A Turkish clothing company is buying material in Mexico. It needs to pay 1 million Mexican pesos. The exchange rates published in a local newspaper are as follows:
$\bullet$ One U.S. dollar is worth 1356 Turkish liras.
$\bullet$ One U.S. dollar is worth 129.64 Mexican pesos.
The Turkish company calls its local banker, who advises that it needs to do two foreign exchange transactions: One selling liras to buy dollars, and the other buying pesos with these dollars. The company is surprised that its banker does not engage directly in a single transaction from liras to pesos. Why would the bid-ask spread be much larger on the lira/peso transaction than the sum of the bid-ask spread of the two lira/dollar and peso/dollar transactions?

Question

Quizplus · Accepted Answer

The Answer is For each currency, there exists a "wholesale" foreign exchange market only against the U.S. dollar. This rule suffers very few exceptions, such as other European currencies against the euro, or some Asian currencies against the yen. This is motivated by liquidity.
A market between the Turkish lira and the Mexican peso would see very few daily transactions, if any. Hence, liquidity would be very limited. Any bank making a firm bid-ask quote would have to take a huge spread as it may take several days to unwind a position. In reality, all transactions involving the lira (and another foreign currency) are done against the U.S dollar. So, there are two transactions; first the lira against the dollar and then the foreign currency against the dollar (except of course when the foreign currency is the dollar itself). Similarly, any transaction involving the peso is done against the U.S. dollar. Because there are quite a few daily transactions involving the lira against all other currencies, the bid-ask spread on the lira/dollar exchange rate is fairly low. It is better to have to pay two small spreads than a single large one.

A Turkish Clothing Company Is Buying Material in Mexico ∙\bullet∙ One US Dollar Is Worth 1356 Turkish Liras

A Turkish Clothing Company Is Buying Material in Mexico $\bullet$ One US Dollar Is Worth 1356 Turkish Liras