Foreign Exchange Market and Yield Differentials Quiz

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.