2

Question 1

What is a rate of exchange

Answer 1

Price of one currency in terms of another
Expressed as units of underlying currency equal to one unit of base currency

Question 2

What is a spot transaction

Answer 2

The immediate purchase or sale of a currency

Question 3

What does USD/GBP = 1.50 mean

Answer 3

£1 = $1.50

Question 4

What is the bid price/ ask price

Answer 4

The bid price is the rate at which the dealer is willing to buy a currency
The ask price is the rate at which a dealer is willing to sell a currency

Question 5

What is a forward

Answer 5

A forward is an obligation to trade in an asset at a predetermined price at a predetermined time

Question 6

For a forward when is the payment for an asset

Answer 6

At delivery
For Foreign exchange a forward contract is one with delivery after 2 days

Question 7

What can the forward rate F of USD/GBP be compared to spot rate (HI/LO)

Answer 7

Same as the spot rate
Higher than spot rate (£ at premium)
Lower than spot rate (£ at discount)

Question 8

How is the forward premium or discount of forward currency expressed

Answer 8

In annualised percentages
(F-S)/S x 360/N x 100
(S-F)/S x 360/N x 100
N is no of days

Question 9

What are forward points

Answer 9

Forward points = 10000 x [Forward rate - Spot rate]

Question 10

What is forward rate in terms of forward points

Answer 10

Forward rate = Spot rate + (Forward points)/10000

Question 11

What 2 options does a company have when companies have receipt or payment in foreign currency which are to be settled at a known point in the future? What does this have to do with hedging?

Answer 11

Option 1 - Wait until settlement date and fulfil transaction at the spot rate - risky as future currency rate unknown
Option 2 - Arrange forward contract - this hedges the foreign currency value

Question 12

What is arbitrage

Answer 12

Simultaneous buying and selling of assets to take advantage of differing prices for the same assets

Question 13

What is the formula for forward price

Answer 13

Forward price = [Spot price x (1+holding cost]/(1 + holding benefit)

Question 14

What are examples of holding costs?

Answer 14

Cost of financing position
Storage cost
Insurance
Spoilage
Transportation

Question 15

What are examples of holding benefits

Answer 15

Dividends
Coupon payments
Convenience yield

Question 16

What is the future price for $/£ foreign exchange

Answer 16

F{$/£} = S{$/£}(1+i{$}N/360)/(1+i{£}*N/360)
Where i is interest rate

Question 17

What formula can be obtained from future price for foreign exchange that is used for covered interest rate parity

Answer 17

(F{$/£}-S{$/£})/S{$/£}) =
[(i{$}-i{£})N/360]/(1+i{£}N/360)
From forward price formula

Question 18

How does the covered interest rate parity simplify if i{£} is small? What implication does this have

Answer 18

If i{£} is small 1+i{£}*N/360 is approximately equal to 1

(F{$/£}-S{$/£})/S{$/£})*N/360 = (i{$}-i{£})

Forward premium/discount reflects interest rate differentials between 2 countries

Question 19

What does the interest rate parity imply

Answer 19

Interest Rate Parity implies that currencies with high interest rates also have high depreciating currencies

Question 20

What is the currency carry trade

Answer 20

A strategy where you borrow funds at a low interest rate in one currency (funding currency) and buy a higher yielding asset in another (target currency) in the spot market

The strategy is only profitable if interest rate differentials are not dominated by exchange rate movements

Question 21

Shella Kinsey works for Barclays in London. Suppose she observes following data: Spot exchange rate: ¥/£=179.5, 30-day £ interest rate: 2.7% per year, 30-day ¥ interest rate: 0.6% per year, 30-day forward rate: ¥/£=180
She has about 1million pounds or the equivalent in yen for investment/arbitrage purposes. What should she do?

Question 22

Uncovered interest rate arbitrage example