Money and Foreign Currency Quiz

Money and Foreign Currency

• Money is legal tender used as a unit of measurement in economic transactions.
• Money functions as a mean of payment, store of value, and unit of account.
• Foreign currency is the currency acceptable in international transactions.
• Foreign currency is typically held in deposits at financial institutions, banknotes are not considered foreign currency.

Foreign Exchange Market (FOREX)

• The FOREX is where suppliers and demanders of foreign currency meet to determine its price.
• Its main function is to facilitate international trade and investment by transferring purchasing power between currencies.
• It is the largest and oldest financial market in the world, trading over $7.5 billion USD daily.
• It is an Over The Counter (OTC) market, primarily interbank.
• It functions 24 hours a day, due to its global character, consisting of interconnected markets.

Exchange Rates

• Exchange rates reflect the price of one currency in terms of another.
• The direct exchange rate indicates the units of domestic currency needed to acquire one unit of foreign currency.
• The indirect exchange rate indicates the units of foreign currency needed to acquire one unit of domestic currency.
• Both measures express the same value, as one is the inverse of the other.
• In FOREX, a standard representation uses currency symbols separated by a slash, with the base currency on the left and the counter currency on the right.
• The ratio represents the units of counter currency required to buy one unit of the base currency.

Swap Contracts

• Swap contracts involve the exchange of future cash flows between two parties.
• They can be used to hedge against interest rate or exchange rate volatility.
• Swap contracts are typically arranged through financial intermediaries to mitigate counterparty risk.

Interest Rate Swap (IRS)

• An IRS allows parties to manage interest rate risk by exchanging interest payments based on different rates.
• Requirements for an IRS:
  • Two parties with contrary expectations about interest rate movements.
  • Access to different markets with potentially favorable conditions.
  • The combined position of both parties generates savings compared to individual actions.
• An IRS involves exchange of future cash flows calculated based on different interest rate bases (fixed and variable or both variable).
• Interest payments are settled based on the net difference between the payments.
• Cash flows are denominated in the same currency.
• The principal amount is not exchanged.

Fixed-Variable IRS (Plain Vanilla Swap)

• Each IRS leg represents a set of payments associated with a specific interest rate.
  • Fixed leg (typically annual)
  • Variable leg (typically semiannual)
• The fixed rate to be paid is the swap coupon.
• The notional principal (notional) is the base on which interest is calculated.
• A swap broker acts as an intermediary who buys and sells interest rates.

Valuation of an IRS

• Valuation allows calculating the theoretical swap coupon at any time.
• The theoretical swap coupon is the fixed coupon that equates the present values of both legs of the swap.
• Changes in interest rates affect the theoretical swap coupon.

Currency Swaps

• Currency swaps are used to hedge against exchange rate volatility.
• Two parties exchange principals of equal amounts in different currencies.
• During the swap term, interest payment streams are exchanged in different currencies.
• At the end of the term, principal amounts are exchanged at the exchange rate agreed upon at the beginning of the contract.
• Principals are typically obtained through borrowing in the respective currency markets.

Explore the essential concepts of money and foreign currency in this quiz. Understand how money functions in economic transactions and the role of the Foreign Exchange Market (FOREX). Test your knowledge of exchange rates and their impact on international trade.