Topic 3 - The Market For Foreign Exchange Flashcards
Why does most interbank currency trading worldwide involve the U.S. dollar?
Trading in currencies worldwide is against a common currency that has international appeal. That currency has been the U.S. dollar since the end of World War II. However, the euro and Japanese yen have started to be used much more as international currencies in recent years. More importantly, trading would be exceedingly cumbersome and difficult to manage if each trader made a market against all other currencies
A CD/$ bank trader is currently quoting a small figure bid-ask of 35-40, when the rest of the market is trading at CD1.3436-CD1.3441. What is implied about the trader’s beliefs by his prices?
The trader must think the Canadian dollar is going to appreciate against the U.S. dollar and therefore he is trying to increase his inventory of Canadian dollars by standing willing to buy $ at only CD1.3435/$1.00 (As a client wanting to sell $, you will choose to sell $ to the rest of the market at a higher price) and offering to sell from inventory at the slightly lower than market price of CD1.3440/$1.00 (As a client wanting to buy $, you are attracted to the lower price offered by this trader. As a result, you buy $ from this trader using the CD; the trader ends up with more CD). The future appreciation of the CD will provide an opportunity to make profit on the CD inventory.
Over the past five years, the exchange rate between British pound and U.S. dollar, $/£, has changed from about 1.90 to about 1.45. Would you agree that over this five-year period that British goods have become cheaper for buyers in the United States?
The value of the British pound in U.S. dollars has gone from about 1.90 to about 1.45. The British pound has depreciated relative to the dollar. Therefore, the dollar has appreciated relative to the British pound, and the dollars needed by Americans to purchase British goods have decreased. Thus, the statement is correct
What is meant by a currency trading at a discount or at a premium in the forward market?
The forward market involves contracting today for the future purchase or sale of foreign exchange. The forward price may be the same as the spot price, but usually it is higher (at a premium) or lower (at a discount) than the spot price.
Give a full definition of the market for foreign exchange.
Broadly defined, the foreign exchange (FX) market encompasses the conversion of purchasing power from one currency into another, bank deposits of foreign currency, the extension of credit denominated in a foreign currency, foreign trade financing, and trading in foreign currency options and futures contracts.
What is the difference between the retail or client market and the wholesale or interbank market for foreign exchange?
The market for foreign exchange can be viewed as a two-tier market. One tier is the wholesale or interbank market and the other tier is the retail or client market. International banks provide the core of the FX market. They stand willing to buy or sell foreign currency for their own account. These international banks serve their retail clients, corporations or individuals, in conducting foreign commerce or making international investment in financial assets that requires foreign exchange. Retail transactions account for only about 14 percent of FX trades. The other 86 percent is interbank trades between international banks, or non-bank dealers large enough to transact in the interbank market.
Who are the market participants in the foreign exchange market?
The market participants that comprise the FX market can be categorized into five groups: international banks, bank customers, non-bank dealers, FX brokers, and central banks. I
How are foreign exchange transactions between international banks settled?
The interbank market is a network of correspondent banking relationships, with large commercial banks maintaining demand deposit accounts with one another, called correspondent bank accounts. The correspondent bank account network allows for the efficient functioning of the foreign exchange market. As an example of how the network of correspondent bank accounts facilities international foreign exchange transactions, consider a U.S. importer desiring to purchase merchandise invoiced in guilders from a Dutch exporter. The U.S. importer will contact his bank and inquire about the exchange rate. If the U.S. importer accepts the offered exchange rate, the bank will debit the U.S. importer’s account for the purchase of the Dutch guilders. The bank will instruct its correspondent bank in the Netherlands to debit its correspondent bank account the appropriate amount of guilders and to credit the Dutch exporter’s bank account. The importer’s bank will then debit its books to offset the debit of U.S. importer’s account, reflecting the decrease in its correspondent bank account balance.
What is triangular arbitrage? What is a condition that will give rise to a triangular arbitrage opportunity?
Triangular arbitrage is the process of trading out of the U.S. dollar into a second currency, then trading it for a third currency, which is in turn traded for U.S. dollars. The purpose is to earn an arbitrage
profit via trading from the second to the third currency when the direct exchange between the two is not in alignment with the cross exchange rate.
Most, but not all, currency transactions go through the dollar. Certain banks specialize in making a direct market between non-dollar currencies, pricing at a narrower bid-ask spread than the cross-rate spread. Nevertheless, the implied cross-rate bid-ask quotations impose a discipline on the non-dollar market makers. If their direct quotes are not consistent with the cross exchange rates, a triangular arbitrage profit is possible.
foreign exchange market
ncompasses the conversion of purchasing power from one currency into another, bank deposits of foreign currency, the extension of credit denominated in foreign currency, foreign trade financing, trading in foreign currency options and futures, and currency swaps
direct quotes
a foreign exchange rate quoted as the domestic currency per unit of the foreign currency
indirect quotes
the quantity of foreign currency required to buy units of the domestic currency
most currencies in inter bank market are quotes how
in European terms: ex. us dollar priced in terms of foreign currency (indirect quote)
bid price
the price at which an inter bank trader buys currencies for inventory, quoted as per us dollar (European term)
ask price
the price at which inter bank trader sells currency from inventory, quoted as in us dollar (American term)
