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CFA Level II 2020 > 10.1 Forex Quotes, Spreads, and Triangular Arbitrage > Flashcards

10.1 Forex Quotes, Spreads, and Triangular Arbitrage Flashcards

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1
Q

A quote of 1.4126 USD/EUR means that each ______ costs 1.4126 ________.

A

euro;

dollars;

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2
Q

The “bid-ask” spread is also known as the “bid-____” spread. The terms “ask” and ______ mean the same thing.

A

offer;

offer;

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3
Q

For a quote of 1.4126 USD/EUR, the euro is called the _____ currency and the USD the _____ currency.

A

base (remember that the “base” is the bottom of the fraction);
price;

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4
Q

A spot exchange rate is the currency exchange rate for _________ delivery, which for most currencies means the exchange of currency takes place ___ days after the trade.

A

immediate;

two;

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5
Q

If the euro is quoted as $1.4124 - $1.4128, the ___ price ($1.4124) is the price at which the dealer will ___ euros, and the _____ price ($1.4128) is the price at which the dealer will _____ euros.

A

bid;
buy;
ask (offer);
sell;

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6
Q

The difference between the offer and bid price is called the ____.

A

spread;

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7
Q

Spreads are often stated as “____” which are 1/____ . How does the value in the denominator equate to the number of decimal places in the quote?

A

pips;
10,000;
There are four zeros in the number 10,000, which matches up to the four places left of the “.” in the decimal.

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8
Q

If the euro is quoted as $1.4124 - $1.4128, what is the spread in decimals and in pips?

A

$0.0004 => 4 pips

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9
Q

Dealers manage their foreign currency inventories by transacting in the ______ market. Are the spreads in this market narrow or wide?

A

interbank;

narrow;

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10
Q

The spreads quoted by a dealer depend on what three things?

A
  1. The spread in an interbank market for the same currency pair (dealer spreads vary directly with spreads quoted in the interbank market);
  2. The size of the transaction (larger, liquidity-demanding transactions generally get quoted a larger spread; you don’t get a volume discount … just the opposite; a larger, liquidity-demanding transaction causes disruption to the dealer’s inventory and thus commands a higher spread.)
  3. The relationship between the dealer and the client;
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11
Q

The interbank spread on a currency pair depends on what three things and “why” for each?

A
  1. Currencies involved (high-volume currency pairs (e.g., USD/EUR; USD/JPY, and USD/GBP, command lower spreads than do lower-volume currency pairs, e.g., AUD/CAD;
  2. Time of day (the time overlap during the trading day when both the New York and London currency markets are open is considered the most liquid time window; spreads are narrower during this period than at other times of the day);
  3. Market volatility (Spreads are directly related to the exchange rate volatility of the currencies involved. Higher volatility leads to higher spreads to compensate market makers for the increased risk of holding those currencies. Spreads change over time due to volatility changes).
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12
Q

Does a longer maturity of a contract tend to increase or decrease the associated spread?

A

Increases the associated spread because of increased risks.

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13
Q

The reasons why a longer contract maturity tends to increase the associated spread are as follows:

  1. Longer maturity contracts tend to be less _____.
  2. Longer maturity contracts have greater _______ risk.
  3. Longer maturity contracts have greater _____ ___ risk.
A

liquid;
counterparty;
interest rate;

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14
Q

Investors always take a ____ due to the spread.

A

loss;

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15
Q

For BASE DEALS: The investor buys the base currency at ____, and sells the base currency at ______.

A

ask (offer);

bid;

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16
Q

For PRICE DEALS: The investor buys the price currency at ____, and sells the price currency at ______.

A

bid;

ask (offer);

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17
Q

Which of the two components in the rule “up-the-bid-and-multiply” or “down-the-ask-and-divide” would you use given:
A dealer is quoting the AUD/GBP spot rate as 1.5060-1.5067. How would you compute the proceeds of converting 1 million GBP?

A

use “up-the-bid-and-multiply”;

1 million x 1.5060 = 1,506,000 AUD

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18
Q

Which of the two components in the rule “up-the-bid-and-multiply” or “down-the-ask-and-divide” would you use given:
A dealer is quoting the AUD/GBP spot rate as 1.5060-1.5067. How would you compute the proceeds of converting 1 million AUD?

A

use “down-the-ask-and-divide”;

1 million x (1/1.5067) = 663,702 GBP

19
Q

The dealer sells the base currency at ____ and buys the base currency at _____.

A

ask (offer);

bid;

20
Q

The ____ price will always be greater than the _____ price. Why?

A

ask (offer);
bid;
because the dealer will never take a loss on the spread;

21
Q

The _____ spread is wider than the spot spread.

A

forward;

22
Q

Important! Give the rule for how you know whether he bid or the ask is the appropriate rate given an fx price quote.

A

“up-the-bid-and-multiply” and “down-the-ask-and divide”.

23
Q

Given a price quote as AUD/GBP, if you are converting 1 million GBP to AUD, are you going up the quote or down the quote.

A

Up the quote because you are starting with GBP and converting into AUD.

24
Q

Given a price quote as AUD/GBP, if you are converting 1 million AUD to GBP, are you going up the quote or down the quote?

A

Down the quote because you are starting with AUD and converting into GBP.

25
Q

The cross rate is the exchange rate between two currencies implied by their exchange rates with what?

A

A common third currency.

26
Q

Ignoring bid-ask spreads, given USD/AUD = 0.60 and MXN/USD = 10.70, what is the cross rate between AUD and MXN?

A

MXN/AUD = USD/AUD X MXN/USD = 0.60 X 10.70 = 6.42 note that you must set up the quotes so that the common third currency must be in the numerator of one rate and in the denominator of the other rate so that the USD cancels out (basic algebra) and you can then multiply the two rates together.

27
Q

Using cross rates in fx trading, the goal of the ______ _______ is to see if you can pick the dealer’s pocket.

A

triangular arbitrage;

28
Q

The _____ of the bid rate is the ask rate.

A

reciprocal;

29
Q

The _____ of the ask rate is the bid rate.

A

reciprocal;

30
Q

1.4124-1.4128 USD/EUR bid ask means the dealer will ____ Euros at 1.4124 and ____ Euros at 1.4128

A

buy;

sell;

31
Q

___ X _____ = cross-currency bid

___ X _____ = cross-currency ask (offer)

A

bid; bid;

ask (offer); ask (offer);

32
Q

To determine if there is a triangular arbitrage opportunity, you use what three inputs from what two sources?

A
  1. A currency exchange rate bid & ask quotes from a dealer (e.g., MXN/AUD);
  2. A currency exchange rate from the interbank markets for one of the above currencies per a common third currency, and
  3. A currency exchange rate from the interbank markets for the other of the above currencies per the same common third currency.
    the two sources: the dealer and the interbank markets.
33
Q

As it applies to a dealer, what is the rhyme that illustrates how a dealer can be on the losing end of an fx trade?

A

“bid too high, ask too low, out of business sure to go!”

34
Q

For a dealer’s bid to be too high (and disadvantageous to him) his bid is greater than what?

A

The dealer’s bid is higher than the cross rate ask (offer) rate.

35
Q

For a dealer’s ask (offer) to be too low (and disadvantageous to him) his ask (offer) is lower than what?

A

The dealer’s ask (offer) is lower than the cross rate bid.

36
Q

Can there ever be a situation where both the dealer’s bid is too high and the dealer’s ask is too low in a triangular arbitrage situation?

A

Never! Only one of the two rules can be broken.

37
Q

Given that a dealer quotes MXN/AUD at 6.3000 - 6.3025, and you calculate an interbank cross rate of 6.4200 - 6.4481 using MXN/USD and AUD/USD, is there a triangular arbitrage opportunity? If so, explain where/how.

A

Yes, the dealer’s ask (offer) is too low.
At 6.3025, the dealer is willing to sell AUD for MXN. Using the rule “up-the-bid-multiply” and “down-the-ask-divide”, you use the “down-the-ask-divide” rule, you convert MXN to AUD – THAT is your winning arbitrage trade. Obtain MXN from the interbank market using some common currency (it doesn’t matter which common currency but assume $100 USD), then sell the MXN to the dealer for AUD at his ask. Then convert that AUD at the interbank market rate (since you’re going up the quote of AUD/USD, use the market bid price). You will then receive an amount in USD greater than the $100 you started with, less the transaction cost.

38
Q

For how many days into the future are forward rates typically quoted?

A

30, 60 or 90 days.

39
Q

Is the bid-ask spread for forward rates calculated the same as for spot rates (offer price minus bid price)?

A

Yes.

40
Q

What is the formula for calculating the forward premium/discount?

A

forward rate - spot rate (positive is a premium and negative is a discount);

41
Q

When referring to a currency trading at a premium or a discount, which currency – the price currency or the base currency – is being referred to?

A

the BASE currency! important!

42
Q

Given USD/EUR spot of 1.10 and an anticipated future rate of 1.20, which currency is expected to appreciate and by how much?

A

The BASE currency, the euro, is expected to appreciate by 0.10.

43
Q

Assume AUD/CAD spot of 1.0511 - 1.01519 (can also be written 1.0511 / 1.0519). if the 30-day forward is given as +3.9 / +4.1, what are the 30-day forward bid/ask rates?
What is the future position of which currency?

A

bid: 1.0511 + (3.09/10,000) = 1.0511 + 0.00039 = 1.05149
ask: 1.0519 + (4.1/10,000) = 1.0519 + 0.00041 = 1.05231
The CAD is priced to appreciate versus the AUD.

CFA Level II 2020 (9 decks)

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