Currency Risk Definitions

Question 1

A foreign exchange transaction:

Answer 1

An agreement between a buyer and a seller that a fixed amount of one currency will be delivered for some other currency at a specified rate

Question 2

The FOREX markets provide the physical and institutional structure through which

Answer 2

The money of one country (currency) is exchanged for that of another country
The rate of exchange between currencies is determined
Foreign exchange transactions are ‘physically’ completed

Question 3

6 Main characteristics of FOREX markets.

Answer 3

The geographic extent
The daily transaction volume
The functions of FOREX markets
The market’s participants
Types of transactions including spot, forward and swaps
Methods of stating exchange rates, quotations, and changes in exchange rates

Question 4

1.The geographic extent

Answer 4

Worldwide 24 hours on business days.

Question 5

2.The daily transaction volume

Answer 5

Size of the FOREX markets, with USD, JPY and the Euro in the top 3 currencies. 4. Pound sterling 5. Australian dollar. total also add up to 200%

Question 6

3.Function of the FOREX markets.

Answer 6

provide the mechanism by which participants:
Transfer purchasing power between countries
Obtain or provides credit for international trade transactions
Minimize exposure to exchange rate risk

Question 7

4. Market Participantsoperating in the wholesale and/or retail markets

Answer 7

1. Central banks and treasuries
2. FOREX
3. Foreign exchange brokers
4. Banks and non banks exchange dealers
5. speculators & arbitragers
6. individuals and firms

Question 8

Central banks and treasuries operate to do what?

Answer 8

Influence exchange rates of own currency for the benefit of citizens of their own country

Question 9

FOREX markets operate to do what?

Answer 9

To facilitate trading between dealers. They stay anonymous. No positions

Question 10

Banks and non-banks exchange dealers operate to do what?

Answer 10

Trading for customers or for themselves. ‘‘Market makers/ inventory position. Exchange dealers as they earn money by spreading bid/ask and the changes in exchange rates.

Question 11

Speculators & Arbitragers operate to do what?

Answer 11

Trading for themselves to make profit. They earn money by: exchange rate changes as speculators. exchange rate differences in different markets are arbitragers.

Question 12

The authors identify two tiers of foreign exchange markets, what are they?

Answer 12

Interbank and client markets.

Question 13

While trading in foreign exchange takes place worldwide, where are the major currency trading centers located?

Answer 13

London, New York, and Tokyo.

Question 14

In the foreign exchange market which participants seek all of their profit from exchange rate changes?

Answer 14

Speculators

Question 15

5. Types of transactions in the Interbank Market

Answer 15

Transactions within this market can be executed on a spot, forward, or swap basis:

Question 16

Transactions within this market can be executed on a spot, forward, or swap basis:

Answer 16

• A spot transaction requires almost immediate delivery of foreign exchange
• A forward transaction requires delivery of foreign exchange at some future date
• A swap transaction is the simultaneous exchange of one foreign currency for another for two different value dates (a temporarily exchange)

Question 17

5b. (Outright) Forward Transactions

Answer 17

This transaction requires delivery at a future value date of a specified amount of one currency for another

The exchange rate is established at the time of the agreement, but payment and delivery are not required until maturity.
Forward rates are contracts quoted for value dates of one, two, three, six, nine and twelve months
Example: Suppose one company purchases products from another foreign company. The payment terms: 3 months. Is forward contact beneficial?

Question 18

Floating, Fixed, Managed Exchange rates

Answer 18

Free floating currencies
Fixed exchange rates
Managed Floating exchange rates

Question 19

Free floating currencies

Answer 19

No state intervention on FOREX markets: exchange rates reflect supply and demand conditions
Examples $, ¥ (yen), £, €

Question 20

Fixed exchange rates

Answer 20

Central Bank buys or sells its currency at a fixed price in order to stabilize the value to another currency
Examples: gold standard; Bretton Woods ($ key role), EU currencies before start of the €

Question 21

Managed Floating exchange rates

Answer 21

Examples ¥ (Chinese Yuan)

Question 22

6. Stating Foreign Exchange Rates & Quotations

Answer 22

A foreign exchange quote is a statement of willingness to buy or sell at an announced rate
Currency Traditional Symbol 	ISO 4217 Code
U.S. dollar 		        $ 	USD
European euro 		€ 	EUR
Great Britain pound       £ 	GBP
Japanese yen 		¥ 	JPY
Mexican peso 		Ps 	MXN
Renminbi (Yuan)		¥ 	CNY

In the retail market (newspapers and exchange-‘shops’), quotes are often given as the home currency price of the foreign currency: £(GBP)1.770/$

Question 23

The foreign currency price of the unit one dollarSfr1.6000/$, read as ‘I have to pay 1.600 Swiss francs for one dollar’

Answer 23

SFR1.6000/$
Swiss franc is foreign currency
($ is HOME currency)

Question 24

The dollar price of a unit of foreign currency$0.6250/Sfr, read as ‘I have to pay 0.625 dollars per Swiss franc’

Answer 24

$0.6250/Sfr

$ is home currency and swiss franc is foreign currency.

Question 25

Direct Quotes

Answer 25

A direct quote is a home currency price of a unit of a foreign currencyEUR0.8214/USD1.00 is a direct quote (on the dollar) in Europe

Question 26

Indirect Quote

Answer 26

An indirect quote is a foreign currency price in a unit of the home currency EUR0.8214/USD1.00 is an indirect quote in the US

Question 27

Interbank quotes are given as a bid and ask:

Answer 27

The bid is the price at which a dealer will buy another currency
The ask or offer is the price at which a dealer will sell another currency

Question 28

Forward Quotations in Percentage Terms

Answer 28

Forward quotations may also be expressed as the percent-per-annum deviation from the spot rate (the ‘premium’);
The ‘premium’ can be positive (a ‘premium’) or negative (a ‘discount’)
The important thing to remember is which currency is being used as the home or base currency
For indirect quotes (i.e. quote expressed in foreign currency terms, like (from US point of view) Euro 0.8214 / USD), the formula is

Question 29

Interbank (wholesale)

Answer 29

Large sums

Question 30

The client (Retail)

Answer 30

specific amounts

Question 31

What is the forward premium/discount?

Answer 31

is the % difference between the spot and forward exchange rate stated in annual % terms

Question 32

Relative Purchasing Power Parity

Answer 32

“If the spot exchange rate between 2 countries starts in equilibrium, any change in the differential rate of inflation between them tends to be offset over the long run by an equal but opposite change in the spot exchange rate.”

Question 33

Interest Rate Parity

Answer 33

“The difference in the national interest rates for securities of similar risk and maturity should be equal to, but opposite in sign to, the forward rate discount or premium for the foreign currency, except for transaction costs.”