Foreign Exchange

Question 1

What is the fx market? (9)

Answer 1

• Foreign exchange is a global OTC or off exchange market for different world currencies
• Quote driven market - major international banks and brokerage houses are participants
• Private investors and corporates do not act directly
• Large companies and investment funds use bank to access FX markets
• Banks are market makers - two way prices
• Settlement of currency is processed directly between the counterparties to the trade
• No central counterparty
• Spot market - largest component and the forward market
• London is largest fx market

Question 2

What is a spot market? (7)

Answer 2

• Largest component of FX market
• Standard settlement - T+2
• Two way prices quoted
• Buy rate: bid rate (left)
• Sell rate: offer rate (right)
• Bank making the quote always buys the base currency at the left and sells on the rate on the right
• Term for GBP vs USD exchange rate is called cable rate

Question 3

What is a forward rate? (5)

Answer 3

• Adjusted spot rate - this can be positive or negative
• If adjustment is positive, pips are added on - forward rate = discount
• Referred to as discount because currency is cheaper for forward delivery than spot
• If adjustment is negative, pips are subtracted from spot rate = premium
• Referred to as premium because currency is more expensive for forward delivery than spot

Question 4

What is interest rate parity? (3)

Answer 4

• Exchange rate between 2 currencies for a future date will take account the difference in their interest rate over the period up to the future date
• Covered interest rate parity: forward ER should incorporate the difference in IR between 2 countries, otherwise arbitrage would exist
• Uncovered interest rate parity: difference in IR between 2 countries equals the expected change in ER between 2 countries. E.g if difference in IR is 2% between 2 countries, the country with the higher IR would be expected to depreciate 2% against the other

Question 5

What is purchasing power parity? (4)

Answer 5

• Assume ER between 2 countries will adjust automatically in order to take into account their respective inflation rates
• Rationale - a good ought to cost the same regardless of which country it is bought in (law of one price)
• Law assumes that shield a good be cheaper in one country than anywhere else, the demand for the country’s currency would appreciate, as consumers buy the currency to buy the good
• This would continue until the currency outweighed true benefit of the good being cheaper

Question 6

What is the Fisher effect? (1)

Answer 6

• In a global market with free capital flows, the real interest rate (less an adjustment for inflation) will be equal in all countries

Question 7

What is fx risk? (2)

Answer 7

• Where an investment is made is forex, the total return consists of: the return expressed in fx and return made on changes in the rate of exchange of the fx e.g. buying USD for GBP, selling GBP back to USD
• If a manager wishes to reduce fx risk, they may do so by entering into a forward agreement - locking in the future value of the currency

Question 8

What are the 3 ways in which national government can intervene in managing their currency vs foreign currencies? (3)

Answer 8

• Fixed exchange rate: value of the domestic currency is fixed to that of the foreign currency (usually a larger and stronger currency e.g. USD)
• Floating exchange rate: there is no intervention in fx market and the price of the domestic currency is allowed to reach its own value determined by the supply and demand of that currency
• Managed or ‘dirty floating’ rate - there is some intervention in the fx market to coax the exchange rate in a particular direction, but there is no fixed target in mind

Question 9

What are the arguments for fixed exchange rate? (3)

Answer 9

• Reduced fx risk: Imports and exports of goods are certain in value over time. Foreign trade may rise as a result
• Increased government discipline in economic management: Governments find it difficult to engage in inflationary policies - depreciation of currency cannot be used to pay for deficit govt spending
• Speculation is discouraged: currency speculation is pointless where EXR is fixed - discourages potential damage to net exports from country

Question 10

What are argument against fixed exchange rate? (3)

Answer 10

• No automatic balance of payments: floating EXR can aurtomatically deal with current account imbalances between imports and exports. With fixed rate, current account deficits can only be adjusted for by a drop in aggregate demand for domestic products
• System requires large holdings of foreign currency reserves: Holdings of wealth in foreign currency reserves could potentially be put to better use
• Loss of freedom of economic policy: decisions regarding EXR may dominate monetary policy when other issues such as inflation and unemployment could be more pressing

Question 11

What are optimal currency areas (OCA)? (2)

Answer 11

• A region, usually bigger than a single country, that’s shares a single currency e.g. Eurozone, US
• Only works where political union and shared sovereignty takes place - success of USD but difficulty the EUR is facing in light of Eurozone.