Interest rate parity, Balance of payments model

Interest rate parity

Interest rate parity (IRP) states that an appreciation or depreciation of one currency against another currency might be neutralized by a change in the interest rate differential. If US interest rates exceed Japanese interest rates then the US dollar should depreciate against the Japanese yen by an amount that prevents arbitrage. The future exchange rate is reflected into the forward exchange rate stated today. In our example, the forward exchange rate of the dollar is said to be at a discount because it buys fewer Japanese yen in the forward rate than it does in the spot rate. The yen is said to be at a premium.

IRP showed no proof of working after 1990s. Contrary to the theory, currencies with high interest rates characteristically appreciated rather than depreciated on the reward of the containment of inflation and a higher yielding currency.

Balance of payments model

This model holds that a foreign exchange rate must be at its equilibrium level - the rate which produces a stable current account balance. A nation with a trade deficit will experience reduction in its foreign exchange reserves which ultimately lowers (depreciates) the value of its currency. The cheaper currency renders the nation's goods (exports) more affordable in the global market place while making imports more expensive. After an intermediate period, imports are forced down and exports rise, thus stabilizing the trade balance and the currency towards equilibrium.

Like PPP, the balance of payments model focuses largely on tradable goods and services, ignoring the increasing role of global capital flows. In other words, money is not only chasing goods and services, but to a larger extent, financial assets such as stocks and bonds. Their flows go into the capital account item of the balance of payments, thus, balancing the deficit in the current account. The increase in capital flows has given rise to the asset market model.

Nominal and real exchange rates

Nominal and real exchange rates

* The nominal exchange rate e is the price in domestic currency of one unit of a foreign currency.
* The real exchange rate (RER) is defined as RER = e (\frac{P^*}{P} ), where P is the domestic price level and P * the foreign price level. P and P * must have the same arbitrary value in some chosen base year. Hence in the base year, RER = e.

The RER is only a theoretical ideal. In practice, there are many foreign currencies and price level values to take into consideration. Correspondingly, the model calculations become increasingly more complex. Furthermore, the model is based on purchasing power parity (PPP), which implies a constant RER. The empirical determination of a constant RER value could never be realised, due to limitations on data collection. PPP would imply that the RER is the rate at which an organization can trade goods and services of one economy (e.g. country) for those of another. For example, if the price of a good increases 10% in the UK, and the Japanese currency simultaneously appreciates 10% against the UK currency, then the price of the good remains constant for someone in Japan. The people in the UK, however, would still have to deal with the 10% increase in domestic prices. It is also worth mentioning that government-enacted tariffs can affect the actual rate of exchange, helping to reduce price pressures. PPP appears to hold only in the long term (3–5 years) when prices eventually correct towards parity.

More recent approaches in modelling the RER employ a set of macroeconomic variables, such as relative productivity and the real interest rate differential.

N R_i = (R R_i + 1)(Expected \ inflation + 1) - 1

Exchange Rate, Quotations

Exchange rate

In finance, the exchange rate (also known as the foreign-exchange rate, forex rate or FX rate) between two currencies specifies how much one currency is worth in terms of the other. For example an exchange rate of 123 Japanese yen (JPY, ¥) to the United States dollar (USD, $) means that JPY 123 is worth the same as USD 1. The foreign exchange market is one of the largest markets in the world. By some estimates, about 2 trillion USD worth of currency changes hands every day.

The spot exchange rate refers to the current exchange rate. The forward exchange rate refers to an exchange rate that is quoted and traded today but for delivery and payment on a specific future date.

Quotations

An exchange rate quotation is given by stating the number of units of a price currency that can be bought in terms of 1 unit currency (also called base currency). For example, in a quotation that says the EUR/USD exchange rate is 1.3 (USD per EUR), the price currency is USD and the unit currency is EUR.

Quotes using a country's home currency as the price currency (e.g., 0.50593 = $1 in the UK) are known as direct quotation or price quotation (from that country's perspective) ([1]) and are used by most countries.

Quotes using a country's home currency as the unit currency (e.g., $1.97656 = £1 in the UK) are known as indirect quotation or quantity quotation and are used in British newspapers and are also common in Australia, New Zealand and Canada.

* direct quotation: 1 foreign currency unit = x home currency units
* indirect quotation: 1 home currency unit = x foreign currency units

Note that, using direct quotation, if the home currency is strengthening (i.e., appreciating, or becoming more valuable) then the exchange rate number decreases. Conversely if the foreign currency is strengthening, the exchange rate number increases and the home currency is depreciating.

When looking at a currency pair such as EUR/USD, many times the first component (EUR in this case) will be called the base currency. The second is called the counter currency. For example : EUR/USD = 1.33866, means EUR is the base and USD the counter, so 1 EUR = 1.33866 USD.

Currency pair are given with four decimal places, except JPY with two decimal places (EUR/USD : 1.3386 - EUR/JPY : 165.29). In other words, quotes are given with 5 digits. Where rates are below 1, quotes frequently include 5 decimal places.

Valuing FX options: The Garman-Kohlhagen model, Examples

Valuing FX options: The Garman-Kohlhagen model

As in the Black-Scholes model for stock options and the Black model for certain interest rate options, the value of an european option on a FX rate is typically calculated by assuming that the rate follows a log-normal process.

Examples

Suppose a United Kingdom manufacturing firm is expecting to be paid US$100,000 for a piece of engineering equipment to be delivered in 90 days. If the GBP strengthen against the US$ over the next 90 days the UK firm will lose money, as it will receive less GBP when the US$100,000 is converted into GBP. However, if the GBP weaken against the US$,then the UK firm will gain additional money. In this case, to protect the GBP value that the firm will receive in 90 day's time, the UK firm can purchase a GBP call/ USD put option (the right to sell part or all of their expected income for pounds sterling at a given rate near today's rate) to mitigate their risk of exchange rate fluctuation over the 90 days. Conversely another party may wish to have the reverse option for a similar reason. A market maker will buy and sell these options with the aim of making a profit while not incurring too much risk.

The advantage of using an option instead is that it gives unlimited profit potential to the buyer at a limited cost (this cost is known as option premium).

In 1983 Garman and Kohlhagen extended the Black-Scholes model to cope with the presence of two interest rates (one for each currency). Suppose that rd is the risk-free interest rate to expiry of the domestic currency and rf is the foreign currency risk-free interest rate (where domestic currency is the currency in which we obtain the value of the option; the formula also requires that FX rates - both strike and current spot be quoted in terms of "units of domestic currency per unit of foreign currency"). Then the domestic currency value of a call option into the foreign currency is

c = S\exp(-r_f T)\N(d_1) - K\exp(-r_d T)\N(d_2)

The value of a put option has value

p = K\exp(-r_d T)\N(-d_2) - S\exp(-r_f T)\N(-d_1)

where :

d_1 = \frac{\ln(S/K) + (r_d - r_f + \sigma^2/2)T}{\sigma\sqrt{T}}
d_2 = d_1 - \sigma\sqrt{T}

S is the current spot rate
K is the strike rate
N is the cumulative normal distribution function
rd is domestic risk free rate
rf is foreign risk free rate
and σ is the volatility of the FX rate.

Foreign exchange option

In finance, a foreign exchange option (commonly shortened to just FX option or currency option) is a derivative financial instrument where the owner has the right but not the obligation to exchange money denominated in one currency into another currency at a pre-agreed exchange rate on a specified date. The FX options market is the deepest, largest and most liquid market for options of any kind in the world. Most of the FX option volume is traded OTC but a fraction is traded on exchanges like the Philadelphia Stock Exchange, or the Chicago Mercantile Exchange for options on futures contracts.

For example a GBPUSD FX option might be specified by a contract allowing the owner to sell £1,000,000 and buy $2,000,000 on December 31. In this case the pre-agreed exchange rate, or strike price, is 2.0000 GBPUSD or 0.5000 USDGBP and the notional is £1,000,000. This type of contract is both a call on dollars and a put on sterling, and is often called a GBPUSD put by market participants. If the dollar is stronger than 2.0000 GBPUSD come December 31 (say at 1.9000 GBPUSD) then the option will be exercised, allowing the owner to sell GBP at 2.0000 and immediately buy it back in the spot market at 1.9000, making a profit of (2.0000 - 1.9000)*1,000,000 GBP = 100,000 USD in the process. If he immediately exchanges his profit, this amounts to 100,000/1.9000 = 52,631.58 GBP.

Retail Forex Trading

Retail Forex Trading

Take two of the most common currency pairs, the EUR/USD (the price for Euros in US dollars) and the GBP/USD (the price for The Great British Pound in US dollars). If there is positive economic news in the Euro zone and negative economic news in the United Kingdom, it is very conceivable that the EUR/USD would go up in value, meaning it is now more expensive in US dollars to purchase one EUR, and that the GBP/USD would go down in value, meaning it is now cheaper to buy Great British Pounds with US dollars. In this scenario, the US dollar went up in value against one currency and down in relation to another. It is important to understand this idea that currency pairs move mostly independently from one another. Currency pairs with similar currencies on one side (like the USD in the previous example) can be similarly affected by news regarding the common currency, but the crucial concept is that they don’t have to be.

United States dollar and the euro

United States dollar and the euro

Since the mid-20th century, the de facto world currency has been the United States dollar. According to Robert Gilpin in Global Political Economy: Understanding the International Economic Order (2001): "Somewhere between 40 and 60 percent of international financial transactions are denominated in dollars. For decades the dollar has also been the world's principle reserve currency; in 1996, the dollar accounted for approximately two-thirds of the world's foreign exchange reserves" (255).

Many of the world's currencies are pegged against the dollar. Some countries, such as Ecuador, El Salvador, and Panama, have gone even further and eliminated their own currency in favor of the United States dollar.

Since 1999, the dollar's dominance has begun to be undermined by the euro, that represents an equivalent size economy, with the prospect of more countries adopting the euro as their national currency. Quite a few of the world's currencies are pegged against the euro. They are usually Eastern European currencies like the Estonian kroon and the Bulgarian lev, plus several north African currencies like the Cape Verdean escudo and the CFA franc.

As of December 2006, the euro surpassed the dollar in the combined value of cash in circulation. The value of euro notes in circulation has risen to more than €610 billion, equivalent to US$800 billion at the exchange rates at this time.

Speculation

Speculation

Controversy about currency speculators and their effect on currency devaluations and national economies recurs regularly. Nevertheless, many economists (e.g. Milton Friedman) have argued that speculators perform the important function of providing a market for hedgers and transferring risk from those people who don't wish to bear it, to those who do. Other economists (e.g. Joseph Stiglitz) however, may consider this argument to be based more on politics and a free market philosophy than on economics.

Large hedge funds and other well capitalized "position traders" are the main professional speculators.

Currency speculation is considered a highly suspect activity in many countries. While investment in traditional financial instruments like bonds or stocks often is considered to contribute positively to economic growth by providing capital, currency speculation does not, according to this view; it is simply gambling, that often interferes with economic policy. For example, in 1992, currency speculation forced the Central Bank of Sweden to raise interest rates for a few days to 150% per annum, and later to devalue the krona. Former Malaysian Prime Minister Mahathir Mohamad is one well known proponent of this view. He blamed the devaluation of the Malaysian ringgit in 1997 on George Soros and other speculators.[7]

Gregory Millman reports on an opposing view, comparing speculators to "vigilantes" who simply help "enforce" international agreements and anticipate the effects of basic economic "laws" in order to profit.

In this view, countries may develop unsustainable financial bubbles or otherwise mishandle their national economies, and forex speculators made the inevitable collapse happen sooner. A relatively quick collapse might even be preferable to continued economic mishandling. Mahathir Mohamad and other critics of speculation are viewed as trying to deflect the blame from themselves for having caused the unsustainable economic conditions.

Algorithmic trading in forex

Algorithmic trading in forex

Electronic trading is growing in the FX market, and algorithmic trading is becoming much more common. There is much confusion about the technique. According to financial consultancy Celent estimates, by 2008 up to 25% of all trades by volume will be executed using algorithm, up from about 18% in 2005.

Financial instruments

There are several types of financial instruments commonly used.

Spot: A spot transaction is a two-day delivery transaction, as opposed to the futures contracts, which are usually three months. This trade represents a “direct exchange” between two currencies, has the shortest time frame, involves cash rather than a contract; and interest is not included in the agreed-upon transaction. The data for this study come from the spot market. Spot has the largest share by volume in FX transactions among all instruments.

Forward transaction: One way to deal with the Forex risk is to engage in a forward transaction. In this transaction, money does not actually change hands until some agreed upon future date. A buyer and seller agree on an exchange rate for any date in the future, and the transaction occurs on that date, regardless of what the market rates are then. The duration of the trade can be a few days, months or years.

Futures: Foreign currency futures are forward transactions with standard contract sizes and maturity dates — for example, 500,000 British pounds for next November at an agreed rate. Futures are standardized and are usually traded on an exchange created for this purpose. The average contract length is roughly 3 months. Futures contracts are usually inclusive of any interest amounts.

Swap: The most common type of forward transaction is the currency swap. In a swap, two parties exchange currencies for a certain length of time and agree to reverse the transaction at a later date. These are not standardized contracts and are not traded through an exchange.

Options: A foreign exchange option (commonly shortened to just FX option) is a derivative where the owner has the right but not the obligation to exchange money denominated in one currency into another currency at a pre-agreed exchange rate on a specified date. The FX options market is the deepest, largest and most liquid market for options of any kind in the world.

Market Psychology

Market Psychology

Market psychology and trader perceptions influence the foreign exchange market in a variety of ways:

Flights to quality: Unsettling international events can lead to a "flight to quality," with investors seeking a "safe haven". There will be a greater demand, thus a higher price, for currencies perceived as stronger over their relatively weaker counterparts.

Long-term trends: Currency markets often move in visible long-term trends. Although currencies do not have an annual growing season like physical commodities, business cycles do make themselves felt. Cycle analysis looks at longer-term price trends that may rise from economic or political trends. [4]

"Buy the rumor, sell the fact:" This market truism can apply to many currency situations. It is the tendency for the price of a currency to reflect the impact of a particular action before it occurs and, when the anticipated event comes to pass, react in exactly the opposite direction. This may also be referred to as a market being "oversold" or "overbought".[5] To buy the rumor or sell the fact can also be an example of the cognitive bias known as anchoring, when investors focus too much on the relevance of outside events to currency prices.

Economic numbers: While economic numbers can certainly reflect economic policy, some reports and numbers take on a talisman-like effect: the number itself becomes important to market psychology and may have an immediate impact on short-term market moves. "What to watch" can change over time. In recent years, for example, money supply, employment, trade balance figures and inflation numbers have all taken turns in the spotlight.

Technical trading considerations: As in other markets, the accumulated price movements in a currency pair such as EUR/USD can form apparent patterns that traders may attempt to use. Many traders study price charts in order to identify such patterns. [6]

Factors Affecting Currency Trading, Economic Factors

Factors Affecting Currency Trading

Although exchange rates are affected by many factors, in the end, currency prices are a result of supply and demand forces. The world's currency markets can be viewed as a huge melting pot: in a large and ever-changing mix of current events, supply and demand factors are constantly shifting, and the price of one currency in relation to another shifts accordingly. No other market encompasses (and distills) as much of what is going on in the world at any given time as foreign exchange.

Supply and demand for any given currency, and thus its value, are not influenced by any single element, but rather by several. These elements generally fall into three categories: economic factors, political conditions and market psychology.

Economic factors

These include economic policy, disseminated by government agencies and central banks, economic conditions, generally revealed through economic reports, and other economic indicators.

Economic policy comprises government fiscal policy (budget/spending practices) and monetary policy (the means by which a government's central bank influences the supply and "cost" of money, which is reflected by the level of interest rates).

Economic conditions include:

Government budget deficits or surpluses: The market usually reacts negatively to widening government budget deficits, and positively to narrowing budget deficits. The impact is reflected in the value of a country's currency.

Balance of trade levels and trends: The trade flow between countries illustrates the demand for goods and services, which in turn indicates demand for a country's currency to conduct trade. Surpluses and deficits in trade of goods and services reflect the competitiveness of a nation's economy. For example, trade deficits may have a negative impact on a nation's currency.

Inflation levels and trends: Typically, a currency will lose value if there is a high level of inflation in the country or if inflation levels are perceived to be rising. This is because inflation erodes purchasing power, thus demand, for that particular currency.

Economic growth and health: Reports such as gross domestic product (GDP), employment levels, retail sales, capacity utilization and others, detail the levels of a country's economic growth and health. Generally, the more healthy and robust a country's economy, the better its currency will perform, and the more demand for it there will be.

Trading Characteristics

Trading Characteristics

There is no unified or centrally cleared market for the majority of FX trades, and there is very little cross-border regulation. Due to the over-the-counter (OTC) nature of currency markets, there are rather a number of interconnected marketplaces, where different currency instruments are traded. This implies that there is not a single dollar rate but rather a number of different rates (prices), depending on what bank or market maker is trading. In practice the rates are often very close, otherwise they could be exploited by arbitrageurs instantaneously. A joint venture of the Chicago Mercantile Exchange and Reuters, called FXMarketSpace opened in 2007 and aspires to the role of a central market clearing mechanism.

The main trading centers are in London, New York, Tokyo, and Singapore, but banks throughout the world participate. Currency trading happens continuously throughout the day; as the Asian trading session ends, the European session begins, followed by the US session and then back to the Asian session, excluding weekends.

There is little or no 'inside information' in the foreign exchange markets. Exchange rate fluctuations are usually caused by actual monetary flows as well as by expectations of changes in monetary flows caused by changes in GDP growth, inflation, interest rates, budget and trade deficits or surpluses, large cross-border M&A deals and other macroeconomic conditions. Major news is released publicly, often on scheduled dates, so many people have access to the same news at the same time. However, the large banks have an important advantage; they can see their customers' order flow.

Currencies are traded against one another. Each pair of currencies thus constitutes an individual product and is traditionally noted XXX/YYY, where YYY is the ISO 4217 international three-letter code of the currency into which the price of one unit of XXX is expressed. For instance, EUR/USD is the price of the euro expressed in US dollars, as in 1 euro = 1.3045 dollar. Out of convention, the first currency in the pair, the base currency, was the stronger currency at the creation of the pair. The second currency, counter currency, was the weaker currency at the creation of the pair.

The factors affecting XXX will affect both XXX/YYY and XXX/ZZZ. This causes positive currency correlation between XXX/YYY and XXX/ZZZ.

On the spot market, according to the BIS study, the most heavily traded products were:

* EUR/USD: 28 %
* USD/JPY: 18 %
* GBP/USD (also called sterling or cable): 14 %

and the US currency was involved in 88.7% of transactions, followed by the euro (37.2%), the yen (20.3%), and the sterling (16.9%) (see table). Note that volume percentages should add up to 200%: 100% for all the sellers and 100% for all the buyers.

Although trading in the euro has grown considerably since the currency's creation in January 1999, the foreign exchange market is thus far still largely dollar-centered. For instance, trading the euro versus a non-European currency ZZZ will usually involve two trades: EUR/USD and USD/ZZZ. The exception to this is EUR/JPY, which is an established traded currency pair in the interbank spot market.

Investment Management Firms, Hedge Funds, Retail Forex Brokers

Investment management firms

Investment management firms (who typically manage large accounts on behalf of customers such as pension funds and endowments) use the foreign exchange market to facilitate transactions in foreign securities. For example, an investment manager with an international equity portfolio will need to buy and sell foreign currencies in the spot market in order to pay for purchases of foreign equities. Since the forex transactions are secondary to the actual investment decision, they are not seen as speculative or aimed at profit-maximization.

Some investment management firms also have more speculative specialist currency overlay operations, which manage clients' currency exposures with the aim of generating profits as well as limiting risk. Whilst the number of this type of specialist firms is quite small, many have a large value of assets under management (AUM), and hence can generate large trades.

Hedge funds

Hedge funds, such as George Soros's Quantum fund have gained a reputation for aggressive currency speculation since 1990. They control billions of dollars of equity and may borrow billions more, and thus may overwhelm intervention by central banks to support almost any currency, if the economic fundamentals are in the hedge funds' favor.

Retail forex brokers

Retail forex brokers or market makers handle a minute fraction of the total volume of the foreign exchange market. According to CNN, one retail broker estimates retail volume at $25–50 billion daily, which is about 2% of the whole market and it has been reported by the CFTC website that unexperienced investors may become targets of forex scams.

Market participants, Banks, Commercial Companies

Top 10 Currency Traders

% of overall volume, May 2006

Source: Euromoney FX survey^[3]

Rank	Name	% of volume
1	Deutsche Bank	19.26
2	UBS AG	11.86
3	Citigroup	10.39
4	Barclays Capital	6.61
5	Royal Bank of Scotland	6.43
6	Goldman Sachs	5.25
7	HSBC	5.04
8	Bank of America	3.97
9	JPMorgan Chase	3.89
10	Merrill Lynch	3.68

Unlike a stock market, where all participants have access to the same prices, the forex market is divided into levels of access. At the top is the inter-bank market, which is made up of the largest investment banking firms. Within the inter-bank market, spreads, which are the difference between the bid and ask prices, are razor sharp and usually unavailable, and not known to players outside the inner circle. As you descend the levels of access, the difference between the bid and ask prices widens (from 0-1 pip to 1-2 pips only for major currencies like the Euro). This is due to volume. If a trader can guarantee large numbers of transactions for large amounts, they can demand a smaller difference between the bid and ask price, which is referred to as a better spread. The levels of access that make up the forex market are determined by the size of the “line” (the amount of money with which they are trading). The top-tier inter-bank market accounts for 53% of all transactions. After that there are usually smaller investment banks, followed by large multi-national corporations (which need to hedge risk and pay employees in different countries), large hedge funds, and even some of the retail forex market makers. According to Galati and Melvin, “Pension funds, insurance companies, mutual funds, and other institutional investors have played an increasingly important role in financial markets in general, and in FX markets in particular, since the early 2000s.” (2004) In addition, he notes, “Hedge funds have grown markedly over the 2001–2004 period in terms of both number and overall size” Central banks also participate in the forex market to align currencies to their economic needs.

Banks

The interbank market caters for both the majority of commercial turnover and large amounts of speculative trading every day. A large bank may trade billions of dollars daily. Some of this trading is undertaken on behalf of customers, but much is conducted by proprietary desks, trading for the bank's own account.

Until recently, foreign exchange brokers did large amounts of business, facilitating interbank trading and matching anonymous counterparts for small fees. Today, however, much of this business has moved on to more efficient electronic systems, such as EBS (now owned by ICAP), Reuters Dealing 3000 Matching (D2), the Chicago Mercantile Exchange, Bloomberg, and TradeBook(R). The broker squawk box lets traders listen in on ongoing interbank trading and is heard in most trading rooms, but turnover is noticeably smaller than just a few years ago.

Commercial companies

An important part of this market comes from the financial activities of companies seeking foreign exchange to pay for goods or services. Commercial companies often trade fairly small amounts compared to those of banks or speculators, and their trades often have little short term impact on market rates. Nevertheless, trade flows are an important factor in the long-term direction of a currency's exchange rate. Some multinational companies can have an unpredictable impact when very large positions are covered due to exposures that are not widely known by other market participants.

Learn Foreign Exchange

The foreign exchange (currency or forex or FX) market exists wherever one currency is traded for another. It is by far the largest financial market in the world, and includes trading between large banks, central banks, currency speculators, multinational corporations, governments, and other financial markets and institutions. The average daily trade in the global forex markets currently around US$ 1.9 trillion.[1] Retail traders (individuals) are a small fraction of this market and may only participate indirectly through brokers or banks.

In addition to "traditional" turnover, $1.26 trillion was traded in derivatives.

Exchange-traded forex futures contracts were introduced in 1972 at the Chicago Mercantile Exchange and are actively traded relative to most other futures contracts. Forex futures volume has grown rapidly in recent years, and accounts for about 7% of the total foreign exchange market volume, according to The Wall Street Journal Europe (5/5/06, p. 20).

Average daily global turnover in traditional foreign exchange market transactions totaled $2.7 trillion in April 2006 according to IFSL estimates based on semi-annual London, New York, Tokyo and Singapore Foreign Exchange Committee data. Overall turnover, including non-traditional foreign exchange derivatives and products traded on exchanges, averaged around $2.9 trillion a day. This was more than ten times the size of the combined daily turnover on all the world’s equity markets. Foreign exchange trading increased by 38% between April 2005 and April 2006 and has more than doubled since 2001. This is largely due to the growing importance of foreign exchange as an asset class and an increase in fund management assets, particularly of hedge funds and pension funds. The diverse selection of execution venues such as internet trading platforms has also made it easier for retail traders to trade in the foreign exchange market. [2]

Because foreign exchange is an OTC market where brokers/dealers negotiate directly with one another, there is no central exchange or clearing house. The biggest geographic trading centre is the UK, primarily London, which according to IFSL estimates has increased its share of global turnover in traditional transactions from 31.3% in April 2004 to 32.4% in April 2006. RPP

The ten most active traders account for almost 73% of trading volume, according to The Wall Street Journal Europe, (2/9/06 p. 20). These large international banks continually provide the market with both bid (buy) and ask (sell) prices. The bid/ask spread is the difference between the price at which a bank or market maker will sell ("ask", or "offer") and the price at which a market-maker will buy ("bid") from a wholesale customer. This spread is minimal for actively traded pairs of currencies, usually 0–3 pips. For example, the bid/ask quote of EUR/USD might be 1.2200/1.2203. Minimum trading size for most deals is usually $100,000.

These spreads might not apply to retail customers at banks, which will routinely mark up the difference to say 1.2100 / 1.2300 for transfers, or say 1.2000 / 1.2400 for banknotes or travelers' checks. Spot prices at market makers vary, but on EUR/USD are usually no more than 3 pips wide (i.e. 0.0003). Competition has greatly increased with pip spreads shrinking on the major pairs to as little as 1 to 2 pips.