Chapter 9: Foreign Exchange

Question 1

Spot Market

Answer 1

• Largest component on the FX Market
• Settlement T+2
• Quote driven: major banks quote two-way FX prices

Question 2

FX Forwards

Answer 2

• For settlement other than spot (up to 12 months)

Question 3

FX Forward Discount

Answer 3

• adjustment is positive, pips are added on
• dollars are cheaper for forward delivery (more dollars for one pound)

Question 4

Covered Interest Rate Parity

Answer 4

• Forward exchange rates should incorporate the difference in the interest rates between the two countries otherwise an arbitrage opportunity would exist

Question 5

Uncovered Interest Rate Parity

Answer 5

• The difference in interest rates between the two countries equals the expected change in exchange rates between those two counties

Question 6

Purchasing Power Theory

Answer 6

• the exchange rate between two countries’ currencies will adjust automatically taking into account their respective inflation rates
• rational behind this is that a good ought to cost the same regardless of which country it = the law of one price

Question 7

Where an investment is made in a foreign currency the total return consists of…

Answer 7

• The return expressed in the foreign currency
• The return made on changes in the rate of exchange of the foreign currency

Question 8

Arguments for and against fixed exchange rates

Answer 8

+ Reduced FX risk
+ Increased government discipline in economic management
+ Speculation is discourages
- No automatic balance of payments adjusted
- System requires large holdings of foreign currency reserves
- Loss of freedom of economic policy

Question 9

Optimal currency area

Answer 9

• typically bigger than a single country in which economic efficiency would be maximized by having the entire region share a single currency

Question 10

200 pips in decimal

Answer 10

0.02