Market of Foreign Exchange

Question 1

Introduction to Forex Market

Answer 1

• largest financial market in the world
• open 24/7
• 7 trillion volume per day
• London is the biggest trading center

Question 2

Exchange rate quotes

Answer 2

Currency pairs - base currency/quote currency
- the base is always given first.

Question 3

What does USD/EUR mean?

Answer 3

How many EUR per USD

Question 4

What does EUR/USD mean?

Answer 4

How many USD per EUR

Question 5

What is it called when the currency goes up?

Answer 5

The currency increases in value - currency appreciation

Question 6

What is it called when the currency goes down?

Answer 6

The currency decreases in value - currency depreciation

Question 7

What is a direct quote?

Answer 7

Price in home currency (USD) for unit of foreign currency (EUR).
Example:
EUR/USD = 1.09 - 1 EUR will cost me $1.09

Question 8

What is an indirect quote?

Answer 8

Amount of foreign currency (EUR) per unit of home currency (USD).
Example:
USD/EUR = 0.92 - for $1 you will get 0.92 EUR

Question 9

What are the types of Forex Markets?

Answer 9

1. Spot market - current transactions
2. Forward market - future transactions

Question 10

What is the forward market?

Answer 10

• purchase or sale of currency in the future
• forward rate for delivery in N months
• the forward rate is the expected future spot rate

Question 11

How to hedge foreign currency payables with a forward contract?

Answer 11

1. Buy forward contract for the currency of the payable
2. Calculate the cost of purchase = Payable amount x F

Question 12

How to hedge foreign currency payables with an options contract?

Answer 12

1. Buy call option on the currency of the payable
2. Calculate the FV of the option premium
3. Total cost in 12 months depending on the current situation

Question 13

Why do we calculate the FV of the option premium when we are hedging currency payables or receivables?

Answer 13

I have to take into account that I pay the premium now, but the actual currency transaction and settlement of my contact with the other company will take place in the future.

Question 14

Which hedging alternative is more expensive and why?

Answer 14

An options hedge is more expensive because it doesn’t limit the upside potential, only the downside risk, while the forward hedge limits both sides.

Question 15

How to hedge foreign currency receivables with a forward contract?

Answer 15

1. Sell forward contact for the foreign currency of the receivable at the forward rate
2. Calculate revenue from the contract = receivable x F

Question 16

How to hedge foreign currency receivables with an options contract?

Answer 16

1. Buy put option on the currency of the receivable
2. Calculate FV of the premium
3. Total revenue depending on the situation

Question 17

Which currency appreciates when a quote goes up?

Answer 17

Quote goes up - Base currency appreciates

Question 18

Which currency depreciates when a quote goes down?

Answer 18

Quote goes down - Base currency depreciates

Question 19

What causes exchange rates to move?

Answer 19

Supply and demand for the currency

Question 20

What is Interest Rate Parity?

Answer 20

• Different interest rates allow for carry trades
• Interest rate changes => Exchange rate changes

Question 21

What is Purchasing Power Parity?

Answer 21

• Everything should cost the same across different countries
• Rarely holds in reality due to taxes, tariffs, labour costs, etc. which are all different in the different countries.

Question 22

What is the carry trade arbitrage opportunity?

Answer 22

1. Borrow money from the country with the lower interest rate
2. Convert into the currency with the higher rate
3. Invest in the country with the higher rate
4. At the end of the year get your investment and change it back
5. Repay the loan
6. Calculate your profit