4. Foreign Exchange Instruments Flashcards
The FX market is a what market?
Decentralised, OTC market.
How big is the FX market?
It is the largest in the world - trading approximately $7 trillion each day.
Explain the features of the spot market?
The exchange of one currency for another, usually settled on T+2.
The FX markets are dominated by which players?
Major international banks, such as HSBC and Goldman Sachs etc
In FX, quotes are to how many figures.
5 figures eg 1.2345
In a GBP/USD pairing, which one is the base and which one is the variable currency?
GBP = base = the fixed amount eg 1
USD = variable = eg the variable amount
GBP/USD - 1.2345/50
Which one is the bid, which one is the offer?
What does each one mean?
1.2345 = bid
1.2350 = offer
BBBB - the bank buys base at bid (client sells)
Offer - the bank sells base at offer (client buys)
What is it important to note in this exam concerning FX?
You are a price taker, you ALWAYS lose
If someone requires FX to settle in a timeframe beyond T+2, what could they consider doing?
Entering a forward FX contract, instead of spot.
How are forward FX rates determined?
By applying an adjustment to the spot rate
When making forward adjustments what is the rule, at to whether to discount (-) from spot, or premium (+) to spot?
If the adjustment is ascending e.g. 5/6 - you add (premium)
If the adjustment is descending e.g. 6/5 - you minus (discount)
What is an important rule to remember when calculating forward adjusted rates?
For
Forward contracts carry more risk, so the spread should always widen in a forward contract.
What is a key advantage of forward contracts?
Certainty
In addition to commercial users, the forward market is also used extensively by who?
Speculators - such as hedge fund managers
Forward rates are based on the differential in what, between the two currencies?
Interest rate differential
What are the two types of exchange rates?
- Floating/free exchange - the most common in major economies
- Fixed exchange rate/pegged exchange rate - where a currency is linked to the value of another single currency, or asset, such as gold.
What are fixed exchange rates usually used to achieve?
To stabilise the value of currency against the currency it is pegged to. Making trades between the two countries easier, and more predictable.
Whilst macroeconomic factors affect exchange rates, ultimately currency prices are a result of..?
Dual forces - supply and demand.
How does inflation impact FX rates?
High inflation (rising inflation) typically sees that a currency loses value.
Usually this is because high inflation erodes purchasing power, which suppresses demand. However a currency may strengthen as in times of high inflation, central banks will often increase short term interest rates to combat. Ultimately it depends on whether investors have confidence in the central banks ability to increase rates.
How do government budget deficits/surpluses affect FX rates?
Markets usually react negatively to widening deficits and positively to narrowing deficits.
How do trades deficits and surpluses affect FX rates?
Trade deficits reflect les competitiveness and have a negative impact on FX rates. Trade surpluses have a positive impact.
Key statistics, such as GDP, employment data etc generally affect FX rates how?
The more bullish the data and reports, the better the currency will perform.
Can political instability affect FX rates?
Yes. Sudden government collapses, or snap elections can negatively impact the currency value.
What is devaluation?
Whereby governments deliberately make decisions to reduce the value of their country’s currency.
When might a devaluation take place?
When a country has a large current account deficit
What does mainstream investment theory assume?
That investors act rationally at all times, without risk of emotional bias.
Behavioural finance, by contrast allowed for what?
Inherent human biases which lead to widespread non-rational behaviour
Explain the term ‘flights to quality’.
Investors fleeing to such currencies and assets at times of unrest, such as: USD, CHF and gold.
Explain the ‘buy the rumour, sell the fact’ theory.
The tendency for exchange rates to reflect rumours, when when the event comes to pass, to react in exactly the opposite direction. May referred to as the market being oversold or overbought on a short term basis.
Explain what is meant by interest-rate parity
An arbitrage-free method of pricing FX forwards. The bank calculates the FX forward in such a way to take away any arbitrage profits from the carry trade.
What is the formula for calculating a forward rate?
What are non-deliverable forwards (NDFs).
- example of an OTC contract for difference
- usually quoted and settled in USD
