Seminars Flashcards
- a) What are the key differences between spot and forward FX markets?
The spot market is for immediate delivery, although in practice a deal done today will normally be settled after two working days. In a forward deal, you agree on the price today at which you will exchange two currencies on a specific day in the future
- What is the difference between a direct quote and an indirect quote?
A direct quote shows the amount of domestic currency needed to buy one unit of foreign currency. For example, 1.06 CHF/EUR means 1.06 Euros buys 1 CHF. This is useful for domestic buyers.
An indirect quote, like 1.2 GBP/USD, shows how much foreign currency (USD) is needed to buy one unit of domestic currency (GBP).
- What are cross rates? Provide an example of a cross rate?
The currency exchange rate between two currencies, both of which are not the official currencies of the country in which the exchange rate quote is given in. For example, the exchange rate between € and £ quoted in a U.S. newspaper.
Why might the economy take a long time to achieve PPP?
PPP stands for Purchasing Power Parity, which is an economic theory that suggests that in the absence of transportation costs and other trade barriers, in the long term, exchange rates between currencies should adjust so that an identical good or service in two different countries will cost the same when expressed in a common currency.
If all goods are homogenous then consumers (or importers) would immediately know
whether foreign goods (e.g. oil from Saudi Arabia) expressed in the domestic currency (e.g.
Pound Sterling), equalled the price of similar domestically produced goods (e.g. British
‘North Sea’ oil). Some goods are fairly homogenous (e.g. oil, raw materials, agricultural
produce) and here PPP will hold almost continuously. However, for non-homogenous goods
(e.g. machine tools) a change in foreign prices (or the exchange rate) may take some time to
be reflected in the price of home-produced goods. This applies a fortiori if it is the ‘wageprice spiral’ that is the mechanism whereby domestic prices respond to foreign prices. The latter mechanism is relatively slow as it works through wages and the price of goods and services in various sectors. For example, prices in the retail sector may not immediately adjust one-for-one with any rise in the prices of agricultural products or raw materials.
what is Covered Interest Rate Parity?
Covered Interest Rate Parity (CIRP) is a financial theory that describes the relationship between interest rates and exchange rates. It asserts that the difference in interest rates between two countries should be equal to the difference between the forward exchange rate and the spot exchange rate, assuming no arbitrage opportunities exist. This theory is grounded in the idea that an investor cannot make a risk-free profit by exploiting discrepancies between interest rates in different countries, because the forward exchange rate adjusts to prevent such arbitrage.
The CIRP Formula:
𝐹
=
𝑆
×
(
1
+
𝑖
𝑑
1
+
𝑖
𝑓
)
F=S×(
1+i
f
1+i
d
)
Where:
𝐹
F = Forward exchange rate
𝑆
S = Spot exchange rate
𝑖
𝑑
i
d
= Interest rate in the domestic country
𝑖
𝑓
i
f
= Interest rate in the foreign country
Key Concepts:
Spot Exchange Rate (S): The current exchange rate at which one currency can be exchanged for another.
Forward Exchange Rate (F): The exchange rate agreed upon today for a currency transaction that will occur at a future date (often 30, 90, or 180 days).
Domestic Interest Rate (i_d): The interest rate offered in the domestic country.
Foreign Interest Rate (i_f): The interest rate offered in the foreign country.
How Covered Interest Rate Parity Works:
If an investor is considering lending or borrowing in one currency and converting the funds to another currency, the difference in interest rates between the two countries will determine the expected movement of the exchange rate over time.
The forward exchange rate is adjusted in a way that eliminates any potential for arbitrage between the interest rates of two countries. This means that investors cannot make risk-free profits by borrowing in one country, converting the currency, and lending in another country.
For example:
If the interest rate in the U.S. is 2% and the interest rate in the Eurozone is 4%, then the forward exchange rate for EUR/USD should be set in such a way that the investor is indifferent between investing in the U.S. or the Eurozone. Any deviation from this would present an arbitrage opportunity.
Why It Matters:
Arbitrage Prevention: CIRP ensures there is no arbitrage opportunity between countries by adjusting the forward exchange rate.
Currency Hedging: The concept of CIRP is useful for businesses and investors who need to hedge currency risk. By entering into forward contracts, they can lock in exchange rates and eliminate the risk of adverse currency movements.
Currency Exchange Rate Movements: It explains how interest rates can influence exchange rates and helps in forecasting future exchange rates based on the difference in interest rates.
Assumptions:
No Arbitrage: There are no risk-free profit opportunities available in the market.
Capital Mobility: Investors can freely move capital across countries without restrictions.
Perfect Substitutes: The financial instruments in different countries are perfect substitutes, meaning there is no credit risk and no transaction costs involved.
Limitations:
Transaction Costs: In the real world, transaction costs, such as bid-ask spreads and commissions, can prevent CIRP from holding perfectly.
Capital Controls: Some countries impose restrictions on capital movement, which can prevent the implementation of CIRP.
Risk: The theory assumes no risk of default, but in reality, there may be credit risks or political risks involved in international transactions.
In practice, Covered Interest Rate Parity is often used to explain and predict the movements of exchange rates and is a cornerstone of modern international finance theory.
1) What are alternative investments?
Although there is no universally accepted definition, they can be referred to as an investment
in any asset class other than the traditional asset classes such as stocks, bonds, foreign
exchange, and cash. Examples may range from gold, art, real estate investment trusts
(REITs), hedge funds, cryptocurrency, etc
What are the main risks involved in investing in alternative assets compared to traditional ones?
the main risks involved in investing in alternative assets compared to traditional ones:
Low liquidity – can be hard to sell quickly e.g., art or real estate,
- Hard to value – can be hard to value and often down to a matter of opinion
- Transaction costs may be high.
- Lack of income from the investments (usually not the case however with real estate),
- The price greatly relies on trends and fashions,
- Regulation lacking (can be a good or bad characteristic),
- Fraud and forgery
How are hedge funds different to mutual funds?
hedge funds different to mutual funds becaase of:
a) Are private investment vehicles that pool resources together, not publicly available
b) Portfolios are much more concentrated
c) Tend to use derivatives much more
d) Go long and short much more
e) Invest in non-public securities
f) Use a lot of leverage
How can investors gain exposure to commodity markets?
investors gain exposure to commodity markets by investment in:
a) The underlying commodity
b) Natural resource companies
c) Commodity future contracts
d) Commodity swaps and forward contracts
e) Commodity-linked assets
Explain the role of Venture Capital Funds?
the role of Venture Capital Funds are to:
VC Funds invests/supports young companies or startup ventures
- Most venture capital funds are set up as limited partnerships
- The management company of VC starts with its own money and raises additional
capital from limited partners such as pension funds. - The success of the new firm depends on the management Therefore, venture capital company places a certain number of restrictions on management to minimise the risk of financial loss
The management company of VC usually sits on the start-up company’s board
of directors
What are the main disadvantages of real estate investments?
the main disadvantages of real estate investments are:Illiquid market
o Properties cannot be quickly and easily sold without a substantial loss in value
longer-term strategy
* Higher fees
o Agent’s commission, closing costs, title search fees, appraisal fees, legal fees,
and government fees (e.g., stamp duty land tax, etc.)
* Significant risks due to the many market inefficiencies
o Real Estate Cycles (recovery, expansion, hypersupply, and recession)
* Management and maintenance
o Financing payments, real estate taxes, insurance, management fees, and
maintenance costs
* Government controls
o policies used to, e.g., maintain the real estate value, prevent bubbles)
* Legal Complexity
What are the main advantages of cryptocurrencies?
They are online ledgers and therefore money can be sent between individuals on a peer-topeer basis without the need to go through a financial institution. They have no physical
association with any authority/country, have no physical representation, and have been
argued to be an alternative currency.
what is the volitility of risk free assets?
risk free assets like t bills have zero volitility.
If you have two risky assets, what is meant by the opportunity set?
It’s the set of all possible combinations of two risky assets (weights w₁ and w₂, where w₁ + w₂ = 1) using only the investor’s own wealth.
The return-risk relationship forms a curve, showing all achievable portfolios and trade-offs between risk and return.
What is another nathe for the Sharpe ratio?
Sharpe Ratio is also known as the Reward-to-Variability Ratio
what is abother name for the treynor ratio?
Treynor Ratio is also called the Reward-to-Beta Ratio
What is the equation for aversion?
U = E(R) - 1/2 A σ 2
Where:
U = investor’s utility
E(r) = expected return
σ 2= variance of the portfolio
A = coefficient of risk aversion
