92 CHAPTER 3. SPOT MARKETS FOR FOREIGN CURRENCY
ward contract is settled six months later than a spot contract—each time including
the two-day initial-delay convention.^12
Example 3.9
A 180-day contract signed on March 2 works as follows. Assuming that March 4 is
a working day, spot settlement would have been on March 4. For a 180-day forward
deal, the settlement date would be moved by six months to, in principle, September
4, or the first working day thereafter if that would have been a holiday. The actual
number of calendar days is at least (2+)184 days: there are four 31-day months in
the March-September window.
The above holds for standard dates, But you can always obtain a price for a
“broken date” (i.e. a non-standard maturity), too. For instance, on April 20 you
can stipulate settlement on November 19 or any other desired date.
Worldwide, spot transactions represent less than 50 percent of the total foreign-
exchange market volume. The forward market, together with the closely related
swap market (see Chapter 7), make up over 50 percent of the volume. About 3
percent of total trade consists of currency-futures contracts (a variant of forward
contracts traded in secondary markets—see Chapter 6) and currency options (see
Chapter 8).
After this digression on the meaning of exchange rates and their relation to real
quantities, we now return to the operations of the spot exchange market. We want
to introduce one of the cornerstones of finance theory, the Law of One Price.
3.3 The Law of One Price for Spot Exchange Quotes
In frictionless markets, two securities that have identical cash flows must have the
same price. This is called the Law of One Price. There are two mechanisms that
enforce this law. The first one is calledarbitrageand the second one can be called
shopping around. We explain these two concepts below.
Suppose that two assets or portfolios with identical cash flows do not have the
same price. Then any holder of the overpriced asset could simultaneously sell this
asset and buy the cheaper asset instead, thus netting the price difference without
taking on any additional risk. If one does not hold the overpriced asset, one could still
take advantage of this mispricing by short-selling^13 the overpriced asset and covering
this with the purchase of the cheaper security. For example, you sell an overpriced
(^12) Further details of settlement rules are provided in Grabbe (1995).
(^13) see box in Figure 3.9.