WEEK 1 - Foreign Exchange and the Foreign Exchange Market

Question 1

What exactly is foreign exchange?

Answer 1

Act of trading one country’s currency for another

Question 2

What can drive FOREX?

Answer 2

Tourism and Illegal Activity -> Lead to movement of bank notes across national borders

Question 3

What does the foreign exchange market consist of?

Answer 3

1. Private Banks -> Bid for others or themselves
2. Foreign Exchange Dealers and Brokers
3. Central Banks -> Ownership of currencies (only ones that can issue the currency)

via which
-> Households, Firms and Govts (Customers) participate in FOREX

Question 4

In 2016 what were the 3 most traded currencies?

Answer 4

2016 -> 5.088 Trillion traded

1. USD/EUR -> 23% of total trading
2. USD/YEN -> 17.7% of total trading
3. USD/GBP -> 9.2%

Trading Volume:
UK -> 2,426 BN (37.1%)
US -> 1,272 BN (19.4%)

Question 5

What make up most of transactions?

Answer 5

Interbank trading and speculation

Question 6

How does interbank trading work and what is its benefit?

Answer 6

Trading among banks themselves
Only for banks

Positive:

• Allow banks to readjust position in foreign currency quickly at low cost
  e. g. Citibank too much yen -> Can sell to other banks and buy dollars quickly

Question 7

What does the overall forex market look like?

Answer 7

SEE GRAPH IN NOTES

Question 8

What is an exchange rate and how is it expressed?

Answer 8

Price of one currency in terms of another:
e.g. $1.4 =£1

Expressed as $/£ = 1.4 (per £1 =$1.4)

Question 9

How do we find the pound price of £1 (following $/£ = 1.4)

Answer 9

£/$ = 0.71 (1/1.4)

Question 10

How do we calculate appreciation and depreciation?

Answer 10

e.g.
BEFORE: £/$ = 0.71
NOW: £/$ = 0.67

% CHANGE IN VALUE OF DOLLAR
% change £/$ = (NOW - BEFORE)/BEFORE = -.0.0563 = 5.63% Depreciation

Question 11

What is a Spot Market?

Answer 11

Mkt of immediate sale or purchase of an asset

Question 12

What is a Forward market?

Answer 12

Exchange of Currency at specified future date

Question 13

What is the Bid/Offer Spread?

Answer 13

Bid Rate -> Rate at which currency is bought
Offer Rate -> Rate at which currency sold

Spread is difference between the two

-> Only shows last 3 digits of the rate

Question 14

What is Arbitrage?

Answer 14

Creating position to realise riskless profit from mkt disequilibrium (BID/OFFER IN EACH MARKET)

Question 15

What is Speculation?

Answer 15

Creating positions to realise profit from his/her expectations

• Risk taking position
• Betting on actual future price or expected future price
• Either gain or lose

Question 16

How can Arbitrage firms make money? (2 point arbitrage)

Answer 16

SEE GRAPH IN NOTES FOR BETTER EXPLANATION

Question 17

How can Arbitrage Firms make money? (3 point arbitrage)

Answer 17

SEE GRAPH IN NOTES FOR BETTER EXPLANATION

Question 18

Why are there so many flucuations in SR?

Answer 18

1. Inventory Control:
   Effect of exchange rate when traders alter quotes to maintain balance between amount of currency bought and sold to ‘square off’ during the day
2. Asymmetric Info:
   Changes due to trader fear that they quoting prices to someone who knows more about current conditions than they do

Question 19

What are some of the causes of Asymmetric Info?

Answer 19

Order Flow: (Which Currency is requested becomes info)
e.g If people want to buy JPY from you 3 times in one day, something might be happening

Insider Info

Question 20

What causes LR Fluctuations of exchange rate?

Answer 20

• Econ Factors:

Change in Demand for domestic goods relative to foreign goods causing more movement in exchange rates

Question 21

What is the trade flow model?

Answer 21

Supply and Demand Model to explain LR movements of exchange rates

D of £
- US Importers want to buy UK goods, need to buy £
S of £
- UK Importers want to buy US goods, need to give up £ for $,

Equilibrium as S=D

SEE GRAPHS IN NOTES

Question 22

What is a Exchange rate index?

Answer 22

Broad measure of avg value of currency relative to several other major currencies

e.g USD against avg value of 10 currencies