ECO 2.1 Flashcards
What is the Base currency and Price currency? What is the Bid-ask or Bid-offer spread?
- The base currency (usually the denominator) is the currency of which we have one unit with us and the price of which is quoted in the price currency (usually the numerator).
- The bid-ask spread is the spread in the price of the base currency by the currency dealer. The bid representing the price at which the dealer will buy the base and give the price currency & the offer/ask is vice versa.
What is a pip? Usually upto how many decimal places are the pip quoted? give examples.
- Most currency spreads are given by 0.0001 (upto 4 decimal places) and the bid may be 1.4126 and the offer will be 1.4131, thus having a difference of 5 pips.
- Some currencies like yen have pips represented only upto 2 decimal places -> 0.01
What is higher? The offer price or the bid price? Where is the base currency in the currency fraction quote?
- The offer price is always going to be higher than the bid price as the dealer always buys at a lower cost and sells at a higher price to make his money. The base currency in the curriculum will always be given in the denominator.
Primary factors that affect the Bid-offer spread? Secondary factors?
Primary:
- Currency Pair
- Time of the day
- Market Volatality
Secondary:
- Transaction size.
- Relationship between dealer & client
- Client’s credit profile.
Arbitrage Constraints on Spot Exchange rate quotes:
- Dealer bid can’t be higher than interbank offer
- Dealer offer can’t be lower than interbank bid
What is Triangular Arbitrage?
- Triangular arbitrage is the same as the arbitrage constraints we looked at earlier, except they are cross rates instead of normal currency pair rates.
The logic remains the same as it does in the spot rate market. (like the earlier constraints in the spot rate quotes)
What are the 2 shortcuts to remember the arbitrage constraints?
- DB iG IO
- DO L IB
What is a forward contract?
- Just like derivatives, it is a contract to exchange a currency against another on a future date but at an exchange rate which was agreed upon today. Any transaction which has a settlement date longer than T + 2 is a forward contract.
How do we calculate the forward price?
- by the forward price formula :
F p/b = S p/b x [ 1 + iP (no.of days/360) / 1 + iB (no.of days/360)] -> “Base in the base” phrase to remember formula.
After the forward price, we can get the forward premium as forward price - spot price.
When is the forward premium positive and when is it negative?
- Positive when the interest rate of base currency is less than interest rate of price currency
- Negative when vice versa i.e. iB > iP
What are forward points & how do we come to a forward price from the spot price and forward points?
- The spot price is usually given and are the forward points, so we just need to divide the forward points number by 10,000 and add it back to the spot price. This gives up the forward price.
How are forward contracts marked to market?
- Foward contracts are marked to market which a 4 step approach.
We first need to create an offset position of our current position.
Then, we need to determine the appropriate all-in forward position rate for this new offsetting position.
After getting the rate, we can calculate the cash flow on the settlement date.
Then we can discount this back using the interest rate (which will be given) & the number of days we’d like to discount it. (In simple words, we need to get the PV of our cash flow which we calculated we’d have on the settlement date)
What is the FX Carry trade?
- It’s a type of trade where one borrows in low-yield currency and invests in another high-yield currency. It’s based on an assumption that the uncovered interest rate parity doesn’t hold.
What is the Balance of Payments?
- It consists of: Current account, which reflects flows related to the real economy (i.e. trade in goods and services) and a Capital account, which reflects financial/investment flows.
Basically a track of how much money is coming in and going out of a country.
What is the current account?
- The current account is used to monitor the inflows and outflows of goods and services into a country. A surplus in current account means that exports are greater than imports or outflows are more than inflows. To balance the current account, the balance must be matched by an equal and opposite capital account balance. Persistent current account surplus results in currency appreciation.
The current account always needs to be balanced against the combined capital & financial account.
