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Questions and Answers
Questions and Answers
Which of the following exemplifies currency depreciation?
Which of the following exemplifies currency depreciation?
- ¥120/$ increasing to ¥130/$
- €1.00/$ decreasing to €0.90/$
- CHF 0.95/€ increasing to CHF 1.05/€
- $1.50/£ decreasing to $1.40/£ (correct)
A company based in the United States needs to pay a supplier in Japan. Which action would directly address this need within the FX market?
A company based in the United States needs to pay a supplier in Japan. Which action would directly address this need within the FX market?
- Selling EUR to obtain JPY.
- Selling JPY to obtain USD.
- Selling CHF to obtain USD.
- Selling USD to obtain JPY. (correct)
What characterizes Over-The-Counter (OTC) FX markets?
What characterizes Over-The-Counter (OTC) FX markets?
- Trading occurs in a centralized physical exchange.
- Deals are primarily negotiated between dealers and private customers. (correct)
- All orders must be placed through exchanges.
- Transactions are limited to spot trades only.
If a trader believes the EUR will appreciate against the USD, what action would they likely take in the spot market?
If a trader believes the EUR will appreciate against the USD, what action would they likely take in the spot market?
What does 'S(j/k)' represent in the context of spot rate quotations?
What does 'S(j/k)' represent in the context of spot rate quotations?
Given a bid quote of S(£/$) = 1.2520 and an ask quote of S(£/$) = 1.2525, how would you calculate the bid-ask spread?
Given a bid quote of S(£/$) = 1.2520 and an ask quote of S(£/$) = 1.2525, how would you calculate the bid-ask spread?
If a dealer provides a bid quote of S(USD/CAD) = 1.3400, what does this signify?
If a dealer provides a bid quote of S(USD/CAD) = 1.3400, what does this signify?
Which of the following describes a cross rate?
Which of the following describes a cross rate?
Using the following rates, compute the EUR/JPY cross rate: EUR/CAD = 0.65 (bid) and CAD/JPY = 0.011 (bid).
Using the following rates, compute the EUR/JPY cross rate: EUR/CAD = 0.65 (bid) and CAD/JPY = 0.011 (bid).
Which transaction requires delivery of foreign exchange at a future date?
Which transaction requires delivery of foreign exchange at a future date?
If the forward rate for a currency is higher than the spot rate, this currency is trading at what?
If the forward rate for a currency is higher than the spot rate, this currency is trading at what?
In a forward contract, if you agree to sell a currency at a set price, you are considered to be in which position?
In a forward contract, if you agree to sell a currency at a set price, you are considered to be in which position?
If a trader buys £1 forward for $1.90, and the spot exchange rate at the delivery date is $1.86/£, what is the result for the trader?
If a trader buys £1 forward for $1.90, and the spot exchange rate at the delivery date is $1.86/£, what is the result for the trader?
What is the primary aim of the FX market?
What is the primary aim of the FX market?
Which currency is involved in the majority of foreign exchange transactions?
Which currency is involved in the majority of foreign exchange transactions?
How are most currencies priced in the FX market?
How are most currencies priced in the FX market?
What does a 'direct quote' represent from a U.S. perspective?
What does a 'direct quote' represent from a U.S. perspective?
What is the standard trade size in the interbank market, according to the text?
What is the standard trade size in the interbank market, according to the text?
What is the common settlement timeframe for a spot transaction in the FX market?
What is the common settlement timeframe for a spot transaction in the FX market?
Questions and Answers
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Flashcards
Flashcards
Exchange Rate
Exchange Rate
Price of one currency in terms of another.
Depreciation
Depreciation
Currency becomes less valuable; takes more of your currency to buy foreign currency. Example: $1.50/£ -> $1.40/£
Appreciation
Appreciation
Currency becomes more valuable; takes less of your currency to buy foreign currency. Example: $1.20/£ -> $1.40/£
Devaluation
Devaluation
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Foreign Exchange (FX) Market
Foreign Exchange (FX) Market
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FX Market Negotiation
FX Market Negotiation
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FX Trading Sessions
FX Trading Sessions
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Major Traded Currencies
Major Traded Currencies
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FX Market Transactions
FX Market Transactions
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Spot Transaction
Spot Transaction
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Forward Transaction
Forward Transaction
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Foreign Exchange Rate
Foreign Exchange Rate
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Foreign Exchange Quotation
Foreign Exchange Quotation
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Bid Price
Bid Price
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Ask Price
Ask Price
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Bid-Ask Spread
Bid-Ask Spread
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Cross Rate
Cross Rate
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Forward Transaction
Forward Transaction
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Forward Contract
Forward Contract
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Forward Premium
Forward Premium
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Flashcards
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Study Notes
Study Notes
Function and Structure of the FX Market
- Exchange rate represents the price of one currency in another, like £1.20/€
- Exchange rates fluctuate freely
Key Terminology
- Depreciation means a currency weakens, exemplified by $1.50/£ becoming $1.40/£.
- Appreciation means a currency strengthens, such as $1.20/£ becoming $1.40/£.
- Devaluation refers to a drop in a currency's foreign exchange value when it is pegged.
Currency Codes
- GBP represents Great British Pound.
- CHF represents Swiss Francs.
- ZAR represents South African Rand.
- CAD represents Canadian Dollar.
- JPY represents Japanese Yen.
- SEK represents Swedish Krona.
FX Market Overview
- The Foreign Exchange market is the largest financial market globally.
- Daily transactions are worth approximately $5.6 trillion.
- It facilitates international trade by enabling transactions outside local currency.
- It operates 24/7, Monday to Friday.
- The FX market structure evolved from commercial banks assisting clients with international commerce.
- Corporate clients use it to exchange currencies for imports/exports.
- Financial investors use it to speculate on currency appreciation.
- FX markets are over-the-counter (OTC), with deals negotiated between dealers and private customers, often via phone.
FX Market Participants and Trading Dynamics
- Trading occurs across three sessions: European, Asian, and US.
- Trading is global and continuous.
- Main currencies in each market are traded mostly during market hours.
- Currency pairs with the dollar have more volume during the US trading session.
- There are around 18 currency pairs are actively traded.
- Most traded currencies are USD, CAD, EUR, GBP, CHF, NZD, AUD, and JPY.
Spot Market
- FX market transactions include spot, forward, and swap.
- Spot transactions require immediate delivery, with cash settlement within 2 business days.
- Forward transactions require delivery at a future date, typically > 2 days, such as 1, 3, 6, 9, or 12 months.
Key Concepts in FX Trading
- Spot Rate Quotations define the price of one currency in terms of another.
- Cross Rates the exchange rate between two currencies, neither of which is USD.
- Bid-Ask Spread refers to the difference between the buying and selling prices.
- Spot FX Trading involves immediate transactions.
Spot Rate Quotations Details
- A foreign exchange quotation is a willingness to buy/sell at a specific rate.
- An FX quotation is the price of one currency in another, like $1.20/£.
- S(j/k) is the spot price of currency k in terms of currency j.
- The inverse to determine currency j in terms of k is 1/S(k/j).
- Most FX transactions (87%) involve the US dollar.
- Dealers express quotations as the foreign currency price of one dollar or the dollar price of a unit of foreign currency.
- Currency trading is done in pairs.
Additional Spot Rate Aspects
- Currencies are priced to 4 decimal places, 2-3 for JPY.
- Quotes can be direct or indirect.
- A direct quote is the home currency price of a foreign currency (£1.50/$).
- An indirect quote is the foreign currency price of a home currency ($1.50/£).
- Quote form depends on the "home" currency.
- In the US perspective, direct quote: "a japanese yen is worth about a penny"; indirect quote: "you get 100 yen to the dollar".
- Cross rates don't involve USD, calculated from USD exchange rates.
Bid-Ask Spread Dynamics
- Interbank traders buy at the bid price and sell at the ask price.
- A bid is the price a dealer will buy a currency; it is the client's selling price.
- An ask is the price a dealer will sell a currency; it is the client's buying price.
- The bid-ask spread is the difference between the bid and ask prices.
- Dealers profit from the spread, where ask > bid.
Bid-Ask Spread Example
- Formula: Sa($/£) = 1/Sb(£/$)
- A bid quote: Sb(£/$) = 0.6491
- A bank dealer pays £0.6491 for $1.
- An ask quote: Sa($/£) = 1.5405
- With a bid price $0.0005 less than the ask, Sb($/£) = 1.5400.
- Sa(£/$) = 1/1.5400 = 0.6494.
- A dealer's ask price of £0.6494 for $1 is greater than the bid price of £0.6491.
Spot FX Trading Nuances
- Yesterday's spot quote: S(CAD/£) 2.3134 - 2.3180
- The quote is for £ in terms of CAD.
- The ask rate (for CAD in terms of £) is 1 / 2.3134 = 0.432 while the bid rate is 2.3134.
- Quotes are to four decimal places and valid briefly.
- Dealers trade in/out of position every 10 minutes, with $10 million US the interbank standard trade size.
Cross-Rate Trading
- Currency against currency trading exchanges two non-USD currencies, like selling £ and buying CHF.
Trading Example with EUR/JPY
- Bank rates: EUR/CAD Bid at 0.64, Ask at 0.645; CAD/JPY Bid at 0.01, Ask at 0.012
- S(EUR/JPY) = S(EUR/CAD) * S(CAD/JPY)
- Hence, S(EUR/JPY)=0.64 x 0.01=0.0064.
Forward Market Characteristics
- A spot transaction is immediate.
- A forward transaction involves future delivery/payment.
- Bank quotes available for 1, 3, 6, 9, 12 months.
- Maturities > 1 year are becoming more frequent.
- A forward contract involves a future buy/sell agreement at today's prices, where one can agree to sell $ and receive CHF in the future.
Forward Market example
- If F1(CHF/$) = 0.9418, F3(CHF/$) = 0.9412, F6(CHF/$) = 0.9402
- To get $ for CHF200 in 3 months, CHF200 / F3(CHF/$) = $212.49
- To get CHF for $300 in 6 months, $300 x F6(CHF/$) = CHF282.06
- To sell $ to get CHF100 in 1 month, CHF100 / F1(CHF/$) = $106.18
- Currencies that are more expensive to buy forward are at a premium which Forward > Spot.
Long and Short Positions
- If agreed to sell, one is "short".
- If agreed to buy, one is "long".
- Short/long positions depend on unpredictable FX rates, leading to speculation for profit by buying/selling currencies at low/high forward prices.
Speculating on Forward Markets Example
- Spot rate is $1.95/£, and the three-month forward rate is $1.90/£.
- If confidence is indicated that the spot exchange rate will be $1.92/£ in three months, then buy forward for $1.90/£.
- The expected profit is $0.02 as a result of $1.92 - $1.90
- If beliefs are incorrect and the rate falls to $1.86/£, the loss is -$0.04, from $1.86 - $1.90.
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