FINS3616 · International Business Finance
The Foreign Exchange Market
Week 2 of UNSW FINS3616 teaches the mechanics of the foreign-exchange market (Shapiro Ch 6): spot versus forward transactions, American versus European quoting terms, bid-ask spreads, pips, and — the calculation backbone examined heavily in the 35% mid-term — computing cross rates, triangular no-arbitrage, and annualised forward premiums. These are pure setup-and-arithmetic questions, so the marks go to picking the correct side of each bid-ask leg and keeping the units straight. Everything here feeds the parity-condition and hedging chapters that follow.
What this chapter covers
- 01Market structure: the interbank/wholesale market, ~20 major dealer banks, SWIFT messaging, FX brokers, and CHIPS dollar clearing; ~95% of turnover is capital-flow not trade
- 02Quotation conventions: American terms ($/FC) vs European terms (FC/$); which major currencies are quoted in American terms; the pip and the 'big figure'
- 03Bid-ask spread: dealers buy the base at the bid, sell at the ask; % spread = (ask − bid)/ask; the customer buys at the ask and sells at the bid
- 04Cross rates via a common third currency: A/C = (A/B)×(B/C); with bid/ask, bid cross = bid(2/$)/ask(1/$), ask cross = ask(2/$)/bid(1/$)
- 05Triangular currency arbitrage: compare the implied cross to the quoted cross, route USD → cheap ccy → third ccy → USD from a round notional
- 06Forward contracts: fixed rate for future delivery, standard 30/60/90/180/360-day maturities, used to hedge a known FX exposure
- 07Forward premium/discount: outright vs swap rate; annualised premium = (F − S)/S × 360/days; the low-interest currency trades at a forward premium
- 08The law of one price enforced across currency markets by arbitrage — the thread linking this chapter to the parity conditions
Bid-ask cross rate between two non-dollar currencies
- +1Set the direction: the cross is currency-2 (baht) per currency-1 (krona). Use the rule bid cross = bid(baht/$)/ask(krona/$) and ask cross = ask(baht/$)/bid(krona/$) — you go through the worse side of each leg because you cross via the US dollar.
- +1Bid cross (buying baht, selling krona): = bid(baht/$)/ask(krona/$) = 34.00 / 9.45 = 3.5979 baht per krona.
- +1Ask cross (selling baht, buying krona): = ask(baht/$)/bid(krona/$) = 34.20 / 9.40 = 3.6383 baht per krona.
- +1Report the two-sided cross: 3.5979 – 3.6383 baht per krona. The spread on the cross (≈ 1.1%) is wider than either single-currency spread, because you pay the bid-ask cost on both legs of the triangle.
Key terms
- American vs European terms
- American terms quote US dollars per one unit of foreign currency ($/FC); European terms quote foreign-currency units per one US dollar (FC/$). Most currencies are quoted in European terms against the USD; exceptions quoted in American terms include EUR, GBP, AUD and NZD.
- Bid-ask spread
- The dealer buys the base currency at the bid and sells it at the ask (ask > bid); a customer therefore buys at the ask and sells at the bid. The percentage spread is (ask − bid)/ask × 100.
- Cross rate
- The exchange rate between two currencies computed through a common third currency (usually the USD), used when the pair is not directly traded. Simple form A/C = (A/B)×(B/C); with bid/ask, cross each leg on its worse side.
- Triangular arbitrage
- Trading around three currencies when the quoted cross rate differs from the implied cross computed via the USD legs; a round notional is routed USD → cheap currency → third currency → USD to lock a small riskless profit, enforcing the law of one price.
- Forward premium/discount
- If the outright forward exceeds the spot the currency trades at a forward premium; if below, a discount. Annualised = (F − S)/S × 360/(contract days). The lower-interest-rate currency sells forward at a premium.
- Pip
- The last digit of a standard quote — 0.0001 for a 4-decimal quote, 0.01 for 2-decimal quotes such as JPY. The 'big figure' is the first two digits after the decimal; a pipette is one-tenth of a pip.
The Foreign Exchange Market FAQ
How do I compute a cross rate with bid-ask quotes without inverting a leg?
Write both quotes in the same 'currency per US dollar' form, then divide so the dollars cancel: baht-per-krona = (baht/$) ÷ (krona/$). For the bid side of the cross take the numerator's bid over the denominator's ask; for the ask side take the numerator's ask over the denominator's bid. The rule 'go through the worse side of each leg' is what widens the cross spread — you pay a bid-ask cost twice.
What is triangular arbitrage and how do I know it exists?
Compute the implied cross rate from the two USD legs and compare it to the directly quoted cross. If they differ by more than transaction costs, an arbitrage exists: route a round notional (say $1,000,000) USD → buy the cheap currency → buy the third currency → sell back to USD, and the ending balance exceeds the starting one by a small profit. The trades push the quotes back into line, which is arbitrage enforcing the law of one price across currency markets.
Why does the low-interest-rate currency trade at a forward premium?
Because of interest rate parity (covered in Week 3): the forward has to adjust so a covered investment earns the same in either currency. If a currency has a lower interest rate, it must sell forward at a premium to compensate — otherwise there would be a covered-interest-arbitrage profit. You annualise the premium as (F − S)/S × 360/days, and it approximately equals the interest differential.
Can AI help me with cross rates and forward premiums in FINS3616?
Yes. Sia is an AI tutor built to mirror how FINS3616 is taught and assessed at UNSW Sydney: it can walk you through a bid-ask cross-rate calculation, check which side of each leg you took, run a triangular-arbitrage money loop, and annualise a forward premium step by step. Bring your own tutorial question and ask it to explain each line. It checks your reasoning but does not do graded assessment, and UNSW academic-integrity rules apply.
Exam move
This chapter is almost pure calculation, so drill it as a set of clean procedures. Fix the quote convention (American vs European) first, then rehearse the bid-ask rule until you never confuse which side the customer trades on. For cross rates, always rewrite every quote as 'currency per US dollar' and cancel the dollars — that one habit removes most errors — and practise selecting the worse side of each leg for the two-sided cross. Work several triangular-arbitrage loops from a round notional so the sequence (implied vs quoted cross → route the trades → net profit) is automatic, and annualise a forward premium with the 360/days scaling. Every one of these is prime Weeks 1–4 material for the 35% closed-book mid-term, where you have one single-sided A4 formula sheet and a UNSW-approved calculator, so build that sheet with the cross-rate and forward-premium formulas early and rehearse the recorded tutorial questions under time. When a leg selection or a units step won't click, ask Sia to re-derive it on a fresh quote and check your working.
Working through The Foreign Exchange Market in FINS3616? Sia is AskSia’s AI Business and Economics tutor — ask any FINS3616 The Foreign Exchange Market question and get a clear, step-by-step explanation grounded in how FINS3616 is taught and assessed. Read this chapter free, then take your hardest questions to Sia.
