CHAPTER 5
THE FOREIGN EXCHANGE MARKET
1. Definitions. Define the following terms:
b. Foreign exchange transaction. A foreign exchange transaction is an agreement between a buyer
2. Functions of the Foreign Exchange Market. What are the three major functions of the foreign
exchange market?
3. Structure of the FX Market. How is the global foreign exchange market structured? Is digital
telecommunications replacing people?
One of the biggest changes in the foreign exchange market in the past decade has been its shift from a
two-tier market (the interbank or wholesale market and the client or retail market) to a single-tier
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4. Market Participants. For each of the foreign exchange market participants, identify their motive for
buying or selling foreign exchange.
Foreign exchange dealers are banks and a few nonbank institutions that “make a market” in
foreign exchange. They buy and sell foreign exchange in the wholesale market and resell or rebuy
5. Foreign Exchange Transaction. Define each of the following types of foreign exchange
transactions:
a. Spot. A spot transaction is an agreement between two parties to exchange one currency for
another, with the transaction being carried out at once for commercial customers and on the
6. Swap Transactions. Define and differentiate the different type of swap transactions in the foreign
exchange markets.
Chapter 5 The Foreign Exchange Market 27
Spot Against Forward. The most common type of swap is a “spot against forward.” The dealer buys
Forward-Forward Swaps. A more sophisticated swap transaction is called a forward-forward swap.
Nondeliverable Forwards (NDFs). Created in the early 1990s, the nondeliverable forward (NDF) is
7. Nondeliverable Forward. What is a nondeliverable forward, and why does it exist?
The nondeliverable forward (NDF) is now a relatively common derivative offered by the largest
8. Foreign Exchange Market Characteristics. With reference to foreign exchange turnover in 2010:
9. Foreign Exchange Rate Quotations. Define and give an example of each of the following quotes:
a. Bid rate quote.
b. Ask rate quote.
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10. Reciprocals. Convert the following indirect quotes to direct quotes and direct quotes to indirect
quotes:
a. Euro: €1.22/$ (indirect quote); 1/1.22 = $0.8197/€ (direct)
11. Geographical Extent of the Foreign Exchange Market.
b. What are the two main types of trading systems? (1) Trading on an exchange or exchange floor
c. How are foreign exchange markets connected for trading activities? Telecommunications
linkages.
12. American and European Terms. With reference to interbank quotations, what is the difference
between American terms and European terms?
Chapter 5 The Foreign Exchange Market 29
© 2016 Pearson Education, Inc.
Under American terms, foreign exchange rates are stated as the U.S. dollar price of one unit of
foreign currency. Note that European terms and American terms are reciprocals:
1USD 0.6250 / SF
SF1.60000 / USD
=
With several exceptions, including two important ones, most interbank quotations around the world
are stated in European terms. Thus, throughout the world the normal way of quoting the relationship
between the Swiss franc and U.S. dollar is SF1.6000/$; this method may also be called “Swiss terms.”
A Japanese yen quote of ¥118.32/$ is called “Japanese terms,” although the expression “European
terms” is often used as the generic name for Asian as well as European currency prices of the dollar.
European terms were adopted as the universal way of expressing foreign exchange rates for most (but
not all) currencies in 1978 to facilitate worldwide trading through telecommunications
13. Direct and Indirect Quotes. Define and give an example of the following:
a. An example of a direct quote between the U.S. dollar and the Mexican peso, where the United
States is designated as the home country.
b. An example of an indirect quote between the Japanese yen and the Chinese renminbi (yuan),
where China is designated as the home country.
14. Base and Price Currency. Define base currency, unit currency, price currency, and quote currency.
Foreign exchange quotations follow a number of principles, which at first may seem a bit confusing
or nonintuitive. Every currency exchange involves two currencies, currency 1 (CUR1) and currency 2
(CUR2):
CUR1/CUR2
EUR/USD 1.2174
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© 2016 Pearson Education, Inc.
overview of the multitude of terms often used around the world to quote currencies through an
example using the European euro and U.S. dollar.
15. Cross Rates and Intermarket Arbitrage. Why are cross currency rates of special interest when
discussing intermarket arbitrage?
16. Percentage Change in Exchange Rates. Why do percentage change calculations end up being rather
confusing on occasion?
Foreign Currency Terms. When the foreign currency price (the price, Ps) of the home currency (the
Home Currency Terms. When the home currency price (the price) for a foreign currency (the unit)