1
Q
What is the bid price?
A
The price a dealer is willing to buy a currency at
2
Q
What is the ask price?
A
The price a dealer is willing to sell a currency at
3
Q
What is the bid–ask spread formula?
A
(Ask−Bid)/Ask×100
4
Q
Why do spreads exist?
A
To compensate dealers for risk and profit
5
Q
What is a direct quote (UK)?
A
£ per unit of foreign currency
6
Q
What is an indirect quote?
A
Foreign currency per £
7
Q
How do you convert direct → indirect?
A
indirect= 1/direct
8
Q
What is a cross rate?
A
Exchange rate between two currencies using a third currency
9
Q
Cross rate formula (via £)?
A
Currency A / Currency B = (A in £) ÷ (B in £)
10
Q
Key rule when comparing FX options?
A
Convert everything into the same currency
11
Q
What is locational arbitrage?
A
Exploiting price differences between banks
12
Q
what eliminates locational arbitrage
A
market forces (price adjustments)
12
Q
what is the strategy for locational arbitrage
A
Buy low (ask), sell high (bid)
13
Q
When does locational arbitrage exist?
A
When bid (one bank) > ask (another bank)
14
Q
What is triangular arbitrage?
A
Exploiting inconsistencies between 3 exchange rates
15
Q
how do you detect triangular arbitrage
A
compare implied cross rate vs actual rate
16
Q
what indicates arbitrage
A
ending with more money than you started
17
Q
what is covered interest arbitrage (CIA)
A
Arbitrage using interest rates + forward contracts
18
Q
what is the steps of CIA
A
Convert currency (spot)
Invest abroad
Lock forward rate
Convert back
19
Q
When does CIA exist
A
when the IRP (interest rate parity) does not hold
20
Q
What does IRP state?
A
No arbitrage between domestic and foreign investments
21
Q
Key relationship? of the IRP
A
Forward premium ≈ interest rate differential
22
Q
Forward premium formula?
A
(F−S)/S
23
Q
What does a forward premium mean?
A
Currency expected to appreciate
24
what does High interest rate currency trades at?
Forward discount
25
what does Purchasing Power Parity (PPP) state
Exchange rates reflect inflation differences
26
PPP formula?
%ΔS ≈ inflation differential
27
What does high inflation do to the currency
depreciates
28
: Why might PPP fail?
Trade barriers, speculation, capital flows
29
what does interantonal fisher effect IFE state
Currencies with higher interest rates will depreciate
30
what the IFE forumula
%ΔS≈ihome−iforeign
%ΔS ≈ interest rate differential
31
What happens when arbitrage exists?
Traders exploit it → prices adjust
32
what is the covered interest arbitrage?
Covered Interest Arbitrage is a strategy to earn risk-free profit by exploiting differences in interest rates between countries, while eliminating exchange rate risk using a forward contract.
33
What does a forward premium reflect?
The interest rate differential between two countries
34
What is the key IRP relationship?
Forward premium ≈ 𝑖home−𝑖foreign
35
If a currency has a forward premium, what does it imply?
The home country has a higher interest rate than the foreign country
36
If the forward premium decreases, what happens to the interest rate differential?
It decreases
37
If forward premium is higher than before, what does it mean?
The interest rate gap is larger
38
If forward premium is lower than before, what does it mean?
The interest rate gap is smaller
39
If the euro’s forward premium was higher last month than today, what does this imply?
The US–Europe interest rate differential has decreased
40
What could cause a decrease in the interest rate differential?
US interest rates ↓
European interest rates ↑
Or both
41
What happens when interest rate differences shrink?
Forward premiums also shrink
42
what's the link between IRP and forward premiums
Forward premium moves in line with interest rate differentials
43
in equation form what does it look like for the forward premium on the euro to be higher last month than today
(iUS−iEurope)last month>(iUS−iEurope)today
44
What is Purchasing Power Parity (PPP)?
A theory stating that exchange rates adjust to reflect inflation differences between countries
45
what is the PPP rule?
Countries with higher inflation → currency depreciates
Countries with lower inflation → currency appreciates
46
Japan has lower inflation than the US. What happens to the yen?
The yen is expected to appreciate
47
Why does lower inflation cause currency appreciation?
Goods become relatively cheaper
Exports increase
Demand for the currency increases
48
What happens if a country has higher inflation than another?
Its currency will depreciate
49
why does a PPP not always hold in reality
because of market imperfections and other forces
50
What are common reasons PPP does not hold?
Trade barriers (tariffs, quotas)
Transport costs
Capital flows (investment movements)
Speculation in FX markets
Non-traded goods (e.g. services)
51
Which factor often dominates PPP in the short run?
Capital flows
52
does PPP hold better in the long or short run?
long run
53
what does the international fisher effect mean?
IFE says currencies with higher interest rates will depreciate
54
how do you work out the forward premium?
Forward Premium (%)=F−S/S×100
Where:
F = forward rate
S = spot rate
55
whats the cross rate formula
A/B= A in £/ B in £
56
when does locational arbitrage exist?
Bid (Bank A)>Ask (Bank B)
57
whats the strategy of locational arbitrage
Buy low (ask), sell high (bid)
58
whats the locational arbitrage profit formula shortcut
Profit=Amount×(Buy/Sell−1)
59
what is a note on market forces for locational arbitrage
Demand ↑ → price ↑
Supply ↑ → price ↓
60
what is triangular arbitrage
Exploiting inconsistency between 3 exchange rates
61
whats the three steps of triangular arbitrage
: Step 1?
: Compute implied cross rate
: Step 2?
: Compare with actual rate
: Step 3?
: Choose profitable direction
Start with £
Convert → currency A
Convert → currency B
Convert back → £
62
what's the definition of the Covered interest Arbitrage
Earn risk-free profit using interest rates + forward contract
63
whats the steps of a CIA
£ → foreign currency (spot)
Invest abroad
Lock forward rate
Convert back
64
What is the yield formula?
yield= final-initial/initial
65
what is the interest rate parity? (IRP)
no arbitrage between domestic and foreign investing
66
whats the IRP formula
ef=1+if
----------------------- -1
1+ih
67
steps for the IRP
Calculate ef
Apply to spot
Compare with forward
68
whats the purchasing power parity?
the exchange rate reflects inflation differences
69
whats the ppp equation
e=1+πf
-------------- -1
1+πh−1
pi is the inflation
70
whats the PPP steps
Compute inflation differential
Apply to spot
71
what is the international fisher effect
interest rate predict exchange rate change
72
what's the equation of the international fisher effect
e=1+if
---------------- -1
1+ih
73
whats the step of the IFE
Same as IRP but:
👉 predicting future spot, not forward
74
What is the forward premium/ discount
F-S
----
S
75
What is the interpretation of the forward premium/ discount
positive is premium
negative is the discount
76
what is market forces
Supply & demand adjusting prices
77
whats the effect in arbitrage
Buy cheap → price rises
Sell expensive → price falls
→ arbitrage disappears
78
how do you calculate the spot rate?
New rate=Spot rate×(1+percentage change)
If % is negative → currency depreciates → rate goes down
If % is positive → currency appreciates → rate goes up
79
: How do exchange rates change under direct quotation (home currency = GBP)
If foreign currency appreciates → exchange rate increases
👉 If foreign currency depreciates → exchange rate decreases
80
What happens when the home currency (GBP) appreciates or depreciates under direct quotation?
If home currency appreciates (GBP ↑) → exchange rate decreases
👉 If home currency depreciates (GBP ↓) → exchange rate increases
81
What happens to the exchange rate when the home currency appreciates (indirect quote)?
Exchange rate increases
82
What happens when the home currency depreciates (indirect quote)?
exchange rate decreases
83
How do you remember indirect quotation movements?
Home ↑ → Exchange rate ↑
👉 Home ↓ → Exchange rate ↓
84
How do you solve FX conversion questions (like EUR/GBP → USD)?
Step 1: Identify what you HAVE and what you WANT
👉 Example: Have: € and £
Want: $
🔁 Step 2: Find the correct exchange rate direction
👉 You ALWAYS need:
€ → $ → EUR/USD
£ → $ → GBP/USD
👉 If the quote is not in that form → INVERT IT
Take the reciprocal (flip it):
New rate= 1/old rate
USD/GBP= 0.5025 -> GDP/USD=1/0.5025=1.990
🔁 Step 3: Choose the correct price (VERY IMPORTANT)
👉 If you are selling currency → use BID
👉 If you are buying currency → use ASK
💡 In these questions, you are usually selling foreign currency → use BID
🔁 Step 4: Convert each currency separately
👉 Multiply:
Amount × Exchange rate
step 5 add everything together
85
when do you convert on a conversion question?
You invert when the exchange rate is in the wrong direction
If you have £ → $, you need GBP/USD
If you are given USD/GBP → ❌ wrong
👉 Invert it
new rate= 1/ old rate
Have → Want = correct direction
👉 If not → INVERT
86
what is a spread
its a transaction cost
87
what determines a big spread?
Order costs (+) → more expensive to process trades
Inventory costs (+) → dealers hold risk when holding currencies
Currency risk (+) → riskier currencies = wider spreads
Volatility (+) → more uncertainty → dealers protect themselves
more cost or risk= higher spread
Risk ↑
Uncertainty ↑
Trading ↓
88
what makes a spread smaller?
Competition (−) → more dealers → lower spreads
Volume (−) → more trading → easier to match buyers/sellers
More competition + trading = lower spread
Volume ↑
Competition ↑
Market stable
89
do spreads change over time and why?
yes they are not constant
hey get wider when:
Market opens/closes
Important economic news is released
Uncertainty is high
👉 Why?
➡️ Dealers face more risk → increase spreads
90
how do you calculate a cross exchange rate
Cross rate= Currency 1 / USD
------------------------------
Currency 2 / USD
= AUD → USD → GBP
- Convert AUD to USD
- Convert USD to GBP (invert if needed)
- Multiply
when to invert:
If the quote is the wrong way round:
Need USD → GBP
Given GBP → USD
91
What are the key principles of triangular arbitrage?
- Simultaneous Execution: all three transactions should be executed at the same time to lock in profit. in reality this is difficult, so there is a risk that exchange rates may change before all trades are completed
- market realignment: as traders exploit arbitrage oppertunities, their buying and selling activities creates market forces (supply and demand) that push exchange rates back to equillibrium, eliminating that oppertunity
- currency flexibility: triangular arbitrage can begin with any of the three currencies, as long as the trade creates a complete loop and follows the right direction around the triangle
92
treasury management
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