Topic 1: Introduction to Foreign Exchange markets and Risks

Question 1

Types of contracts

Answer 1

Immediate: Spot
Future: Forwards/FX Swaps
Futures
Options

Question 2

Quoting foreign exchange rates

Answer 2

GBP100 = USD1 (same as..)
¥100 = $1 (…)
¥100/$
JPY100/USD
USDJPY=100
(^Whatever you are converting into, you put as the denominator)

Question 3

Direct Quotes

Answer 3

e.g., in U.S., every good is denoted as the domestic currency ($) price of
the good (e.g., $2 per an apple)

In the US, what is a direct quote for the British pound?
the number of dollars that it takes to purchase one pound

Question 4

Indirect quotes

Answer 4

In principle, we could also use the quote “0.5 apple per $1”
– the number of apples that it takes to purchase one dollar. This is
called as indirect quote

In the US, what is the indirect quote for the British pound?
the number of pounds that it takes to purchase one dollar

Question 5

Reciprocals in quoting FX rates

Q: In the US, what is the indirect quote for the British pound?

Answer 5

A: the number of pounds that it takes to purchase one dollar

We need to compute ‘X’ in ‘USDGBP = X’

Note: GBPUSD =1.3545 → exchange GBP1 for USD1.3545

GBP 1/1.3545 for USD1
Then USDGBP = 1/1.3545 = 0.7382

(USDGBP = 𝟏/GBPUSD)

Question 6

Market conventions

Answer 6

For GBP and EUR, we frequently use the Dollar price of these currencies
(e.g. $1.3/£ and $1.2/€ - GBPUSD=1.3, EURUSD=1.2)

For other currencies, we use the foreign currency price of one dollar
(e.g. ¥107.10/$ - USDJPY = 107.10)

Question 7

Cross rates

Answer 7

Exchange rates between two currencies that do not involve USD (often not posted in FX markets)

Question 8

Computing cross rates

Answer 8

Formula: EURCAD = EURUSD × USDCAD

Question 9

Triangular transactions

GBPEUR = USDEUR × GBPUSD
How to interpret the above equality?

Answer 9

A trader can
i) buy GBP by selling EUR directly (GBPEUR) in the market or

ii) buy USD by selling EUR (USDEUR) and simultaneously selling USD to buy GBP (GBPUSD). In other words, buy GBP by trading three currencies.

Question 10

Triangular arbitrage

Answer 10

GBPEUR ≠ (USDEUR) × (GBPUSD)

Then a trader can conduct a triangular arbitrage. Triangular arbitrage is
a process that keeps cross-rates in line with exchange rates quoted
relative to the US dollar until we recover the equality.

Note: arbitrage profits are earned when someone can buy something at a
low price and sell it at a higher price, without risk.

Question 11

No arbitrage equilbrium

Answer 11

Follows the same process as Arbitrage strategy, however when you buy a certain currency it drives up its value, and when you sell its decreases its value.

Question 12

Bid Price

Answer 12

The Bid price of GBPUSD is the dollar price at which the FX dealer buyers pounds from customer.

Question 13

Ask price

Answer 13

The Ask price of GBPUSD is the same, but for selling to the customer

Question 14

Bid-Ask spread

Answer 14

FX dealers buy at low price and sell at high price (Bid-ask spread)

The Bid price of USDGBP = ( 𝟏/
the Ask price of GBPUSD)

The Ask price of USDGBP = ( 𝟏/
the Bid price of GBPUSD)

Question 15

Changes in Exchange rates

Answer 15

Currencies ‘Appreciate’ and ‘Depreciate’, instead of increase and decrease.

When we compute, we always put the currency we are computing in the denominator.
(e.g. if computing JPY, we use JPYUSD)

Question 16

Calculating Ap/Dep

Answer 16

The percentage rate of change of the exchange rate:

100 ×
(𝑁𝑒𝑤 𝑒𝑥𝑐ℎ𝑎𝑛𝑔𝑒 𝑟𝑎𝑡𝑒 −𝑜𝑙𝑑 𝑒𝑥𝑐ℎ𝑎𝑛𝑔𝑒 𝑟𝑎𝑡𝑒)/
(𝑜𝑙𝑑 𝑒𝑥𝑐ℎ𝑎𝑛𝑔𝑒 𝑟𝑎𝑡𝑒)

Question 17

Foreign Exchange Risk

Answer 17

The possibility of taking a loss in the foreign exchange transactions because future spot exchange rates are not known today with certainty.

Question 18

Quantifying FX Risk

Answer 18

Can calculate using Historical data:

(New ex. rate - old ex. rate)/ (old ex. rate)

Question 19

Foreign exchange risk/Forecasting

Answer 19

What if you believe the future is not going to be similar to the past? (unprecedented event like Brexit)

Then you want to forecast the future distribution of GBPUSD (say, next month) using all information available today (conditional distribution).

For simplicity, we are going to assume the conditional distribution of exchange rate follows normal distribution.

Question 20

Mean + volatility forecasts

Answer 20

Suppose the conditional volatility (i.e., STD) of the change in GBPUSD ($/£) over 90 days is 4%. What is the conditional volatility of the
distribution of future spot exchange rate at t+90?

STDt[S(t+90, $/£)] = 1.50 × 0.04 = 0.06

Question 21

Forward contract

Answer 21

A (outright) forward contract between a bank and a customer calls for a delivery at a fixed future date (maturity), of a specific amount of one currency with payment of another using the price (known as the forward rate) today.

Question 22

Attributes of a forward contract

Answer 22

Highly customisable
Most active maturities are 30,60,90,180 days
No money changes hands till the maturity date

Question 23

Forward bid-ask spreads

Answer 23

They are larger than in spot markets, and widen as the maturity increases

->In order to compensate forward market dealers for the counter party default risk

Question 24

FX swap

Answer 24

FX swap contract is the simultaneous purchase and sale of a certain amount of foreign currency for two different dates

Typically involves the spot sale of a currency combined with a simultaneous forward repurchase (or vice versa) of that same currency

Question 25

Forward premiums and discounts

Answer 25

When the forward rate of USDJPY (¥/$) is less than the spot rate, there is a forward discount on the dollar

-> because its less expensive to purchase dollars in the forward market than the spot

Question 26

The Bid price of GBPEUR

Answer 26

The Bid price of GBPUSD × The Bid price of USDEUR

Question 27

The Ask price of GBPEUR

Answer 27

The Ask price of GBPUSD × The Ask price of USDEUR

Question 28

Spot FX dealers (e.g., banks) buy £ at…

Answer 28

…the bid price of GBPUSD and sell £ at the ask price of GBPUSD

Question 29

Spot FX dealers (e.g., banks) buy $ at …

Answer 29

…the bid price of USDGBP and sell $ at the ask price of USDGBP

Question 30

“$/£” in this course indicates…

Answer 30

“GBPUSD”

Question 31

Appreciation/depreciation on £

Answer 31

CH = S(t+1, $/£)−S(t, $/£)/ S(t, $/£)

→ S(t+1, $/£) =
S(t, $/£) × (1+ CH)

Question 32

Distribution of S(t+1, $/£) - Mean

Answer 32

Et[S(t+1, $/£)] = S(t, $/£) × (1+ Et[CH])

Question 33

Distribution of S(t+1, $/£) - STD

Answer 33

STDt[S(t+1, $/£)] = S(t, $/£) × STDt[CH]

Question 34

68-95-99 rule on the distribution of
S(t+1, $/£)

Answer 34

95% bounds: Et[S(t+1, $/£)] ± 2 × STDt[S(t+1, $/£)]

Question 35

Forward premium/discount on £

Answer 35

100 x (360/N) x [F(t, $/£)−S(t, $/£) / S(t, $/£)]

where N is the maturity