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CHAPTER 5 THE MARKET FOR FOREIGN EXCHANGE
ANSWERS & SOLUTIONS TO END-OF-CHAPTER QUESTIONS AND PROBLEMS
QUESTIONS
1. Give a full definition of the market for foreign exchange.
Answer: Broadly defined, the foreign exchange (FX) market encompasses the conversion of
purchasing power from one currency into another, bank deposits of foreign currency, the extension
2. What is the difference between the retail or client market and the wholesale or interbank
market for foreign exchange?
Answer: The market for foreign exchange can be viewed as a two-tier market. One tier is the
wholesale or interbank market and the other tier is the retail or client market. International
banks provide the core of the FX market. They stand willing to buy or sell foreign currency for
3. Who are the market participants in the foreign exchange market?
Answer: The market participants that comprise the FX market can be categorized into five
groups: international banks, bank customers, non-bank dealers, FX brokers, and central banks.
International banks provide the core of the FX market. Approximately 100 to 200 banks
worldwide make a market in foreign exchange, i.e., they stand willing to buy or sell foreign
Most interbank trades are speculative or arbitrage transactions where market participants
attempt to correctly judge the future direction of price movements in one currency versus
FX brokers match dealer orders to buy and sell currencies for a fee, but do not take a
Central banks sometimes intervene in the foreign exchange market in an attempt to
influence the price of its currency against that of a major trading partner, or a country that it
“fixes” or “pegs” its currency against. Intervention is the process of using foreign currency
4. How are foreign exchange transactions between international banks settled?
Answer: The interbank market is a network of correspondent banking relationships, with large
commercial banks maintaining demand deposit accounts with one another, called
correspondent bank accounts. The correspondent bank account network allows for the efficient
functioning of the foreign exchange market. As an example of how the network of
correspondent bank accounts facilities international foreign exchange transactions, consider a
5. What is meant by a currency trading at a discount or at a premium in the forward market?
Answer: The forward market involves contracting today for the future purchase or sale of
6. Why does most interbank currency trading worldwide involve the U.S. dollar?
Answer: Trading in currencies worldwide is against a common currency that has international
appeal. That currency has been the U.S. dollar since the end of World War II. However, the
7. Banks find it necessary to accommodate their clients’ needs to buy or sell FX forward, in
many instances for hedging purposes. How can the bank eliminate the currency exposure it
has created for itself by accommodating a client’s forward transaction?
Answer: Swap transactions provide a means for the bank to mitigate the currency exposure in a
forward trade. A swap transaction is the simultaneous sale (or purchase) of spot foreign
exchange against a forward purchase (or sale) of an approximately equal amount of the foreign
currency. To illustrate, suppose a bank customer wants to buy dollars three months forward
8. A CAD/$ bank trader is currently quoting a small figure bid-ask of 35-40, when the rest of the
market is trading at CAD1.3436-CAD1.3441. What is implied about the trader’s beliefs by his
prices?
Answer: The trader must think the Canadian dollar is going to appreciate against the U.S. dollar
and therefore he is trying to increase his inventory of Canadian dollars by discouraging
9. What is triangular arbitrage? What is a condition that will give rise to a triangular arbitrage
opportunity?
Answer: Triangular arbitrage is the process of trading out of the U.S. dollar into a second
currency, then trading it for a third currency, which is in turn traded for U.S. dollars. The purpose
Most, but not all, currency transactions go through the dollar. Certain banks specialize in
making a direct market between non-dollar currencies, pricing at a narrower bid-ask spread than
10. Over the past five years, the exchange rate between British pound and U.S. dollar, $/£, has
changed from about 1.90 to about 1.45. Would you agree that over this five-year period that
British goods have become cheaper for buyers in the United States?
CFA Guideline Answer:
The value of the British pound in U.S. dollars has gone up from about 1.90 to about 1.45.
PROBLEMS
1. Using the American term quotes from Exhibit 5.4, calculate a cross-rate matrix for the euro,
Swiss franc, Japanese yen, and the British pound so that the resulting triangular matrix is similar
to the portion above the diagonal in Exhibit 5.6.
Solution: The cross-rate formula we want to use is:
S(j/k) = S($/k)/S($/j).
The triangular matrix will contain 4 x (4 + 1)/2 = 10 elements.
¥ SF £ $
2. Using the American term quotes from Exhibit 5.4, calculate the one-, three-, and six-month
forward cross-exchange rates between the Australian dollar and the Swiss franc. State the
forward cross-rates in “Australian” terms.
Solution: The formulas we want to use are:
FN(AD/SF) = FN($/SF)/FN($/AD)
or
FN(AD/SF) = FN(AD/$)/FN(SF/$).
We will use the top formula that uses American term forward exchange rates.
3. A foreign exchange trader with a U.S. bank took a short position of £5,000,000 when the $/£
exchange rate was 1.55. Subsequently, the exchange rate has changed to 1.61. Is this
movement in the exchange rate good from the point of view of the position taken by the trader?
By how much has the bank’s liability changed because of the change in the exchange rate?
CFA Guideline Answer:
The increase in the $/£ exchange rate implies that the pound has appreciated with respect to
4. Restate the following one-, three-, and six-month outright forward European term bid-ask
quotes in forward points.
Spot 1.3431-1.3436
Solution:
One-Month 01-06
5. Using the spot and outright forward quotes in problem 4, determine the corresponding bid-
ask spreads in points.
Solution:
Spot 5
6. Using Exhibit 5.4, calculate the one-, three-, and six-month forward premium or discount for
the Japanese yen versus the U.S. dollar using American term quotations. For simplicity,
assume each month has 30 days. What is the interpretation of your results?
Solution: The formula we want to use is:
fN,CD = [(FN($/¥) - S($/¥/$)/S($/¥)] x 360/N
The pattern of forward premiums indicates that the Japanese yen is trading at a premium versus
7. Using Exhibit 5.4, calculate the one-, three-, and six-month forward premium or discount for
the U.S. dollar versus the British pound using European term quotations. For simplicity, assume
each month has 30 days. What is the interpretation of your results?
Solution: The formula we want to use is:
fN,$ = [(FN (£/$) - S(£/$))/S(£/$)] x 360/N
The pattern of forward premiums indicates that the dollar is trading at a premium versus the
8. A bank is quoting the following exchange rates against the dollar for the Swiss franc and
the Australian dollar:
An Australian firm asks the bank for an A$/SFr quote. What cross-rate would the bank
quote?
CFA Guideline Answer:
The SFr/A$ quotation is obtained as follows. In obtaining this quotation, we keep in mind that
The SFr/A$ bid price is the number of SFr the bank is willing to pay to buy one A$. This
transaction (buy A$—sell SFr) is equivalent to selling SFr to buy dollars (at the bid rate of
The SFr/A$ ask price is the number of SFr the bank is asking for one A$. This transaction
(sell A$—buy SFr) is equivalent to buying SFr with dollars (at the ask rate of 1.5970 and then
