Foreign Exchange Market and Yield Differentials Quiz
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Questions and Answers

Which market participants can derive cross-rates to expand trading opportunities?

  • Central banks
  • Individual investors
  • Commercial banks
  • Global entities (correct)

    • What is the market convention for quoting the exchange rate between the US dollar and the euro?

  • euro–dollar (USD/EUR) (correct)
  • dollar–Canada (CAD/USD)
  • euro–Canada (CAD/EUR)
  • dollar–euro (EUR/USD)

    • What is the purpose of understanding the concept of arbitrage relationships in the foreign exchange market?

  • To calculate exchange rates
  • To understand market inputs (correct)
  • To facilitate international currency flows
  • To determine trading opportunities

    • What is the decentralized market where global currencies are bought, sold, and exchanged?

    <p>Foreign exchange market</p> Signup and view all the answers

    Which of the following best describes the relationship between spot and forward rates in the FX market?

    <p>The relationship between spot and forward rates varies depending on market conditions</p> Signup and view all the answers

    What are forward points in the context of FX markets?

    <p>The difference between the spot exchange rate and the forward rate</p> Signup and view all the answers

    How are forward rates typically quoted in professional FX markets?

    <p>In terms of pips</p> Signup and view all the answers

    What factors determine the absolute number of forward points in FX markets?

    <p>The term to maturity and the yield differential between the two countries</p> Signup and view all the answers

    Which equation correctly represents the calculation for obtaining a euro-Canada (CAD/EUR) quote?

    <p>CAD USD × USD EUR = CAD USD × USD EUR = CAD EUR</p> Signup and view all the answers

    Which equation correctly represents the calculation for obtaining a Canada-yen (JPY/CAD) quote?

    <p>CAD USD × JPY USD = USD CAD × JPY USD = JPY CAD</p> Signup and view all the answers

    Which equation correctly represents the calculation for obtaining a Canada-yen (JPY/CAD) quote based on the given spot exchange rates?

    <p>0.7680 × 111.94 = 85.97 JPY per CAD</p> Signup and view all the answers

    Which statement accurately describes the market convention for quoting exchange rates?

    <p>The market uses rate quotes on defined conventional currency pairs.</p> Signup and view all the answers

    Which of the following is an example of swap financing?

    <p>Converting foreign currency to domestic currency using a forward rate</p> Signup and view all the answers

    What is the arbitrage relationship equation based on?

    <p>The underlying intuition of two alternative but equivalent investments</p> Signup and view all the answers

    What is the formula for calculating the forward rate?

    <p>(1 + rd) = Sf/d(1 + rf)( _1 Ff/d)</p> Signup and view all the answers

    What is the purpose of representing forward points as a percentage of the spot rate?

    <p>To calculate the percentage discount or premium in the forward market</p> Signup and view all the answers

    Which equation represents the relationship between forward points (Ff/d - Sf/d), spot exchange rate (Sf/d), interest rate differential (rf - rd), and investment horizon (τ)?

    <p>Ff/d - Sf/d = Sf/d(rf - rd)(1 + rdτ)τ</p> Signup and view all the answers

    What is the 30-day forward exchange rate given a 30-day domestic risk-free interest rate of 2.00 percent per year, a 30-day foreign risk-free interest rate of 3.00 percent per year, and a spot exchange rate (Sf/d) of 1.6555?

    <p>1.6569</p> Signup and view all the answers

    What does a premium of 14 pips mean in the context of forward rates trading at a 30-day term?

    <p>The forward rate is higher than the spot rate by 14 pips</p> Signup and view all the answers

    How are swap points related to the term of the forward contract?

    <p>Swap points are directly proportional to the term of the forward contract</p> Signup and view all the answers

    Which equation can be used to calculate the 12-month forward rate (Ff/d) given the spot exchange rate (Sf/d), domestic risk-free rate (rd), and foreign risk-free rate (rf)?

    <p>(1 + rd) = (1/Sd/f)(1 + rf)Fd/f</p> Signup and view all the answers

    What is the value of the 12-month forward rate (Ff/d) given the spot exchange rate (Sf/d) of 1.6535, domestic risk-free rate (rd) of 3.50%, and foreign risk-free rate (rf) of 5.00%?

    <p>1.6775</p> Signup and view all the answers

    If the misquoted 12-month forward rate (Ff/d) is 1.6900, what is the return on the hedged foreign investment using the arbitrage equation?

    <p>1.0273</p> Signup and view all the answers

    What does the equation _ Ff/d Sf/d = ( 1 + r _f 1 + rd) indicate about the relationship between forward rate and spot rate?

    <p>The forward rate will be higher than the spot rate if foreign interest rates are higher than domestic interest rates.</p> Signup and view all the answers

    Which of the following statements is true about the relationship between the increase in the term of a forward contract and the increase in forward points?

    <p>The increase in forward points is not proportional to the increase in the term of the contract.</p> Signup and view all the answers

    Which of the following statements is true about the relationship between the spread between foreign and domestic interest rates and the number of forward points?

    <p>The number of forward points is not proportional to the spread between foreign and domestic interest rates.</p> Signup and view all the answers

    If the foreign interest rate is set to 4.00 percent, the domestic interest rate is unchanged, and the spot exchange rate is unchanged, what happens to the forward points of a 30-day forward contract?

    <p>The forward points increase.</p> Signup and view all the answers

    What is the formula for calculating the forward points (Ff/d - Sf/d) of a 30-day forward contract when the foreign interest rate is set to 4.00 percent and the domestic interest rate and spot exchange rate are unchanged?

    <p>$Ff/d - Sf/d = 1.6555(0.0400 - 0.0200[\frac{30}{360}])$</p> Signup and view all the answers

    What is the interest rate differential (rf - rd) of the original 30-day forward contract?

    <p>1.00 percent</p> Signup and view all the answers

    What is the value of the forward points (Ff/d - Sf/d) when the foreign interest rate is set to 4.00 percent, the domestic interest rate and spot exchange rate are unchanged, and the term of the forward contract is 30 days?

    <p>0.0028</p> Signup and view all the answers

    Study Notes

    Market Participants and Cross-Rates

    • Market participants who can derive cross-rates to expand trading opportunities include banks, corporations, and speculators.

    Market Convention for Quoting Exchange Rates

    • The market convention for quoting the exchange rate between the US dollar and the euro is EUR/USD.

    Purpose of Understanding Arbitrage Relationships

    • The purpose of understanding arbitrage relationships in the foreign exchange market is to exploit mismatches in exchange rates and earn riskless profits.

    Decentralized Market for Currencies

    • The decentralized market where global currencies are bought, sold, and exchanged is the foreign exchange market (FX market).

    Relationship between Spot and Forward Rates

    • The relationship between spot and forward rates in the FX market is that forward rates are calculated based on spot rates and interest rate differentials.

    Forward Points in FX Markets

    • Forward points in FX markets represent the difference between the forward rate and the spot rate, quoted as a percentage of the spot rate.

    Quoting Forward Rates in Professional FX Markets

    • Forward rates are typically quoted in professional FX markets as a premium or discount to the spot rate.

    Factors Determining Forward Points

    • The absolute number of forward points in FX markets is determined by the interest rate differential and the term of the forward contract.

    Calculating Cross-Rates

    • The equation to calculate the euro-Canada (CAD/EUR) quote is: CAD/EUR = 1 / EUR/CAD.
    • The equation to calculate the Canada-yen (JPY/CAD) quote is: JPY/CAD = JPY/USD × USD/CAD.
    • The equation to calculate the Canada-yen (JPY/CAD) quote based on spot exchange rates is: JPY/CAD = EUR/JPY × CAD/EUR.

    Market Convention for Quoting Exchange Rates

    • The market convention for quoting exchange rates is that the currency with the higher value is quoted first.

    Swap Financing

    • An example of swap financing is a company borrowing euros and lending dollars.

    Arbitrage Relationship Equation

    • The arbitrage relationship equation is based on the concept of no-arbitrage, where the forward rate is calculated based on the spot rate and interest rate differential.

    Formula for Calculating Forward Rate

    • The formula for calculating the forward rate is: Ff/d = Sf/d × [(1 + rf) / (1 + rd)]^τ.

    Representing Forward Points as a Percentage

    • Forward points are represented as a percentage of the spot rate to facilitate easy comparison and calculation.

    Equation Representing Forward Points

    • The equation representing the relationship between forward points (Ff/d - Sf/d), spot exchange rate (Sf/d), interest rate differential (rf - rd), and investment horizon (τ) is: Ff/d - Sf/d = Sf/d × [(1 + rf) / (1 + rd)]^τ - 1.

    Calculating Forward Exchange Rate

    • The formula to calculate the 30-day forward exchange rate given a 30-day domestic risk-free interest rate, a 30-day foreign risk-free interest rate, and a spot exchange rate is: Ff/d = Sf/d × [(1 + rf) / (1 + rd)]^(τ/360).

    Premium in Forward Rates Trading

    • A premium of 14 pips in the context of forward rates trading at a 30-day term means that the forward rate is 14 pips above the spot rate.

    Swap Points and Forward Contract Term

    • Swap points are related to the term of the forward contract, where longer-term contracts have more significant forward points.

    Calculating 12-Month Forward Rate

    • The equation to calculate the 12-month forward rate (Ff/d) given the spot exchange rate (Sf/d), domestic risk-free rate (rd), and foreign risk-free rate (rf) is: Ff/d = Sf/d × [(1 + rf) / (1 + rd)]^(τ/360).

    12-Month Forward Rate Calculation

    • The value of the 12-month forward rate (Ff/d) given the spot exchange rate (Sf/d) of 1.6535, domestic risk-free rate (rd) of 3.50%, and foreign risk-free rate (rf) of 5.00% is: Ff/d = 1.6535 × [(1 + 0.05) / (1 + 0.035)]^(1) ≈ 1.6944.

    Misquoted 12-Month Forward Rate

    • If the misquoted 12-month forward rate (Ff/d) is 1.6900, the return on the hedged foreign investment using the arbitrage equation can be calculated.

    Relationship between Forward Rate and Spot Rate

    • The equation Ff/d / Sf/d = (1 + rf) / (1 + rd) indicates that the forward rate is a function of the spot rate, domestic interest rate, and foreign interest rate.

    Effect of Term on Forward Points

    • As the term of a forward contract increases, the number of forward points also increases.

    Effect of Interest Rate Differential on Forward Points

    • As the spread between foreign and domestic interest rates increases, the number of forward points also increases.

    Effect of Changes in Interest Rates on Forward Points

    • If the foreign interest rate increases, the forward points of a 30-day forward contract also increase, assuming the domestic interest rate and spot exchange rate remain unchanged.

    Formula for Calculating Forward Points

    • The formula for calculating the forward points (Ff/d - Sf/d) of a 30-day forward contract is: Ff/d - Sf/d = Sf/d × [(1 + rf) / (1 + rd)]^(30/360) - 1.

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    Description

    Understanding the complexities of the foreign exchange market and the limitations of yield differentials as a predictor of future spot rates.

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