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CHAPTER 5 The Market for Foreign Exchange

Function and Structure of the FX Market
International Finance in Practice: The Mouse Takes Over the Floor
FXMarketParticipants
CorrespondentBankingRelationships
International Finance in Practice: Where Money Talks Very Loudly
The Spot Market
SpotRateQuotations
TheBidAskSpread
SpotFXTrading
CrossExchangeRateQuotations
AlternativeExpressionsfortheCrossExchangeRate
TheCrossRateTradingDesk
TriangularArbitrage
SpotForeignExchangeMarketMicrostructure
The Forward Market
ForwardRateQuotations
LongandShortForwardPositions
ForwardCrossExchangeRates
SwapTransactions
ForwardPremium
Summary
MINI CASE: Shrewsbury Herbal Products, Ltd.

Function and Structure of the FX Market

1 The worlds largest foreign exchange trading center is:
a) New York
b) Tokyo
c) London
d) Hong Kong
Answer: c)
2

On average, worldwide daily trading of foreign exchange is

a) impossible to estimate
b) $15 billion
c) $504 billion
d) $1.88 trillion
Answer: d)
3

The foreign exchange market closes

a) Never
b) 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)
FXMarketParticipants
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Most foreign exchange transactions are for:

a) Intervention by central banks
b) Interbank trades between international banks or nonbank dealers
c) retail trade
d) purchase of hard currencies
Answer: b)
5

The difference between a broker and a dealer is

a) 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 above
Answer 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 are

a) Speculative or arbitrage transactions
b) Simple order processing for the retail client
c) Overnight loans from one bank to another
d) Brokered by dealers
Answer a)
7

At the wholesale level

a) Most trading takes place OTC between individuals on the floor of the exchange
b) Most trading takes place over the phone
c) Most trading flows over Reuters and EBS platforms
d) Most trading flows through specialized broking firms
Answer: 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)

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CorrespondentBankingRelationships
9

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, $500,000
b) Credit, 512,100
c) Credit, $500,000
d) Debit 512,100
Answer: a)
Rationale: debit, since the importer is paying. $500,000 = 512,100$1.00/1.0242
The Spot Market
10 The spot market
a) Involves the almost-immediate purchase or sale of foreign exchange.
b) Involves the sale of futures, forwards, and options on foreign exchange
c) Takes place only on the floor of a physical trading floor
d) All of the above.
Answer: a)
11 Spot foreign exchange trading
a) accounts for about 5 percent of all foreign exchange trading
b) accounts for about 20 percent of all foreign exchange trading
c) accounts for about 35 percent of all foreign exchange trading
d) accounts for about 70 percent of all foreign exchange trading
Answer: d)
SpotRateQuotations
Country
Britain (Pound) 62,500
1 Month Forward
3 Months Forward
6 Months Forward
12 Months Forward

U.S. $ equiv.
Tuesday
Monday
1.6000
1.6100
1.6100
1.6300
1.6300
1.6600
1.6600
1.7200
1.7200
1.8000

Currency per U.S. $

Tuesday
Monday
0.625
0.6211
0.6211
0.6173
0.6173
0.6024
0.6024
0.5814
0.5814
0.5556

12 Using the table shown, what is the most current spot exchange rate shown for British
pounds? Use a direct quote
a) $1.61 = 1.00
b) $1.60 = 1.00
c) $1.00 = 0.625
d) $1.72 = 1.00
Answer: b)
13 It is common practice among currency traders worldwide to both price and trade
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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 transaction
a) 90 percent
b) 75 percent
c) 45 percent
d) 15 percent
Answer: a)
14 Suppose that the current exchange rate is 0.80 = $1.00. The direct quote, from the
U.S. perspective is
a) 1.00 = $1.25
b) 0.80 = $1.00
c) 1.00 = $1.80
d) None of the above
Answer: a)
Rationale: The direct quotation, from the U.S. perspective, the price of one unit of the
foreign currency priced in U.S. dollars.
TheBidAskSpread
15 The Bid price
a) Is the price that the dealer has paid for something, his historical cost
b) Is the price that a dealer stands ready to pay
c) Refers only to auctions like eBay, not over the counter transactions with dealers
d) Is the price that a dealer stands ready to sell at
Answer: b
The bid price is the price a dealer will pay; the ask price is the price he charges to sell.
Answer a) is a bit tricky, but the dealers historical cost is not necessarily the price at
which he will be willing to buy more
16 Suppose the spot ask exchange rate, Sa($|), 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) $1,000,000
b) $52,910.05
c) $100,000
d) $52,631.58
Answer: d)
1.00
First, buy $10m in pounds: $10, 000, 000
5, 263,157.895
$1.90
$1.89
Rationale:
then sell the pounds for dollars: 5, 263,157.895
$9,947,368.42
1.00
Net loss to bid-ask spread = $10, 000, 000 $9,947,368.42 $52, 631.58
17 If the $/ bid and ask prices are $1.50 and $1.51, respectively, the corresponding /$
bid and ask prices are:
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a) 0.6667 and 0.6623

b) $1.51 and $1.50
c) 0.6623 and 0.6667
d) cannot be determined with the information given
Answer: c)
Rationale: 1/$1.51 = ask price = 0.6623 bid price/$1;
1/$1.50 bid price = 0.6667 ask price/$1.
See equation 5-3:
1
1
0.6623
S a ($ | ) b

S ($ | ) $1.51
$1.00
SpotFXTrading
18 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) $1.9077
b) 1
c) 1.90
d) 77
Answer: c)
19 in the Interbank market, the standard size of a trade among large banks in the major
currencies is
a) for the U.S.-dollar equivalent of $10,000,000,000
b) for the U.S.-dollar equivalent of $10,000,000
c) for the U.S.-dollar equivalent of $100,000.
d) for the U.S.-dollar equivalent of $1,000
Answer: b)
20 A dealer in British pounds who thinks that the pound is about to appreciate
a) May want to widen his bid-ask spread by raising his ask price
b) May want to lower his bid price
c) May want to lower his ask price
d) None of the above
Answer: 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)

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CrossExchangeRateQuotations
Country
Britain (Pound) 62,500
1 Month Forward
3 Months Forward
6 Months Forward
12 Months Forward
Euro 62,500
1 Month Forward
3 Months Forward
6 Months Forward
12 Months Forward

U.S. $ equiv.
Tuesday
Monday
1.6000
1.6100
1.6100
1.6300
1.6300
1.6600
1.6600
1.7200
1.7200
1.8000
1.2000
1.2000
1.2100
1.2100
1.2300
1.2300
1.2600
1.2600
1.2900
1.3200

Currency per U.S. $

Tuesday
Monday
0.625
0.6211
0.6211
0.6173
0.6173
0.6024
0.6024
0.5814
0.5814
0.5556
0.833333
0.833333
0.82645
0.82645
0.813008
0.813008
0.793651
0.793651
0.775194
0.7575758

21 Using the table shown, what is the spot cross-exchange rate between pounds and
euro?
a) 1.00 = 0.75
b) 1.33 = 1.00
c) 1.00 = 0.75
d) none of the above
Answer: a)
$1.20 1.00

0.75 you also get the same result with indirect quotes
Rationale: 1
1 $1.60
22 The dollar-euro exchange rate is $1.25 = 1.00 and the dollar-yen exchange rate is
100 = $1.00. What is the euro-yen cross rate?
a) 125 = 1.00
b) 1.00 = 125
c) 1.00 = 0.80
d) None of the above
Answer: a)
23 The AUD/$ spot exchange rate is AUD1.60/$ and the SF/$ is SF1.25/$. The AUD/SF
cross exchange rate is:
a) 0.7813
b) 2.0000
c) 1.2800
d) 0.3500
Answer: c)
AUD1.60
$1
AUD1.28

Rationale:
$1
SF1.25
SF1.25

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AlternativeExpressionsfortheCrossExchangeRate
24 The euro-pound cross exchange rate can be computed as:
a) S(/) = S($/) S(/$)
S($/)
b) S(/) =
S($/)
S(/$)
c) S(/) =
S(/$)
d) all of the above
Answer: d)
TheCrossRateTradingDesk
25 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 trade
b) 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 as
a) Sb(/) = Sb($/) Sb(/$)
b) Sa(/) = Sa(/$) Sa($/)
1
c) Sb(/) = Sb($/) a
S ( / $)
d) All of the above
Answer: d)
Rationale: The bank could alternatively quote its customer an ask price for pounds in
terms of euro or quote a bid price for euro in terms of pounds. Someone who sells euro
will sell them to the dealer for dollars at the dealers bid price, Sb($/), then he will buy
1
a
pounds with dollars from the dealer at his asking price , S ( / $) b
.
S ($ / )
TriangularArbitrage
27 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 profit
b) $46,093 loss
c) No profit is possible
d) $46,093 profit
Answer: d)
S $1.60 CD1.00
$1

$1, 046, 093

Rationale: $1, 000, 000
$1
S $1.15 CD1.33
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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 possible
b) $1,160,000
c) $500,000
d) $250,000
Answer: a)
1.00 1.50 $1.20

$1, 000,000
Rationale: $1, 000, 000
$1.80 1.00 1.00
SpotForeignExchangeMarketMicrostructure
29 Market microstructure refers to
a) The basic mechanics of how a marketplace operates
b) The basics of how to make small (micro-sized) currency trades.
c) How macroeconomic variables such as GDP and inflation are determined
d) None of the above
Answer: 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 within
a) ten seconds
b) one minute.
c) five minutes
d) one hour
Answer: 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 Market
31 The forward price
a) May be higher than the spot price
b) May be the same as the spot price
c) May be less than the spot price
d) All of the above
Answer: d)

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32 Relative to the spot price the forward price will be

a) Usually less than the spot price
b) Usually more than the spot price
c) Usually equal to the spot price
d) 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 price
a) The currency is trading at a premium in the forward market
b) The currency is trading at a discount in the forward market
c) Then you should buy at the spot, hold on to it and sell at the forwardits a builtin arbitrage.
d) All of the aboveit really depends if youre talking American or European quotes
Answer: 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 market
a) 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 above
Answer: b)
ForwardRateQuotations
35 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-$0.7609
b) $0.7572-$0.7641
c) $0.7512-$0.7616
d) cannot be determined with the information given
Answer: b)
Rationale:
forward bid = $0.7560 + 0.0012 = $0.7572;
forward ask = $0.7625 + 0.0016 = $0.7641.

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LongandShortForwardPositions
36 If one has agreed to buy foreign exchange forward
a) You have a short position in the forward contract
b) You have a long position in the forward contract
c) Until the exchange rate moves, you havent made money, so youre neither short
nor long
d) You have a long position in the spot market
Answer: 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 $100
b) Made 100
c) Lost $50
d) Made $150
Answer: 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 forward
d) Sell pounds today at the spot rate, buy them forward
Answer; 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.

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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 $1.50)
Answer d), while tempting from an accounting standpoint, is wrong since the question
asks you to make money with futures, not by holding a spot position.
ForwardCrossExchangeRates
40 Which of the following are correct?
FN ($ / k )
a) FN ( j / k )
FN ($ / j )
FN ( j / $)
b) FN ( j / k )
FN (k / $)
FN ($ / j )
c) FN (k / j )
FN ($ / k )
d) all of the above are correct.
Answer: d)
Rationale: these are equations 5.14, 5.15, and 5.16.
SwapTransactions
41 Swap transactions
a) 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 above
d) Involve trades of one foreign currency for another without going through the U.S.
dollar
Answer: a)

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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 rate
b) the outright forward rate is more than the spot exchange rate
c) the currency will trade at a premium in the forward contract
d) none of the above
Answer: 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 peers
d) 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:
Spot
1.9072-1.9077
Forward Point Quotations
One-month
32-30
Three-month
57-54
1.9015-1.9023
Six-month
145-138
1.8927-1.8939
a) 1.9040-1.9047
b) 1.9042-1.9049
c) 1.9032-1.9030
d) none of the above
Answer: a)
ForwardPremium
45 When a currency trades at a premium in the forward market
a) The exchange rate is more than one dollar (e.g. 1.00 = $1.28)
b) The exchange rate is less than one dollar
c) The forward rate is less than the spot rate
d) The forward rate is more than the spot rate.
Answer: d)
46 When a currency trades at a discount in the forward market
a) The forward rate is less than the spot rate
b) The forward rate is more than the spot rate.
c) The forward exchange rate is less than one dollar (e.g. 1.00 = $0.928)
d) The exchange rate is less than it was yesterday
Answer: a)
47 The SF/$ spot exchange rate is SF1.25/$ and the 180 day forward exchange rate is
SF1.30/$. The forward premium (discount) is:
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a) The dollar is trading at an 8% premium to the Swiss franc for delivery in 180 days.
b) The dollar is trading at a 4% premium to the Swiss franc for delivery in 180 days.
c) The dollar is trading at an 8% discount to the Swiss franc for delivery in 180 days.
d) The dollar is trading at a 4% discount to the Swiss franc for delivery in 180 days.
Answer: a)
1.30 1.25 360

0.08 or 8% If youre curios about the premium or discount

Rationale:
1.25
180
thing, notice that your dollar-denominated holding period return is negative for
someone who buys at the spot and sells at the forward:
$0.77 / SF $0.80 / SF 360

0.08 or 8%
$0.80 / SF
180
48 The SF/$ spot exchange rate is SF1.25/$ and the 180 forward premium is 8 percent.
What is the outright 180 day forward exchange rate?
a) SF1.30/$
b) SF1.35/$
c) SF6.25/$
d) None of the above
Answer: a)
1.30 1.25 360

0.08 or 8%
Rationale:
1.25
180
Summary
49 The largest and most active financial market in the world is
a) The Fleet Street Exchange in London
b) The NYSE in New York
c) The FX market
d) None of the above
Answer: c).
50 Nondollar currency transactions
a) Are priced by looking at the price that must exist to eliminate arbitrage.
b) Allow for triangular arbitrage opportunities to keep the currency dealers
employed.
c) Are only for poor people who dont have dollars.
d) None of the above.
Answer: a)

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