102 CHAPTER 3. SPOT MARKETS FOR FOREIGN CURRENCY
quotes (the best bid, and the best ask, across all market makers) rather than
the quotes by an individual dealer, the force is even stronger. Individually, a
market maker may very well want to make one of its quotes unappealing for
some time, as we saw. But if there are many market makers it would be quite
unlikely that, across all market makers, even the best direct quote would still
be unappealing against the synthetic one, for that would mean that among all
the competing market makers there is not a single one that is interested in that
particular type of deal. Thus, instances where a direct quote is dominated by
a synthetic one at one side should be rare and short-lived, and the more so
the higher the number of market makers.- The above assumes that the direct market has enough volume. Indeed, with
a very thin market, the spread required to make market-making sustainable
may be too wide to allow the direct market to compete on both sides with
the synthetic market via a heavily-traded vehicle currency (like theusdor the
eur). The volume and depth of the wholesale market for dollars relative to
almost any other currency is so large (and the spreads, therefore, so small)
that a substantial part of the nondollar transactions are, in fact, still executed
by way of the dollar. Direct cross-deals have emerged as of the mid 1980s only,
and are still confined to heavy-volume currency pairs.
As a final note, in the retail markets most customers have no direct access to
cross rates, and bank clerks occasionally compute cross rates even where the actual
transaction could be executed very differently. A Japanese bank, for instance, would
post quotes forjpy/gbpandjpy/eurrates for its retail customers, but typically
not forgbp/eur. Should a retail customer selleurand buygbp, the clerk would
actually compute the synthetic rates we just derived, as if the customer first went
fromeurtojpyand then togbp, even if in the bank’s trading room the actual
conversion may be done directly fromeurintogbp. Unless you have an account
with a Euroland orukbank, or enough clout with your home bank, you would have
little choice but to accept the large spread implied by such synthetic rates.
This finishes our tour of the workings of the exchange markets. We continue the
chapter with some wise advice on the merits and shortcomings of using exchange
rates to translate foreign amounts of money. This brings us to the twin concepts of
“ppp” and “real” exchange rates, key issues to understand the relevance of currency
risk.
3.4 Translating FC Figures: Nominal rates, PPP rates,
and Deviations fromPPP
Obviously, when you exchange afcamount intohcorvice versa, you will use the
exchange rate relevant at the moment. But actual transactions like this are not
the sole conceivable purpose for such a conversion; rather, the purpose may just be