Foreign Exchange

Question 1

What is the fx market? (6)

Answer 1

• OTC or off exchange market
• All currencies
• Quote driven market - major IBs and brokers - 2 way prices
• No direct investments
• Settlement is processed directly between the counterparties
• No central counterparty

Question 2

What is a spot market? (5)

Answer 2

• Largest part of FX market
• T+2
• Base currency (1 unit e.g. £1) and variable currency
• Bid/offer spread
• Term for GBP vs USD exchange rate is called cable rate

Question 3

What is an adjusted forward rate? (2)

Answer 3

• Spread in forward rate is wider than spread in spot
• Discount = add to spot - currency is cheaper for forward delivery than spot
• Premium = subtract from spot - currency is more expensive for forward delivery than spot

Question 4

What is interest rate parity? (2)

Answer 4

• Exchange rate between 2 currencies for a future date
• Accounts for the difference in interest rate over the period up to the future date

Question 5

What is covered interest rate parity? (1)

Answer 5

• Forward rate incorporates the difference in IR between 2 countries

Question 6

What is uncovered interest rate parity? (1)

Answer 6

• Difference in IR between 2 countries equals the expected change in ER between 2 countries

Question 7

What is the Fisher effect? (3)

Answer 7

• Focuses on fwd markets
• Long run theory
• Real interest rate (minus inflation) equals all international rates

Question 8

What is fx risk? (1)

Answer 8

• Changes in ER impacts returns

Question 9

What are the 3 government interventions in FX? (3)

Answer 9

• Fixed
• Floating
• Managed

Question 10

What is a floating exchange rate? (2)

Answer 10

• No intervention
• Price determined by supply/demand

Question 11

What is a fixed exchange rate regime?

Answer 11

• Value of currency is fixed to foreign currency (usually a larger and stronger currency e.g. USD)

Question 12

What are the arguments for fixed exchange rate? (4)

Answer 12

• Reduced fx risk
• Foreign trade may rise as a result
• Increased government discipline in economic management
• Speculation is discouraged

Question 13

What are argument against fixed exchange rate? (3)

Answer 13

• No automatic balance of payments - current account deficits can only be adjusted for by a drop in aggregate demand for domestic products
• Requires large foreign currency reserves
• Loss of freedom of economic policy: decisions regarding EXR may dominate monetary policy

Question 14

When trading, what is quoted? (3)

Answer 14

• Big figure - first 3 digits
• Pips/ticks - last 2 digits
• Bid/offer price

Question 15

How do you reduce currency risk? (2)

Answer 15

• Hedging
• Forward adjustments

Question 16

What is interest rate parity? (1)

Answer 16

• Arbitrage free method of calculating fx currency

Question 17

What is PPP? (2)

Answer 17

• Purchasing power parity
• Weighted basket of goods bought in foreign countries

Question 18

What are the 2 elements of decomposing returns on overseas investments? (2)

Answer 18

• Return expressed in fx
• Return made on changes in the rate of fx

Question 19

What is an optimal currency area? (1)

Answer 19

• Countries that the same currency e.g. Eurozone and USA

Question 20

What are the benefits of an optimal currency area? (3)

Answer 20

• Reduced fx risk
• Reduced speculation
• Better economic management

Question 21

What are the disadvantages of optimal currency? (3)

Answer 21

• Loss of control over currency
• Loss of identity
• Upfront costs

Question 22

What is a managed exchange rate regime? (3)

Answer 22

• Dirty floating
• Some intervention
• Moves ER in a particular direction, but there is no fixed target in mind