Chapter 4- Foreign exchange market

Question 1

General information about the foreign exchange market

Answer 1

• The market where one currency is traded for another.
• Huge Market – 24Hrs a day:– traded value about $5 trillion per day !!!

Competitive and Efficient +many Participants:
– Large Commercial Banks
– Foreign Exchange Brokers
– Multinational Companies
– Central Banks

Question 2

Financial centers

Answer 2

• London
• NY
• Tokyo
• Zurich
• Frankfurt
• Hong Kong
• Singapore
• Paris
• Sydney

Question 3

Spot market/ cash market

Answer 3

A market in which foreign currencies are bought, sold and delivered immediately

Also called “Spot Forex”
- The spot foreign exchange market has a 2 day delivery date (excluding holidays of buyer or seller), originally due to the time it would take to move cash from one bank to another

Question 4

Bid rate

Answer 4

The rate at which the bank is prepared to buy from the investor.
- When you want to sell

Question 5

Ask rate

Answer 5

The rate in which the bank is prepared to sell at the investor.
- When you want to buy

Question 6

The law of one price

Answer 6

The idea that identical products should sell at the same price regardless of where they are sold

– if not someone can make profit

– this is the base theory for the Purchasing Power Parity (PPP)

Question 7

Arbitrage

Answer 7

The simultaneous buying and selling of securities, currency, or commodities in different markets or in derivative forms in order to take advantage of differing prices for the same asset

Question 8

Three restrictions with this law of one price:

Answer 8

1) Transportation costs, barriers to trade and other transaction costs can be significant.

2) The goods must be identical. Different countries consume different goods.

3) The law of one price only applies to tradeable goods; immobile goods such as houses, and many local services are not traded between countries.

Question 9

Purchasing power parity (PPP)

Answer 9

It asks how much money would be needed to purchase the same goods and services in two countries, and uses that to calculate an implicit foreign exchange rate

Formula:

Europrice of domestic goods/euro price of foreign goods = 1

(over the very long term it should be 1)

Question 10

Floating exchange rates

Answer 10

Price determined only by demand and supply of the currency- no government intervention (EUR/USD)

Question 11

Fixed exchange rates

Answer 11

The value of the currency fixed in relation to and anchor currency- not allowed to fluctuate

Question 12

Dirty floating / Managed exchange rate

Answer 12

Rate influenced by the government via central bank around a preferred rate (Switzerland)

Question 13

Exchange rate policy can be characterized along two dimensions

Answer 13

Commitment (Y axis)
Flexibility (X axis)

Question 14

Hard peg

Answer 14

A currency’s price is held permanently at a fixed level

Question 15

Soft peg

Answer 15

A currency’s price is returned to the predefined parity at regular intervals (monthly, weekly, etc)

Question 16

Adjustable peg

Answer 16

The parity price is adjusted as circumstances warrant (monthly, weekly, etc)

Question 17

Crawling peg

Answer 17

A currency’s price is held permanently at a fixed level, but that parity level has prescheduled changes.

Question 18

Target zone

Answer 18

A currency’s price is held permanently between an upper and lower bound

Question 19

Big FOREX advantage eurozone

Answer 19

The 19 members of the eurozone have no currency risk when they trade amongst each other