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Questions and Answers
What is the definition of an exchange rate?
What characterizes a floating exchange rate regime?
Which type of foreign exchange market involves immediate currency delivery?
What is the primary role of large global banks in the FX market?
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What does devaluation refer to in foreign exchange terminology?
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Which of the following is NOT a characteristic of the foreign exchange market?
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What does depreciation indicate in the context of currencies?
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In what market does delivery of currency occur at a specified future date?
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What does OTC stand for in the context of foreign exchange trading?
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Who are the primary clients that global banks serve in the FX market?
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What is the primary role of a market maker in the foreign exchange market?
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Which currency designation pairs are correctly identified in a market quote?
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How do bid and ask prices relate to market profitability?
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What do liquidity levels in a market reflect?
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Which factor does NOT influence exchange rates?
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What is a direct quote in foreign exchange?
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Which of the following describes the 'bid-ask spread'?
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Which statement about speculators in the currency market is true?
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What does the phrase 'expectations of future exchange rates' imply?
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What is the relationship between nominal interest rates and real interest rates?
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What is the primary function of currency derivatives?
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Which characteristic distinguishes a Future contract from a Forward contract?
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What happens during a daily mark-to-market process in Future contracts?
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What differentiates an American option from a European option?
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What does the 'premium' refer to in the context of options contracts?
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Under which condition is a Call option considered In-the-money (ITM)?
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What does it mean for a Put option to be Out-of-the-money (OTM)?
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What does an option status of At-the-money (ATM) signify?
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What is a common risk when using Future contracts in currency trading?
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Which factor contributes to the higher cost of American options compared to European options?
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What is the primary purpose of a currency forward contract?
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How might a company use a currency option in its operations?
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What distinguishes Future contracts from Forward contracts?
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Explain the concept of 'mark to market' in currency Future contracts.
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What does it mean for an option to be classified as 'In-the-money' for a call option?
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Study Notes
Foreign Exchange Terminology
- The price of one currency in units of another currency is known as the exchange rate.
- Fixed exchange rate refers to a system where the government sets a fixed value for its currency against another currency or a basket of currencies.
- Floating exchange rate allows the value of a currency to freely fluctuate based on market forces.
- Managed exchange rate regime involves government intervention to influence currency values within a specific range.
- Foreign Exchange Market is a global financial market where currencies are bought and sold. It's considered the largest financial market based on trading volume.
- The spot FX market involves immediate delivery or delivery within two business days (typically next business day).
- Devaluation refers to a deliberate decrease in the value of a currency pegged to gold or another currency, often implemented by a government to boost exports.
- Depreciation is the decrease in value of a floating currency due to market forces.
Organization of the FX Market
- The FX market is characterized by OTC (Over-the-Counter) trading, meaning transactions occur through phone, telex, or SWIFT (Society for Worldwide Interbank Financial Telecommunication) rather than a centralized exchange.
- The FX market is primarily dominated by wholesale level participants, with major banks accounting for 95% of the market.
- Retail level includes business customers who engage in transactions with banks and other financial institutions.
- The FX market encompasses two primary types:
- Spot Market: Immediate delivery (typically next business day) after transaction.
- Forward Market: Delivery takes place at a specified future date (after 2 business days).
FX Market Participants
- Large global banks play a crucial role in the FX market, acting on behalf of two main groups:
- External Clients: Primarily global firms (exporters, importers, and multinationals). Banks act as brokers, facilitating transactions and meeting the foreign currency needs of clients. This role generates commissions for the banks.
- Own Banks: Banks involved in dealing and taking positions in currencies to generate profits.
- Global banks establish the "tone" of the market through a market maker function, setting prices with their transactions.
- The market maker provides continuous two-way quotes upon request:
- Bid Rate: The price at which they will buy a currency.
- Ask (Offer) Rate: The price at which they will sell a currency.
- They are obligated to buy and/or sell at the quoted prices, ensuring the availability of liquidity and contributing to the overall efficiency of the market.
ISO Currency Designations
- Each country is assigned a unique ISO currency code to identify its currency in the global market.
- X-Rate is the ratio or value of one currency against another, expressed using the ISO designations of the respective currencies.
- For example, USD/JPY indicates the exchange rate of the US dollar against the Japanese yen, with USD as the base currency and JPY as the quote currency.
Spot Rate Quotes
- Direct Quote: States the price of one unit of foreign currency in units of domestic currency (e.g., 1.600 Swiss francs per US dollar).
- Indirect Quote: States the price of one unit of domestic currency in units of foreign currency (e.g., $0.6250 per Swiss franc).
Bid – Ask Quotes
- Bid – Ask Spread represents the difference between the bid price (what market makers are willing to buy) and the ask price (what market makers are willing to sell). This is a fee charged by the bank.
- Example: EUR/USD = 1.2102 – Bid / 1.2106 – Ask. Customers buy EUR at 1.2106 (higher price) and sell EUR at 1.2102 (lower price).
Factors Affecting Exchange Rates
- Change in inflation differential: Higher inflation in a country relative to other countries leads to increased demand for foreign goods, resulting in a higher exchange rate for the foreign currency.
- Change in interest rate differential: Higher interest rates in a country attract foreign capital, increasing demand for the country's currency and causing an appreciation.
- Change in income level differential: Higher income levels in a country increase demand for foreign goods, leading to a higher exchange rate for the foreign currency.
- Government controls: Exchange barriers, trade barriers, and government interventions in the FX market impact exchange rates.
- Expectations of future exchange rates: Investors anticipate future appreciation in a currency and invest, increasing demand and driving up its value.
- Currency speculation: Speculators may overreact to signals, leading to temporary undervaluation or overvaluation of a currency.
Currency Derivatives
- A currency derivative is a contract whose value is derived from an underlying currency.
- Examples include forward/futures contracts, currency swap contracts, and options contracts.
- Firms use derivatives to speculate on future exchange rate movements or hedge against exchange rate risk.
Forward and Futures Contracts
- A forward contract is an agreement between a corporation and a financial institution to exchange a specified amount of money at a specified exchange rate (forward rate) on a specified date in the future.
- A futures contract is similar to a forward contract but is traded on an exchange.
- Futures contracts are highly standardized and involve an obligation to purchase or sell currency on a specified date.
- Futures contracts are more liquid and faster than forward contracts.
- Futures contracts are marked to market daily, meaning the gains or losses are adjusted daily based on the current market price.
Currency Options
- A currency option is a contract that gives the buyer (holder) the right, but not the obligation, to buy or sell a standard amount of currency at a fixed exchange rate (strike price) for a fixed period.
- A call option allows the holder to buy the underlying currency at the strike price.
- A put option allows the holder to sell the underlying currency at the strike price.
- An American option can be exercised anytime before the expiration date.
- A European option can only be exercised on the expiration date.
- The premium is the price the buyer pays the seller (writer) for the right to buy or sell the underlying currency.
- An option is in-the-money (ITM) if the spot rate is greater than the strike price for a call option or less than the strike price for a put option.
- An option is out-of-the-money (OTM) if the spot rate is lower than the strike price for a call option or higher than the strike price for a put option.
- An option is at-the-money (ATM) if the spot rate is equal to the strike price.
Currency Derivatives
- Currency derivatives are contracts whose value is derived from the price of an underlying currency.
- Examples of currency derivatives include forward contracts, future contracts, currency swap contracts, and options contracts.
- Firms use derivatives to speculate on future exchange rate movements or hedge against potential currency risk.
Forward Contracts
- A forward contract is an agreement between a corporation and a financial institution to exchange a specific amount of currency at a predetermined exchange rate (forward rate) on a future date.
- There is no daily mark-to-market adjustment.
Future Contracts
- Future contracts are similar to forward contracts, with an obligation to buy or sell currency on a specified date.
- They are traded on exchanges and are highly standardized in terms of the currency involved, volume, and trade date.
- They have daily mark-to-market adjustments.
- Future contracts can be used to overhedge or underhedge against currency risk.
Currency Options
- A currency option contract gives the holder (buyer) the right, but not the obligation, to buy or sell a specific amount of currency at a fixed exchange rate (strike price) for a period of time.
Types of Currency Options
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Call Options: They give the holder the right to buy a currency at the strike price.
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Put Options: These options grant the holder the right to sell a currency at the strike price.
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American Options: These options can be exercised at any time prior to the expiration date.
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European Options: These options can only be exercised on the expiration date.
Defining Key Terms
- Strike Price (K): The exchange rate at which the option holder can buy or sell the currency.
- Premium (P): The price of the option that the writer charges the buyer at the contract date.
- In-the-Money (ITM): This occurs when the spot exchange rate (St) is more beneficial to the option holder than the strike price (K).
- Out-of-the-Money (OTM): The spot exchange rate (St) is less favorable to the option holder than the strike price (K).
- At-the-Money (ATM): The spot exchange rate (St) is equal to the strike price (K), resulting in a neutral position for the option holder.
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Description
Test your knowledge on key concepts in foreign exchange terminology. This quiz covers essential terms like exchange rates, fixed and floating rates, and the foreign exchange market. Enhance your understanding of how currencies are traded globally.
