Ch005 Market for Foreign Exchange.doc

Eun & Resnick 4eCHAPTER 5 The Market for Foreign ExchangeFunction and Structure of the FX MarketInternational Finance in Practice: The Mouse Takes Over the FloorFX Market ParticipantsCorrespondent Banking RelationshipsInternational Finance in Practice: Where Money Talks Very LoudlyThe Spot MarketSpot Rate QuotationsThe Bid-Ask SpreadSpot FX TradingCross-Exchange Rate QuotationsAlternative Expressions for the Cross-Exchange RateThe Cross-Rate Trading DeskTriangular ArbitrageSpot Foreign Exchange Market MicrostructureThe Forward MarketForward Rate QuotationsLong and Short Forward PositionsForward Cross-Exchange RatesSwap TransactionsForward PremiumSummaryMINI CASE: Shrewsbury Herbal Products, Ltd.Function and Structure of the FX Market1 The worlds largest foreign exchange trading center is:a) New Yorkb) Tokyoc) Londond) Hong KongAnswer: c)2 On average, worldwide daily trading of foreign exchange isa) impossible to estimateb) $15 billionc) $504 billiond) $1.88 trillionAnswer: d)3 The foreign exchange market closesa) Neverb) 4:00 p.m. EST (New York time)c) 4:00 p.m. GMT (London time)d) 4:00 p.m. (Tokyo time)Answer: a)FX Market Participants4 Most foreign exchange transactions are for:a) Intervention by central banksb) Interbank trades between international banks or nonbank dealersc) retail traded) purchase of hard currenciesAnswer: b)5 The difference between a broker and a dealer isa) Dealers sell drugs, brokers sell houses.b) Brokers bring together buyers and sellers, but carry no inventory. Dealers stand ready to buy and sell from their inventory.c) Brokers transact in stocks and bonds; currency is bought and sold through dealers.d) None of the aboveAnswer b)Rationale: if someone complains about a) being correct, ask them who would sell a crack house or a meth lab.6 Most Interbank trades area) Speculative or arbitrage transactionsb) Simple order processing for the retail clientc) Overnight loans from one bank to anotherd) Brokered by dealersAnswer a)7 At the wholesale levela) Most trading takes place OTC between individuals on the floor of the exchangeb) Most trading takes place over the phonec) Most trading flows over Reuters and EBS platformsd) Most trading flows through specialized “broking” firmsAnswer: c)8 Intervention in the foreign exchange market is the process of:a) A central bank requiring the commercial banks of that country to trade at a set price level.b) Commercial banks in different countries coordinating efforts in order to stabilize one or more currencies.c) A central bank buying or selling its currency in order to influence its value.d) The government of a country prohibiting transactions in one or more currencies.Answer: c) Correspondent Banking Relationships9 Consider a U.S. importer desiring to purchase merchandise from a Dutch exporter invoiced in euros, at a cost of 512,100. The U.S. importer will contact his U.S. bank (where of course he has an account denominated in U.S. dollars) and inquire about the exchange rate, which the bank quotes as 1.0242/$1.00. The importer accepts this price, so his bank will _the importers account in the amount of _.a) Debit, $500,000b) Credit, 512,100c) Credit, $500,000d) Debit 512,100Answer: a)Rationale: debit, since the importer is paying. $500,000 = 512,100$1.00/1.0242The Spot Market10 The spot marketa) Involves the almost-immediate purchase or sale of foreign exchange.b) Involves the sale of futures, forwards, and options on foreign exchangec) Takes place only on the floor of a physical trading floord) All of the above.Answer: a)11 Spot foreign exchange trading a) accounts for about 5 percent of all foreign exchange tradingb) accounts for about 20 percent of all foreign exchange tradingc) accounts for about 35 percent of all foreign exchange tradingd) accounts for about 70 percent of all foreign exchange tradingAnswer: d)Spot Rate Quotations CountryU.S. $ equiv.Currency per U.S. $TuesdayMondayTuesdayMondayBritain (Pound) 62,5001.60001.61000.6250.62111 Month Forward1.61001.63000.62110.61733 Months Forward1.63001.66000.61730.60246 Months Forward1.66001.72000.60240.581412 Months Forward1.72001.80000.58140.555612 Using the table shown, what is the most current spot exchange rate shown for British pounds? Use a direct quotea) $1.61 = 1.00b) $1.60 = 1.00c) $1.00 = 0.625d) $1.72 = 1.00Answer: b)13 It is common practice among currency traders worldwide to both price and trade currencies against the U.S. dollar. In fact, BIS statistics indicate that about _ percent of currency trading in the world involves the U.S. dollar on one side of the transactiona) 90 percentb) 75 percentc) 45 percentd) 15 percentAnswer: a)14 Suppose that the current exchange rate is 0.80 = $1.00. The direct quote, from the U.S. perspective isa) 1.00 = $1.25b) 0.80 = $1.00c) 1.00 = $1.80d) None of the aboveAnswer: a)Rationale: The direct quotation, from the U.S. perspective, the price of one unit of the foreign currency priced in U.S. dollars.The Bid-Ask Spread15 The Bid pricea) Is the price that the dealer has paid for something, his historical costb) Is the price that a dealer stands ready to pay c) Refers only to auctions like eBay, not over the counter transactions with dealersd) Is the price that a dealer stands ready to sell atAnswer: bThe bid price is the price a dealer will pay; the ask price is the price he charges to sell. Answer a) is a bit tricky, but the dealers historical cost is not necessarily the price at which he will be willing to buy more16 Suppose the spot ask exchange rate, Sa($|), is $1.90 = 1.00 and the spot bid exchange rate, Sb($|), is $1.89 = 1.00. If you were to buy $10,000,000 worth of British pounds and then sell them five minutes later, how much of your $10,000,000 would be “eaten” by the bid-ask spread?a) $1,000,000b) $52,910.05c) $100,000d) $52,631.58 Answer: d)Rationale:17 If the $/ bid and ask prices are $1.50 and $1.51, respectively, the corresponding /$ bid and ask prices are:a) 0.6667 and 0.6623b) $1.51 and $1.50c) 0.6623 and 0.6667d) cannot be determined with the information givenAnswer: c)Rationale: 1/$1.51 = ask price = 0.6623 bid price/$1; 1/$1.50 bid price = 0.6667 ask price/$1.See equation 5-3:Spot FX Trading18 In conversation, Interbank FX trades use a shorthand abbreviation in expressing spot currency quotations. Consider a $/ bid-ask quote of $1.9072-$1.9077. The “big figure”, assumed to be known to all traders is:a) $1.9077b) 1c) 1.90d) 77Answer: c)19 in the Interbank market, the standard size of a trade among large banks in the major currencies isa) for the U.S.-dollar equivalent of $10,000,000,000b) for the U.S.-dollar equivalent of $10,000,000c) for the U.S.-dollar equivalent of $100,000.d) for the U.S.-dollar equivalent of $1,000Answer: b)20 A dealer in British pounds who thinks that the pound is about to appreciatea) May want to widen his bid-ask spread by raising his ask priceb) May want to lower his bid pricec) May want to lower his ask priced) None of the aboveAnswer: c) Rationale: A dealer who thinks that the pound is about to appreciate will want to increase his inventory, none of the strategies listed will accomplish this. While a)Cross-Exchange Rate Quotations CountryU.S. $ equiv.Currency per U.S. $TuesdayMondayTuesdayMondayBritain (Pound) 62,5001.60001.61000.6250.62111 Month Forward1.61001.63000.62110.61733 Months Forward1.63001.66000.61730.60246 Months Forward1.66001.72000.60240.581412 Months Forward1.72001.80000.58140.5556Euro 62,5001.20001.20000.8333330.8333331 Month Forward1.21001.21000.826450.826453 Months Forward1.23001.23000.8130080.8130086 Months Forward1.26001.26000.7936510.79365112 Months Forward1.29001.32000.7751940.757575821 Using the table shown, what is the spot cross-exchange rate between pounds and euro?a) 1.00 = 0.75b) 1.33 = 1.00c) 1.00 = 0.75d) none of the aboveAnswer: a)Rationale: you also get the same result with indirect quotes22 The dollar-euro exchange rate is $1.25 = 1.00 and the dollar-yen exchange rate is 100 = $1.00. What is the euro-yen cross rate?a) 125 = 1.00b) 1.00 = 125c) 1.00 = 0.80d) None of the aboveAnswer: a)23 The AUD/$ spot exchange rate is AUD1.60/$ and the SF/$ is SF1.25/$. The AUD/SF cross exchange rate is:a) 0.7813b) 2.0000c) 1.2800d) 0.3500Answer: c)Rationale:Alternative Expressions for the Cross-Exchange Rate24 The euro-pound cross exchange rate can be computed as:a) S(/) = S($/) S(/$)b)c)d) all of the aboveAnswer: d)The Cross-Rate Trading Desk25 Suppose a bank customer wishes to trade out of British pounds and into Swiss francs.a) In dealer jargon, this is a currency against currency tradeb) The bank will frequently handle such a trade by selling British pounds for U.S. dollars and then buying francs with U.S. dollars.c) The bank would sell the British pounds directly for Swiss francs.d) a) and b) but not c)Answer: d)26 Including the transactions costs of the bid-ask spread, the euro-pound cross exchange rate for a customer who wants to sell euro and buy pounds can be computed asa) Sb(/) = Sb($/) Sb(/$)b) Sa(/) = Sa(/$) Sa($/)c) Sb(/) = Sb($/) d) All of the aboveAnswer: d)Rationale: The bank could alternatively quote its customer an ask price for pounds in terms of euro or quote a bid price for euro in terms of pounds. Someone who sells euro will sell them to the dealer for dollars at the dealers bid price, Sb($/), then he will buy pounds with dollars from the dealer at his asking price , .Triangular Arbitrage27 The Singapore dollarU.S. dollar (S$/$) spot exchange rate is S$1.60/$, the Canadian dollarU.S. dollar (CD/$) spot rate is CD1.33/$ and the S$/CD1.15. Determine the triangular arbitrage profit that is possible if you have $1,000,000. a) $44,063 profitb) $46,093 lossc) No profit is possibled) $46,093 profitAnswer: d) Rationale: 28 You are a U.S.-based treasurer with $1,000,000 to invest. The dollar-euro exchange rate is quoted as $1.20 = 1.00 and the dollar-pound exchange rate is quoted at $1.80 = 1.00. If a bank quotes you a cross rate of 1.00 = 1.50 how much money can an astute trader make?a) No arbitrage is possibleb) $1,160,000c) $500,000d) $250,000Answer: a) Rationale: Spot Foreign Exchange Market Microstructure29 Market microstructure refers toa) The basic mechanics of how a marketplace operatesb) The basics of how to make small (micro-sized) currency trades.c) How macroeconomic variables such as GDP and inflation are determinedd) None of the aboveAnswer: a)30 A recent survey of U.S. foreign exchange traders measured traders perceptions about how fast news events that cause movements in exchange rates actually change the exchange rate. The survey respondents claim that the bulk of the adjustment to economic announcements regarding unemployment, trade deficits, inflation, GDP, and the Federal funds rate takes place withina) ten secondsb) one minute.c) five minutesd) one hourAnswer: b). The answer is “one minute” but note that one-third of the respondents claim that full price adjustment takes place in less than ten seconds. You might consider partial credit for response a).The Forward Market31 The forward price a) May be higher than the spot priceb) May be the same as the spot pricec) May be less than the spot priced) All of the aboveAnswer: d)32 Relative to the spot price the forward price will be a) Usually less than the spot priceb) Usually more than the spot pricec) Usually equal to the spot priced) Usually less than or more than the spot price more often than it is equal to the spot price.Answer: d) 33 For a U.S. trader working in American quotes, if the forward price is higher than the spot pricea) The currency is trading at a premium in the forward marketb) The currency is trading at a discount in the forward marketc) Then you should buy at the spot, hold on to it and sell at the forwardits a built-in arbitrage.d) All of the aboveit really depends if youre talking American or European quotesAnswer: a)Rationale: d) is tricky and you will get some students lobbying hard for ituntil you remind them to read the question carefully.34 The forward marketa) Involves contracting today for the future purchase of sale of foreign exchange at the spot rate that will prevail at the maturity of the contract.b) Involves contracting today for the future purchase of sale of foreign exchange at a price agreed upon today.c) Involves contracting today for the right but not obligation to the future purchase of sale of foreign exchange at a price agreed upon today.d) None of the aboveAnswer: b)Forward Rate Quotations35 The $/CD spot bid-ask rates are $0.7560-$0.7625. The 3-month forward points are 12-16. Determine the $/CD 3-month forward bid-ask rates.a) $0.7548-$0.7609b) $0.7572-$0.7641c) $0.7512-$0.7616d) cannot be determined with the information givenAnswer: b)Rationale: forward bid = $0.7560 + 0.0012 = $0.7572; forward ask = $0.7625 + 0.0016 = $0.7641.Long and Short Forward Positions36 If one has agreed to buy foreign exchange forwarda) You have a short position in the forward contractb) You have a long position in the forward contractc) Until the exchange rate moves, you havent made money, so youre neither short nor longd) You have a long position in the spot marketAnswer: b)37 The current spot exchange rate is $1.55/ and the three-month forward rate is $1.50/. You enter into a short position on 1,000. At maturity, the spot exchange rate is $1.60/. How much have you made or lost?a) Lost $100b) Made 100c) Lost $50d) Made $150Answer: a)Rationale: Your loss will be $100 = 1,000 ($1.50/ $1.60/)38 The current spot exchange rate is $1.55/ and the three-month forward rate is $1.50/. Based on your analysis of the exchange rate, you are confident that the spot exchange rate will be $1.52/ in three months. Assume that you would like to buy or sell 1,000,000. What actions do you need to take to speculate in the forward market? a) Take a long position in a forward contract on 1,000,000 at $1.50/. b) Take a short position in a forward contract on 1,000,000 at $1.50/. c) Buy pounds today at the spot rate, sell them forwardd) Sell pounds today at the spot rate, buy them forwardAnswer; a) Rationale: Your expected profit will be $20,000 = 1,000,000 ($1.52 $1.50)c) and d) are wrong because the question asks “What actions do you need to take to speculate in the forward market?” not the spot market. In addition, there is no information regarding interest rates.39 The current spot exchange rate is $1.55/ and the three-month forward rate is $1.50/. Based on your analysis of the exchange rate, you are confident that the spot exchange rate will be $1.52/ in three months. Assume that you would like to buy or sell 1,000,000. What actions do you need to take to speculate in the forward market? What is the expected dollar profit from speculation?a) Sell 1,000,000 forward for $1.50/. b) Buy 1,000,000 forward for $1.50/. c) Wait three months, if your forecast is correct buy 1,000,000 at $1.52/d) Sell 1,000,000 today at $1.55/; wait three months, if your forecast is correct buy 1,000,000 back at $1.52/Answer: b)Rationale: if you agree to buy 1,000,000 forward for $1.50/ and the price is actually turns out to be $1.52/ in three months, your expected profit will be $20,000 = 1,000,000 ($1.52 $1.50)Answer d), while tempting from an accounting standpoint, is wrong since the question asks you to make money with futures, not by holding a spot position.Forward Cross-Exchange Rates40 Which of the following are correct?a)b)c)d) all of the above are correct.Answer: d)Rationale: these are equations 5.14, 5.15, and 5.16. Swap Transactions41 Swap transactionsa) Involve the simultaneous sale (or purchase) of spot foreign exchange against a forward purchase (or sale) of approximately an equal amount of the foreign currency.b) Account for about half of Interbank FX trading.c) All of the aboved) Involve trades of one foreign currency for another without going through the U.S. dollarAnswer: a)42 As a rule, when the interest rate of the foreign currency is greater than the interest rate of the quoting currency, a) the outright forward rate is less than the spot exchange rateb) the outright forward rate is more than the spot exchange ratec) the currency will trade at a premium in the forward contractd) none of the aboveAnswer: a)43 Bank dealers in conversations among themselves use a shorthand notation to quote bid and ask forward prices in terms of forward points. This is convenient because:a) Forward points may change faster than spot and forward quotes.b) In swap transactions where the trader is attempting to minimize currency exposure the actual spot and outright forward rates are often of no consequence.c) Its cool to look smart around your peersd) Time is money.Answer: b)44 Bank dealers in conversations among themselves use a shorthand notation to quote bid and ask forward prices in terms of forward points. Complete the following table:Spot1.9072-1.9077Forward P