Bo Sjö
2009-05-06 (2012-09-26) Still preliminary
Lecture Notes covering the working FX Markets and FX
quotations.1
‘Handbook in Foreign Exchange Markets’
The Foreign Exchange Markets
The foreign exchange market is not one but several markets. The reason being that the market can
be split into the spot market and forward market, as well as the derivative markets.2 The
derivative markets for foreign exchange consist of the forward market, the futures market, the
options market and the swap market.
What the FX market provides
1) Transfer purchase power
2) Provide credit
3) Minimize foreign exchange risk
FX markets are dealer markets. In contrast to stock markets which are usually centralised
exchange markets, sometimes organised as auction markets (NYSE).
Though there are many dealers, the market is dominated by around 10 big dealers. This is (has
been?) a concern for the EU which has criticised the dealers for lack of competition and too high
spreads. Where there are dealers there are also brokers acting on behalf of buyers and sellers.
The average transaction is $4m. $1m is considered small.
Dealers make money from buying low and selling high. A deal quotes bid and ask prices. The
dealer sells foreign currency at the ask price, and buys at the bid price. Since the dealers must
make money, they buy at low prices (bid) and sell at high prices (ask).3
A dealer has a portfolio of currencies. Whenever a dealer sells or buys a currency the portfolio
composition is changing. As result the dealer will have to rebalance the portfolio in order not to
change his/her risk exposure. Thus, the outcome increased turn-over on the FX markets due to
‘fluff’.
1
Lecture notes are given to students as supplementary reading material. These notes are preliminary, the
language is not corrected. If questions are asked in the text, these are addressed to students. If you think
something is wrong, hard to understand etc, you are strongly advised to contact your professor before the
exam.
2
Old textbooks talk about the foreign exchange markets meaning the spot market and the forward market.
This, however, was before the mid 70s, and the evolution of futures, options and swaps.
3
Bid-ask prices, bid-asked prices, bid-offer prices, bid-offered prices are the same.
1
Spot and Futures
The spot market
A spot market contract is an immediate purchase or sell of a currency. A typical spot market
contract takes 2 days to settle. If you buy, or sell today, delivery takes place 2 days from now. In
some market delivery can take 1 day (US - Canada). The length is determined mainly by
practical matters (paperwork)
The forward market
A contract that is written for immediate delivery is called a spot contract. If delivery will be done
less than immediate, but in the future, the contract is called a forward contract. A typical forward
contract has maturity date above 2 days, say T days.
At the day of maturity (T) the contract automatically transforms into a spot market contract, with
delivery in 2 days. The total time to delivery is T+2 days, typically.4
The forward market is mainly for firms with a good credit record dealing with bank. These
contracts can be tailored made for the individual customer. You can find quotations of one moth,
three month, sex month and one-year forwards in the financial databases. Though the market is
very thin after three-months contracts. There are even longer contracts but they are not as
common.
Since you are dealing on an OTC (over-the counter) market, there is no room for speculating
here. You need good credit rating and often collateral in the form of bank accounts.
Even individuals can by forward. Say that you want to study in the US for one-year, you might
purchase dollars sufficient for 6 moths living to be delivered 6 months from know.
Foreign Exchange Codes
There are two ways of writing down short names, or codes, for foreign exchange rates the ISO4217, or just ISO code and using symbols. The ISO code is a three letter short abbreviation for
each currency. Here are some examples:
Currency
US dollar
Great Britain pound
Euro
Swedish krona
Swish franc
Finland markka (not used)
South Korean won
Buthan ngultrum
4
ISO Code
USD
GBP
EUR
SEK
CHF
FIM
KRW
BTN (or you can Use Indian
rupees)
Symbol
$
£
€
Sk (or kr)
SwF
mk
Cannot find it Windows/office
Nu
To be more precise delivery takes place day T+2 or on the first working day after T-2 days.
2
Botswana pula
BWP
P
Eiteman, Stonehill and Moffett,”Multinational Business Finance”, ed. 9 and 10, (and other books) have
updated tables of (some) symbols and codes. Notice that, in the English language, the names of currencies
are written with small letters and no capitalization of the first letter, they are indicating currencies not
names of currencies. Thus, The US dollar is referred to as dollars, or US dollars, not Dollars.
In scientific writing FX rates are usually written as S or E, and in logs with time subscript as ln St
= st or ln Et = et. Forward rate are written as F and ln Ft = ft.
Translation Introduction
Translation means transforming amounts from one currency to another currency. Notice, there
are international accounting standards for how to deal with the translation of financial statements.
First identify the ‘home’ currency, or the accounting currency.
The convention for translation, is to use the most relevant rate, such as daily rates for daily
figures ets. If nothing else is stated use rates from IMF:s International Financial Statistics (IFS)
For flow variables: use (IFS) period-average USD rate (usually code: ..RF)
For stock variable: use (IFS) end-of-period USD rate (usually code: ..AE)
Prices are usually transformed with period-average or end-of-period depending on whether the
price variable is end-of-period or period average.
Third-world countries can have dual exchange rates, one rate for goods transactions and another
rate for financial transactions. Other third world countries can have one official rate, in
combination with exchange controls, and a (quite free) black market rate. In this situation the
official rate might be inappropriate, unless the translation involves contact with, or the
supervision of, official agencies.
Foreign exchange quotations
Direct quotation
Direct quotation 
Number of Domestic Currency U nits
one Foreign Currency U nit
Abbreviation: the symbols s and e are often used to indicate exchange rates. Often St is the
exchange rate at time t. Small letters are used to indicate log transformations ln St = st (and et).
Most countries use direct quotation as the official standard. Direct quotation is the recommended
way of giving quotations. You ask “how much does one unit of foreign exchange cost?” in the
same way as you ask “how much does this newspaper cost?”. You do not ask “how much
newspaper do I get for one dollar?”. Though the latter is possible it becomes inconvenient. By
using direct quotation as the rule life becomes simpler.
3
If you don not know which should be label domestic or foreign, ask "in which currency will the
accounting be done?" The accounting currency is by definition the domestic currency (or 'home'
currency).
Some countries, most notably U.K, Ireland, New Zealand, South Africa, use indirect quotation as
the official standard for foreign exchange quotation. Warning 1: This standard is also used in
official databases and in financial papers like Financial Times. Warning 2: Old British textbooks,
some introduction texts, in trade and open economics sometimes use indirect quotation without
informing the reader about this.
Indirect quotation is defined as,
Indirect quotation 
Number of Foreign Currency U nits
Domestic Currency U nit
Direct and indirect quotation is not the only way to quote exchange rates. In the US, the
terminology European and American quotation is used more often.
Since the dollar FX rate is standard in reporting all countries, including the US reports exchange
rates in US dollars. The US direct quotation s called American quotation, for all other countries
the quotation is simply called European quotation.
European quotation is defined as,
European quotation 
Number of Domestic Currency U nits
USD
Notice that USD reads 1 USD in the formula above. And, be aware of the fact that a quotation of
the pound against the dollar (or “over the dollar”) is likely to be an indirect quotation.
American or dollar quotation is defined as,
American quotation 
Number of USDs
Other Currency U nit
Notice that Domestic Currency Unit reads 1 Domestic Currency Unit.
American quotation is convenient for the Americans, especially since all currencies are officially
listed against the USD. Unfortunately, a number of US textbooks in economics and finance use
this notation as the standard without informing about and using about direct quotation as the
general approach
Thus, the Swedish krona is quoted in a direct way, as SEK#/USD. At the same, time viewed from an
American perspective it also quoted in a European way, while the Americans would prefer the American
quotation, USD#/SEK.
4
Bid and Ask Prices (bid –ask or bid-offer rates)
The foreign exchange markets are Over-the-counter markets (OTC market). It consists of different dealers,
who quote bid and asked prices. That is buy and sell prices. The dealers keep inventories of currencies, and
make a living out of selling at a high price and buy at a low price. The sell high and buy low. Thus, it is
always the case that the bid price < ask price. (This is sometimes referred to as “the rip-off rule”). Dealers
sell foreign currency at the ask price, and buys foreign currency at the bid price.
You, the buyer, purchase foreign currency from the dealer at the ask price, and sell foreign currency to the
dealer at the bid price.
The distance between the ask and the bid price is called the spread and is defined as,
Spread = Ask price – Bid price,
The mid-price is defined as
Mid - price 
(Bid price  Ask price)
2
The spread, the bid and ask prices, can be seen as an absolute sum that is withdrawn and added to the midprice.
Bid and ask prices are also called:
Bid price - asked price
Bid price - offer price
Bid price - offered price
Some currencies, especially those with a history of inflation, is not quoted in terms of units of currencies
but in say 1/100 of the currency, like the Japanese yen.
Cross exchange rates
Different bilateral exchange rates are of course determined such that there are no arbitrage
opportunities from triangular arbitrage.
A simple example, assume that we have SEK8/USD and USD1.3/EUR. What is the cross rate for
SEK against the EUR?
Answer: look for SEK?/EUR.
(SEK8/USD) * (USD1.3/EUR) = SEK(8*1.3)/EUR = SEK10.4/EUR.
Notice the use of mathematical rules here. Yes, you can cancel USD in the nominator for USD in
the denominator. That is how we know we get it right in the end.
Here is a more realistic example. If you look in the IFS or Financial Times you will find that all
currencies are listed (quoted) against the USD. From these quotations other bilateral quotations
can be derived. In FT Thursday March 27, 2001, the British pound is quoted as 1.4335 against
5
the dollar. (Remember indirect quotation) This means USD1.4335/GBP. The Swedish krona is
quoted as SEK10.2130/USD.5
Given these rates we can calculate the krona/pound rate or the pound/krona rate. The SEK/GBP
rate is given as
SEK10.2130 USD1.4435 SEK10.2130  1.4435 SEK14.7511



USD
GBP
GBP
GBP
The next old example is the SEK over Belgian franc. The latter is quoted as BEF45.0499 against
the dollar. The SEK/BEF rate is then
SEK10.2130
SEK10.2130
USD
SEK10.2130
USD



 SEK 22.6704 / BEF
BEF0.45049 9
USD
BEF0.45049 9 BEF0.45049 9
USD
From these calculations it is easy to see that if we have the indirect quotation USD1.4335/GBP,
we can transform it to a direct quotation simply as
1
GBP 0.6976

USD1.4335
USD
GBP
The previous example was also an example of going from American quotation to a European
quotation. Furthermore, what is direct in one country is indirect in another. Thus, it is necessary
to start with defining the accounting currency (= the domestic currency).
Forward rates - Swap Points
Forward exchange rates can be quoted as above (=outright quotation=. However, the standard is
to quote forward rates in terms of swap points defined as
Swap point = Forward outright quotation – Spot quotation
The swap points are calculated from CIP parity conditions, meaning domestic and foreign interest
rates of the same maturity as the forward contract. (More about that later)
Example Forward swap points
Spot EUR/USD
: 1.0566-1.0571
One-month forward outright: 1.0691-1.0701
Forward swap: 0.0125-0.0130
5
Notice that I am only using 3-4 decimals, to be formally correct I should use at least 5 according to
general accounting standards. However, in class we need to save time and effort.
6
The forward outright is the spot price + the swap points, so in this case,
1.0691 = 1.0566 + 0.0125
1.0701 = 1.0571 + 0.0130
The motive behind swap points is 1) it saves time and 2) The bank/dealer who is giving the
offer sets the forward prices directly from differences in Eurocurrency interest rates. In this
case, the one-month Eurocurrency rate for EUR and the one-month USD Eurocurrency rate.
You do the same type calculation (F-S) to get swap points for 1,3,6,12 months forward
quotation.
(Calculate the spread and the spot mid-rate for EUR/USD rate. What is the USD/EUR rate, what
are the bid-ask prices for the USD/EUR rate?)
Examples of swap points and forward outright quotations:
Suppose that the bid ask prices are given as:
Spot
1 month
3 month
6 month
1.169 – 1.171
04 - 06
07 - 11
09 - 15
In this case we add these numbers to the given spot rate to get the outright forward bid and offered prices,
and the spread, as,
1 month 1.169 + 0.004 = 1.173
3 month 1.169 + 0.007 = 1.176
6 month 1.169 + 0.009 = 1.178
1.171 + 0.006 = 1.177
1.170 + 0.011 = 1.181
1.170 + 0.015 = 1.185
Spread 0.004
Spread 0.005
Spread 0.007
Calculate the mid-point spot and forward rates!
Notice that if the swap point were given as,
06 – 04
11 - 07
16 – 10
we must subtract from the spot rates (remember the Rip-off rule) as,
1 month 1.169 - 0.006 = 1.163
3 month 1.169 - 0.011 = 1.158
6 month 1.169 - 0.016 = 1.153
1.171 - 0.004 = 1.167
1.170 - 0.007 = 1.163
1.170 - 0.010 = 1.160
Spread 0.004
Spread 0.005
Spread 0.007
Translation Topics
The mid-price, at the end of the market day is often used for translation purposes, when daily data
is called for, or you want to translate a stock value from say USD December 31 to SEK.
7
An alternative is to think of foreign assets (real or financial) as something that must be sold to
become an asset in the domestic currency. If foreign denominated assets are seen in this way, the
translation rate becomes the bid price, not the mid-price, at the end of the trading day.
Non-accounting translation
A flow variable, like income, earnings consumption etc, is usually translated using the average
exchange rate during the period. This is because a flow variable represents a flow during a
specified period, and be definition a flow can not be observed in a point in time.
A stock variable, like money, equity, debt, inventories, etc, is translated using the exchange rate
corresponding to the moment when the stock variable was measured. A stock variable can
opposite to a flow, be measured at a point in time.
Prices, interest rates are translated using the average or current rate depending on if the price is
recorded as an average or at a moment in time.
How many decimals to use?
Example from translation between two European currencies within the Euro area - just before
creating the euro.
To avoid building up rounding errors into real losses, or get false warnings from computers about
accounts and invoices not fully settled, there are some strict rules.
Suppose that you want to translate from DEM to FRF.
1) Transform from DEM to EUR, and then from EUR to FRF.
2) Use at least 5 decimals.
These principles are the official EU standard.6
Accounting translation
There are special rules for accounting translation, very much in line with what we stated above.
Of course you don’t have to write out five decimals in the financial statements. The general rule
is to use the appropriate current market rate. See also the lecture and transparencies with
accounting translation techniques, and recommendations.
Triangular Arbitrage
If the quoted exchange rates are not in line with the implied cross rates, taking bid-ask prices =
transaction costs, into account, there is an opportunity for triangular arbitrage. A round trip over
two foreign currencies and back to the first currency should lead to profits. This profit would be
6
This scam has been used in real life of course, in the early days of computers. The fifth decimals (labelled
rounding errors) were directed to a special account controlled by the person who wrote the computer
program.
8
risk-free, because it there would be no risk in these transactions. Thus, we call it arbitrage profits
since they are risk free.
Can such differences exist? Answer: only very rarely and for brief moments. They cannot exist
forever because someone will run out of money. Arbitrage will lead to price changes.
Normally, the rip-off rule rules. You loose money by making these types of round trips. If you are
a tourist you loose a lot. However, if you are big player with an absolute minimum of USD10M
to spend on the FX market you face more narrow bid-ask spreads and will loose less money
compared to the tourist.
(See if you can work out an example with triangular arbitrage, with say USD10m to spend)
The futures market
The problem with forward contracts is that they are associated with credit risk. As a consequence
dealers ask for collateral, and reject buyers and sellers of forward contract for speculation
purposes. The futures market is a place for anybody, even those who wants to speculate.
Futures are standardised forward contracts traded at exchanges. One future contract is written in a
specific amount of foreign currency. The value of the contract is settled day by day by the buyer
and the seller of the currency in the contract. The daily settlement is done at a specific account at
the exchange using a mechanisms known as marking to market. This means that the contract be
resold on an exchange. In contrast, a forward contract is only settled at the maturity date. In the
end the exchange, through a so-called clearinghouse, backs up the contract, This procedure
eliminates credit risk almost completely.
The options market
Options contracts involve the right but not the obligation to trade an underlying asset at a specific
price (the strike) price up until or at a specific date in the future.
A foreign exchange call option gives the holder of the option the right but not the obligation to
buy a specific amount of the underlying currency at a strike price.
A foreign exchange put option gives the holder of the option the right but not the obligation to
sell a specific amount of the underlying currency at a specific (strike) price at a given date in the
future.
An option contract is an insurance for a foreign currency hedger. Risk is traded to the seller
(writer) of the option, while the buyer only pays a premium. A speculator on the other hand, pays
a premium but can in principle gain an infinite profit, at the expense of the writer. However, most
option writers are hedging themselves against losses.7
(Notice option theory is very useful, and can be used to value many things, like companies.)
7
History is filled with spectacular losses from option speculation. the so called Tulip mania in the
Netherlands in the 18th century and Baring's Bank in Singapore 1995 are only two examples
9
Foreign currency (and interest rate) swap market.
A swap is defined as an exchange of cash flows. In practice it will work as a series of forward
contracts for many future dates. A firm with regular payments, or income, in foreign currency can
find it attractive to enter into a swap deal to eliminate FX risk. An example of a currency swap is
as follows. I need to borrow British pounds to finance an expansion of my business in Britain. If I
try to obtain a loan in Britain I might find it relative expensive to obtain a loan in the UK.
Suppose that there is a British firm, which wants to borrow SEK. A solution, in which both can
benefit in terms of lower interest rates is to borrow money in our own countries and then
exchange interest payments and the final payment of the principals. This would constitute as a
currency swap. In practice we would also establish a series of (implicit) forward currency
contracts. A swap is an agreement between two counter parties to exchange cash flows. Typical
swaps involve not only two currencies but also a swap of fixed versus floating interest rate
payments.
Again, given the fact that forward contracts are associated with default risk, banks are reluctant to
engage themselves in long-term forward contracts. Instead they will rather act as swap dealer and
help to set up a foreign exchange swap. The practical outcome will be the same a series of
forward contracts. The exchange of cash flows in different currencies will be made at exchange
rates that we can calculate today, as a function of the interest differential between the two
currencies in the deal.
The word "derivative" implies that the value of these instruments is derived from some
underlying asset. By definition, a derivative instrument can always me replicated by using spot
markets instead. Foreign exchange derivatives can be replicated through the spot markets for
foreign exchange in combination with the (risk-free government) bond market.
Forwards and Options are the two principal instruments on the derivatives markets (espically for
FX rates and interest rates).
Here are the principal sub-groups
Forwards
Options
- Futures
- Caps (option on max interest to pay)
- Swaps
- Floors (Option on min interest to recieve)
- FRA:s
- Collars
- Locks
- Put options
- Call options
- Swaptions (Options on swaps)
FRA = Forward Rate Agreement on future interest rates
Locks are a type of forward on future interest rates to pay that “locks in today’s interest rate (See
Treasury lock)
All other instruments are typically combination of these, in combination with the Tbill rates and
the price of some underlying asset.
Growth in FX Markets (Needs some update)
See BIS triannual survey of FX markets
10
http://www.bis.org/publ/rpfxf10t.htm
And, “The $4 trillion question”
http://www.bis.org/publ/qtrpdf/r_qt1012e.htm
The FX markets have grown rapidly since the 1980s, especially during the 90s, and continues to
grow, as show by the recent BIS survey 2010. The growth is spectacular and not easy to explain.
Some (old) figures from BIS survey, May 1999.
Table 1. Estimated Average Turnover in Billions of US dollars
Gross turnover
April 1989
590
April 1992
820
April 1995
1,190
April 1998
1,500
Growth of the New York FX Market Billions of USD
5.0
1977
17
1979
18
1980
26
1983
35
1984
50
1986
130
1989
192
1992
244
1995
Most traded currencies (quite stable over time) April 1998, as shown by the following table.
Table 2. Distribution of Traded Currencies in Percent
Currency
USD
DEM
JPY
GBP
FRF
SFR
CAD
ASD
Other ECU
&EMS
Other
Total
April 1989
90
27
27
15
2
10
1
2
4
April 1987
87
30
21
11
5
7
4
3
17
22
200
15
200
11
Table 3. Biggest Market Places - Spot Market Transactions
Market
April 1989
% share
26
16
15
8
UK
US
Japan
Switzerlan
d
Singapore
8
Hong Kong 7
Australia
4
France
3
Germany
Total "net- 717.9
gross"
turnover1
1
Billions of US dollars.
April 1992
% share
27
16
11
6
April 1995
% share
30
16
10
6
April 1998
% share
Amount1
32
637.3
18
350.9
8
148.6
6
81.7
7
6
3
3
5
1,076.2
7
6
3
4
5
1,571.8
7
4
1
4
5
1,981.6
139.0
78.6
46.6
71.9
94.3
Growth in Over-the-counter (OTC) derivatives market.
Total estimated turnover April 1995 USD 880b. April 1998 USD 1,265b (Growth 44% in three
years)
Table 4. Types of Transactions in OTC Derivative markets
Forex Swaps
Outright forwards
Options
Currency Swaps
April 1995
79%
14%
6%
1%
April 1998
76%
14%
9%
1%
International money and capital markets are closely linked to the FX market. To be complete we
should also study the interest rate contracts involving different currencies. But, not here and now.
Definition of Eurocurrency markets. A deposit in a bank made in a currency, which is not legal
tender in the country where the bank is situated. Example, a DEM account held in a bank in
Singapore. Or an SEK account held in a bank in London. Notice that the term Eurocurrency
markets has nothing to do with foreign exchange markets per se. It only refers to this type of
money markets.
12
A popular lie in the public discussion is that 95% of the turnover in the FX markets are
speculation. This lie is spread by stupid and ignorant people who have never bothered to check
the facts. All good lies have a kernel of truth in them. So has this lie. Of the total turnover in the
FX markets less than 5% is directly associated with fundamental balance of payments (trade with
goods, direct investment etc), reaming 95% is mainly short-term capital flows, trade in
derivatives etc.
Are these 95% speculation as the disciples of the Tobin tax claims? NO and no again.
First of all, the ratio between financial transaction and trade with goods is always high (and
growing) in a developed economy. We refer to this as financial deepening. As an economy
develops it goes from barter trade, to a monetary system based on some valuable good, to banks
and to well developed financial system with various financial instruments, including credit cards
etc.
The ration of M2 over GDP is a typical measure of financial deepening, and the development of
the financial system in an economy. As the financial systems develop and the economy grows, so
does the ratio between M2 and GDP. Your salary goes from the bank used by your employer to
your bank. You spread the money to other banks, pay by credit cards etc. For each good or
service you buy your money will change hands many times as it travels through the financial
system. The financial deepening will grow as new instruments are being developed.
In a market place you cannot force consumers to buy services they do not want. You can only
supply things that are demanded. Financial innovations (and financial deepening) reduce
transaction costs and risks, and lead to higher utility for the consumers. To put it short, our lives
become richer as we can control more risk, and spend less time counting money etc.
In the early 1980 foreign exchange controls were being dismounted in country by country. It
opens for an explosion of cross-country financial settlements, and competition between banks in
different countries. The financial deepening within former closed financial sectors, spread into
the international arena just as expected.
What is in these 95% percent? Well of the total turnover 50% is just "fluff". Recall that the FX
markets are dealer markets. As soon as a dealer makes a sell or a purchase they will have to do a
transaction in the opposite direction in order to avoid risk. Say that you buy 1 million US dollar
forward. The bank will then match your purchase with selling 1 million USD forward to someone
else. The bank might not find a buyer immediately. To minimize risk the bank therefore trades in
the spot market, first to offset the risk associated with your purchase. Then, after the bank has
found a matching forward contract to balance your purchase, it enters the spot market one more
time.
Thus, when you estimate things in the correct way, you will find that the bulk of the FX market is
made up by dealers trading with each other to avoid risk. It is estimated that around 70% of the
FX market are made of hedging activities. These transactions are made to avoid risk, and do not
involve speculation, or lead to increases market volatility.
In a separate lecture we will talk about speculation and "excess volatility" in FX markets. Here
we conclude that speculation can be both stabilising and destabilising. If you apply the wrong
regulations you might increase the destabilising speculation, as reduce the stabilising one.
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Real Exchange Rates
The real rate is like real prices, you deflate the nominal exchange rate with CPI or some other
price index (GDP deflation, whole sale prices, unit labour costs)
Definition
qt 
Pf ,t  S t
Pd ,t
where Pf,t is the foreign price level (such as CPI), St is the exchange rate (direct quotation), and
Pd,t is the domestic price level measured in the same way as the foreign price level. The real rate
is a measure of competitiveness.
Notice the definition, if q increases in value there is a real depreciation, if it decreases in value
there is real appreciation. If domestic inflation increases more than foreign inflation, there is a
real appreciation. Domestic goods will become more expensive than foreign goods. It will be hard
to maintain a fixed rate, unless everyone are willing to pay a higher price for domestic goods.
Effective Exchange Rates
These are weighted averages of several exchange rates for one country, as
K
I t   wk S k ,t
k 1
where k is the number of currencies used, wk are the weights and

k
k 1
wk  1 . Weights are
typically constructed from country shares of trade (export + import of one country over total
value of exports and imports for all k countries)
IMF has a more sophisticated index that takes into account demand elasticities in trade.
A Note on the Tobin Tax
Left-wing populists argue for a Tobin tax to "control international capital flows". The
proceedings of tax are supposed to first pay off third world debt and then be used to all sorts of
things, like give education to the children of world etc. This sounds nice, but is based on
fundamental misunderstanding about how FX markets work, and the forces which drives them.
We will talk more about the Tobin tax in a coming lecture. The tax is a small VAT-type of tax
o.05-01% of total turnover on FX markets. The reasons behind this tax are mainly unknown to the
followers of the so-called Attac movement.
If this type of tax is introduced on one market, the trade in that market place will move to another
market. This could be another existing market or a new market. The FX market in South Africa
has grown rapidly during the last years. The people of South Africa would welcome an increase
in these type markets places, since it will bring income into their economy. Otherwise, plenty of
poor countries stand prepared to offer new market places.
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For this tax work it must be implemented on all FX markets. Thus, first we have to convince the
governments of the US, the UK, Japan, Singapore, China etc. to give up a profitable market.
Then, second, we have to convince these governments to hand over the income from this tax to
some super-national body to be used to pay off third world debt. However, these governments
have already decided how much they want to spend on repaying third world debt. Why should
they impose a new tax, hand over the proceeds like that?
Furthermore, recall that most of the FX trade is made up of inter-bank trade. A tax on these
transactions will motivate banks to merge their FX trading branches. Thus, we are likely to end
up with a few very large traders. This makes the remaining market place even more profitable for
those countries that chose to stay out of the super-national tax system. Just wait until a large
number of marketplaces have taxed away their FX markets and you are left with the big pie.
More, the most common type of transaction is derivative trade, in particular swaps aiming at
reducing risk in most cases. In turns out that it is possible achieve the same type deals without
trading in the FX markets directly, through various swap deals. This is a bit more complex to
explain, and goes far above the heads on all Attac members, but the thing is that the only way for
the Tobin tax once we consider all sorts of possible swap deals, is if it also applies to interest rate
payments. If the Tobin tax is possible to implement technically on FX markets, we have now
come to a point where things become increasingly difficult to handle.
To put it simply, there are thousands of things you can do to help poor countries and avoid
foreign exchange crises; the Tobin tax does not enter that list. Simply study the working of FX
markets and you will understand why.
In a following lecture I will talk about more about the conditions under which the Tobin tax will
work in theory, and point to evidence which shows that the theoretical assumptions (motivations)
behind the tax is not fulfilled in real life.
Questions (Definitions or explain):
Spot and forward rates
Direct and indirect quotation?
European and American quotation?
Ask –bid prices, “the rip-off rule”
Mid-price, spreads (what determines the size of the spread?)
Cross rates, from the mid-rate, from bid-ask prices
Triangular arbitrage
Outright quotation vs. Swap points
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