CAD/USD = 1.00. In one year: CAD/USD = 1.50

	Calculation	Result
USD appreciated by	\((1.50 - 1.00)/1.00\)	+50%
CAD depreciated by	\((1/1.50 - 1/1.00)/(1/1.00)\)	−33.3%

The discrepancy grows with the size of the move.

Rule: Always define which currency is the “asset” and compute changes consistently.

Bid-Ask Spreads

Bid and ask prices

When you trade FX, you face two prices:

• Bid price: The price the dealer pays to buy FC from you (you sell FC)
• Ask price: The price the dealer charges to sell FC to you (you buy FC)

Always: \(\text{Ask} > \text{Bid}\)

The bid-ask spread = Ask − Bid

This is the dealer’s compensation for providing liquidity and warehousing risk.

What drives the spread?

Factor	Effect on spread
Liquidity	Major pairs (EUR/USD): 1–2 pips. Exotic pairs (USD/TRY): 50+ pips
Volatility	Spreads widen during stress (2008, 2020)
Trade size	Institutional spreads < retail spreads
Time of day	Spreads widen outside major session overlaps

Spreads are a transaction cost — they directly affect hedging costs and arbitrage bounds.

Reading FX quotes: bid-ask spreads

Source: OANDA

Walk through: identify bid, ask, spread in pips for EUR/USD (about 0.5 pips). Note how USD/JPY has a wider spread in absolute terms but similar in percentage terms. Compute percentage spread = (ask - bid) / mid.

Inverting quotes with bid-ask spreads

To convert HC/FC quotes to FC/HC quotes:

\[(\text{FC/HC})_{\text{bid}} = \frac{1}{(\text{HC/FC})_{\text{ask}}}\]

\[(\text{FC/HC})_{\text{ask}} = \frac{1}{(\text{HC/FC})_{\text{bid}}}\]

Why? The bid must always be the smaller number. Inverting the larger direct quote gives the smaller inverse quote.

Inverting quotes: worked example

Given: USD/EUR bid = 1.0950, ask = 1.0955

Find: EUR/USD bid and ask

\[(\text{EUR/USD})_{\text{bid}} = \frac{1}{1.0955} = 0.91282\]

\[(\text{EUR/USD})_{\text{ask}} = \frac{1}{1.0950} = 0.91324\]

Check: bid < ask ✓

Cross rates with transaction costs

Use the law of the worst possible combination:

\[(\text{FC}_1/\text{FC}_2)_{\text{ask}} = (\text{FC}_1/\text{USD})_{\text{ask}} \times (\text{USD}/\text{FC}_2)_{\text{ask}}\]

\[(\text{FC}_1/\text{FC}_2)_{\text{bid}} = (\text{FC}_1/\text{USD})_{\text{bid}} \times (\text{USD}/\text{FC}_2)_{\text{bid}}\]

Example: CHF/USD 1.1520–1.1530, USD/EUR 1.2840–1.2850

• CHF/EUR ask = 1.1530 × 1.2850 = 1.4816
• CHF/EUR bid = 1.1520 × 1.2840 = 1.4792
• Synthetic spread: 1.4816 − 1.4792 = 24 pips

Arbitrage and Shopping Around

Two mechanisms enforce the law of one price

Arbitrage:

• Buy the underpriced, sell the overpriced simultaneously
• Riskless profit, no capital required, no change in net position
• Limits price differences to the sum of transaction costs

Shopping around:

• You already intend to trade — you choose the better price
• Buyers go to the cheapest ask; sellers go to the highest bid
• Pushes prices toward a single quote

Arbitrage across market makers

Quotes:

• Bank X: USD/EUR 1.0450 – 1.0455
• Bank Y: USD/EUR 1.0460 – 1.0465

Trade:

• Buy EUR from X at 1.0455
• Sell EUR to Y at 1.0460
• Profit: 0.0005 USD per EUR

This cannot persist — massive trading eliminates the opportunity instantly.

No-arbitrage condition: Dealer quotes must overlap.

Shopping around across market makers

Quotes:

• Bank X: USD/EUR 1.0461 – 1.0466
• Bank Y: USD/EUR 1.0460 – 1.0465

No arbitrage (X’s bid < Y’s ask). But:

• All buyers go to Y (cheaper ask: 1.0465 vs. 1.0466)
• All sellers go to X (higher bid: 1.0461 vs. 1.0460)

Can be intentional — inventory management. But unsustainable for both banks if they want to stay active in the market.

Triangular arbitrage: worked example

Rates: EUR/USD = 0.9, CHF/USD = 1.5, EUR/CHF = 0.66

Implied EUR/CHF = EUR/USD × USD/CHF = 0.9 × (1/1.5) = 0.60

Market EUR/CHF = 0.66 → CHF is too expensive in EUR

Trade (start with EUR 0.9m):

1. Buy USD 1m (pay EUR 0.9m)
2. Buy CHF 1.5m (pay USD 1m)
3. Sell CHF 1.5m for EUR (receive EUR 0.99m)

Profit: EUR 0.09m — riskless, no net capital

In practice, electronic trading closes these gaps in milliseconds.

Why this matters for the course

• Arbitrage-free pricing is the foundation for forward rates
  CIP (Lecture 3) is “triangular arbitrage in the time dimension”

• Bid-ask spreads are the first hedging cost
  Wider spreads → more expensive to hedge (Lectures 4–5)

• USD as vehicle currency explains why dollar funding stress propagates globally
  The basis (Lecture 3) and funding markets (Lecture 6) build on this

• When arbitrage fails — CIP deviations — it signals financial stress
  This is a recurring theme from Lecture 3 onward