114 CHAPTER 3. SPOT MARKETS FOR FOREIGN CURRENCY
3.5 CFO’s Summary
In this chapter, we have seen how spot markets work. From the treasurer’s point of
view, one immediately interesting aspect is the possibility for arbitrage and shopping
around.
- Arbitrage consists of buying and immediately reselling (or vice versa), thus
taking no risk and engaging no capital. One could try to do this across market
makers (for one particular exchange rate) or in a triangular way. In practice,
the likelihood of corporate treasurers finding such a riskless profit opportunity
is tiny. Arbitrage by traders in the wholesale market eliminates this possibility
almost as quickly as it arises. In addition, most firms deal in the retail market,
where spreads are relatively wide. - Shopping around consists of finding the best route for a particular transac-
tion. In contrast to arbitrage, shopping around may work—not in the sense
of creating large profits, but in the sense of saving on commissions or getting
marginally better rates. It is generally worth calling a few banks for the best
rate when you need to make a large transaction. And it may pay to compute
a triangular cross rate, especially through routes that involve heavily traded
currencies like theusdor theeur. Doing such a computation could enable
corporate treasurers to find cheaper routes for undertaking transactions as
compared to direct routes.
The spot rate is, by definition, the right number to use if you need to do an actual
transaction. But for other purposes, other exchange-rate concepts are quite useful:
- Theppprate is the ratio of the two price levels. Translating foreign income
numbers or investment budgets at this rate tells you what the foreign figures
really mean to locals—but expressed in terms that are familiar to you. - Thereal exchange rate (or the deviation from Absoluteppp) is the ratio of
thetranslatedprice levels. It tells you which country is more expensive. This
is relevant if you want to evaluate a country as a destination for exports, or a
source of imports, or a place to live or produce. - Both the above concepts require data on price levels, which are not available
for all countries. Often one makes do with thedeviation fromRPPPrelative
to a given base period, which estimates to what extent the real exchange rate
has changed since then.
There is a clear, but imperfect relation between actual rates andppprates: coun-
tries that have gone through high-inflation episodes and, thus, ended up with high
nominal prices for all goods, pay high nominal prices for currencies too. But the
relation is far from one-to-one: real rates can be five to one (Norway against China,