4. Foreign Exchange Instruments

Question 1

The FX market is a what market?

Answer 1

Decentralised, OTC market.

Question 2

How big is the FX market?

Answer 2

It is the largest in the world - trading approximately $7 trillion each day.

Question 3

Explain the features of the spot market?

Answer 3

The exchange of one currency for another, usually settled on T+2.

Question 4

The FX markets are dominated by which players?

Answer 4

Major international banks, such as HSBC and Goldman Sachs etc

Question 5

In FX, quotes are to how many figures.

Answer 5

5 figures eg 1.2345

Question 6

In a GBP/USD pairing, which one is the base and which one is the variable currency?

Answer 6

GBP = base = the fixed amount eg 1
USD = variable = eg the variable amount

Question 7

GBP/USD - 1.2345/50

Which one is the bid, which one is the offer?

What does each one mean?

Answer 7

1.2345 = bid
1.2350 = offer

BBBB - the bank buys base at bid (client sells)
Offer - the bank sells base at offer (client buys)

Question 8

What is it important to note in this exam concerning FX?

Answer 8

You are a price taker, you ALWAYS lose

Question 9

If someone requires FX to settle in a timeframe beyond T+2, what could they consider doing?

Answer 9

Entering a forward FX contract, instead of spot.

Question 10

How are forward FX rates determined?

Answer 10

By applying an adjustment to the spot rate

Question 11

When making forward adjustments what is the rule, at to whether to discount (-) from spot, or premium (+) to spot?

Answer 11

If the adjustment is ascending e.g. 5/6 - you add (premium)
If the adjustment is descending e.g. 6/5 - you minus (discount)

Question 12

What is an important rule to remember when calculating forward adjusted rates?

Answer 12

For

Forward contracts carry more risk, so the spread should always widen in a forward contract.

Question 13

What is a key advantage of forward contracts?

Answer 13

Certainty

Question 14

In addition to commercial users, the forward market is also used extensively by who?

Answer 14

Speculators - such as hedge fund managers

Question 15

Forward rates are based on the differential in what, between the two currencies?

Answer 15

Interest rate differential

Question 16

What are the two types of exchange rates?

Answer 16

1. Floating/free exchange - the most common in major economies
2. Fixed exchange rate/pegged exchange rate - where a currency is linked to the value of another single currency, or asset, such as gold.

Question 17

What are fixed exchange rates usually used to achieve?

Answer 17

To stabilise the value of currency against the currency it is pegged to. Making trades between the two countries easier, and more predictable.

Question 18

Whilst macroeconomic factors affect exchange rates, ultimately currency prices are a result of..?

Answer 18

Dual forces - supply and demand.

Question 19

How does inflation impact FX rates?

Answer 19

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.

Question 20

How do government budget deficits/surpluses affect FX rates?

Answer 20

Markets usually react negatively to widening deficits and positively to narrowing deficits.

Question 21

How do trades deficits and surpluses affect FX rates?

Answer 21

Trade deficits reflect les competitiveness and have a negative impact on FX rates. Trade surpluses have a positive impact.

Question 22

Key statistics, such as GDP, employment data etc generally affect FX rates how?

Answer 22

The more bullish the data and reports, the better the currency will perform.

Question 23

Can political instability affect FX rates?

Answer 23

Yes. Sudden government collapses, or snap elections can negatively impact the currency value.

Question 24

What is devaluation?

Answer 24

Whereby governments deliberately make decisions to reduce the value of their country’s currency.

Question 25

When might a devaluation take place?

Answer 25

When a country has a large current account deficit

Question 26

What does mainstream investment theory assume?

Answer 26

That investors act rationally at all times, without risk of emotional bias.

Question 27

Behavioural finance, by contrast allowed for what?

Answer 27

Inherent human biases which lead to widespread non-rational behaviour

Question 28

Explain the term ‘flights to quality’.

Answer 28

Investors fleeing to such currencies and assets at times of unrest, such as: USD, CHF and gold.

Question 29

Explain the ‘buy the rumour, sell the fact’ theory.

Answer 29

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.

Question 30

Explain what is meant by interest-rate parity

Answer 30

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.

Question 31

What is the formula for calculating a forward rate?

Answer 31

Question 32

What are non-deliverable forwards (NDFs).

Answer 32

• example of an OTC contract for difference
• usually quoted and settled in USD