FMP9 - Foreign Exchange Markets

Question 1

Explain and describe the mechanics of spot quotes, forward quotes, and futures quotes in the foreign exchange markets; distinguish between bid and ask exchange rates

Answer 1

Ask rate is how much willing to sell for, bid is how much willing to buy for

Forward rate is quoted as 10,000x the rate then added to the spot rate

Question 2

Calculate bid-ask spread and explain why the bid-ask spread for spot quotes may be different from the bid-ask spread for forward quotes

Answer 2

Bid-ask spread = ask - bid (spot quotes)
Bid-ask spread for forwards time t = (ask - bid at time 0) - (ask - bid at time t)

Bid-ask spread tends to increase with time to maturity. Note if bid > ask then exchange rate going down but minus sign not shown in spread

Question 3

Compare outright (forward) and swap transactions

Answer 3

Outright forward is where two parties agree on an exchange at a future date. FX swap transactions are where currency is exchanged on two different dates.

Question 4

Define, compare, and contrast transaction risk, translation risk, and economic risk

Answer 4

• Transaction risk: when company exposed to receivables / payables in another currency
• Translation risk: when companies assets and liabilities denominated in a foreign currency, exposed to FX
• Economic risk: cashflows in future affected by FX movements

Question 5

Describe examples of transaction risk, translation risk, and economic risk and explain how to hedge these risks

Answer 5

• Transaction risk: hedge with outright forward contracts
• Translation risk: finance assets in a country with borrowings in the currency of that country
• Economic risk: more difficult to hedge, FX movements must be considered when making big decisions

Question 6

Explain the rationale for multi-currency hedging using options

Answer 6

Volatility arising from exposure to lots of currencies is usually less than that arising from a single currency

Question 7

Identify and explain the factors that determine exchange rates

Answer 7

1. Balance of payments and trade flows
2. Inflation and purchasing power
3. Money supply

Question 8

Explain the purchasing power parity theorem and use this theorem to calculate appreciation or depreciation of a foreign currency

Answer 8

% strengthening of domestic spot rate = foreign inflation rate - domestic inflation rate

Question 9

Describe the relationship between nominal and real interest rates

Answer 9

R real = R nominal - R inflation roughly

That is, real interest rates are nominal interest rates adjusted for inflation

Question 10

Describe how a non-arbitrage assumption in the foreign exchange markets leads to the interest rate parity theorem and use this theorem to calculate forward foreign exchange rates

Answer 10

Covered interest rate parity means that F = S(1 + Ra)^T / (1 + Rb)^T, where Ra,b are interest rates in currency a and b, F is forward a to b rate, S is spot a to b rate, and where you have a but want b

If F < S(1 + Ra)^T / (1 + Rb)^T, borrow b for T years at Rb, convert funds to b, invest at Rb for T years and enter forward to convert to GBP in T years, arbitrage

Question 11

Distinguish between covered and uncovered interest rate parity conditions

Answer 11

Uncovered interest rate parity argues all investors should earn same interest rate in all currencies when expected FX movements are considered