Chapter 11

Question 1

Explain the foreign exchange market:

Answer 1

• largest, most liquid financial market globally
• facilities for currency transactions
• dominated by the U.S dollar, euro, Japanese yen, and British pound

Question 2

What is the market structure of the foreign exchange market?

Answer 2

-Three major centers: LDN, NYC, TKY
- Operates at three levels:
1) Between banks and customers
2) Domestic interbank market
3) international bank-to-bank trading

Question 3

What is the automation of Forex trading?

Answer 3

• Most transactions are now electronic
• Trading software automates decisions based on preset rules and real-time chart analysis

Question 4

What are the three types of foreign exchange transactions?

Answer 4

1) Spot transactions:
- Immediate delivery; exposed rate volatility
2) Forward transactions:
- Delivery in the future; used to hedge against rate changes
3) Currency swaps:
- Simultaneous purchase/ sale of current now and reserve exchange in the future

Question 5

What is a forward market?

Answer 5

• Customized contracts specifying delivery date, price, and amount
• Used by banks and customers for hedging or planning

Question 6

What is a futures market?

Answer 6

• Standardized exchange-traded contracts
• Only major currencies traded; contracts specify set amounts and dates

Question 7

What is the difference between forward and futures markets?

Answer 7

Forward: customized, riskier private
Future: standardized, safer, public

Question 8

What are the types of options?

Answer 8

Call option: right to buy currency
Put option: right to sell currency

Question 9

What are cross exchange rates?

Answer 9

Rates between two non-USD currencies are derived from their rates with the USD

Question 10

How is the exchange rate determined?

Answer 10

• Determined by supply and demand in free markets
• Demand driven by imports, investment, tourism, etc
• Supply from exports, asset sales, etc

Question 11

What is the difference between nominal vs. real exchange rates?

Answer 11

• Nominal: unadjusted for price level changes
• Real: adjusted for inflation differences; reflects purchasing power

Question 12

What is the effective exchange rate index?

Answer 12

• Weighted average of a currency’s value against major trading partners
• Reflects overall competitiveness

Question 13

What is interest arbitrage?

Answer 13

• Uncovered: Risky but more profitable
• Covered: safe because you lock in the exchange rate

Question 14

What are forward premiums and discounts?

Answer 14

Premium: Forward rate > spot rate
The country has a lower interest rate

Discount: Forward rate < spot rate
The country has a higher interest rate