chunty

Donna Ackerman, CFA, is an analyst in the currency trading department at State Bank. Ackerman is training a new hire, Fred Bos, a recent college graduate with a BA in economics.
Ackerman and Bos have the following information available to them:

Spot Rates
	Bid Price	Ask Price
USD:EUR	1.0000	1.0015
USD:GBP	2.0000	2.0100

Ackerman asks Bos to determine the bid-ask spread (the difference between the ask price and the bid price) for GBP:EUR. The answer is:

A) GBP:EUR 0.0017.

B) GBP:EUR 0.0033.

C) GBP:EUR 0.0085.

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The bid price is 1.0000 / 2.0100 = GBP:EUR 0.4975.
The ask price is 1.0015 / 2.0000 = GBP:EUR 0.5008.
The bid-ask spread is 0.5008 − 0.4975 = 0.0033.

chunty

On a recent vacation, John Dorn exchanged $100 U.S. for euros. Dorn did not spend any of the euros, so at the end of the trip, he exchanged the euros back for dollars. If the bid-ask quote during this period was USD:EUR 1.04-1.13, how many dollars did Dorn have at the end of the trip?

A) $95.

B) $108.

C) $92.

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$100(bid USD:EUR 1.04) = 104 EUR
104 EUR / (ask USD:EUR 1.13) = $92

chunty

A Hong Kong company needs to pay one of its suppliers 8,000,000 Indian rupees 90 days from now. The company is worried that rupees will appreciate during this time and decides to partially hedge its exchange rate risk by entering a contract to purchase half of the rupees 90 days into the future for a price of HKD:INR 5.9364. The current exchange rate is HKD:INR 5.7921.
90 days later, the exchange rate is HKD:INR 5.8764. What is the gain/loss of entering this forward contract?

A) −6,880 HKD.

B) 9,906 HKD.

C) 6,880 HKD.

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By entering into the forward contract, the company gained [(4,000,000 / 5.8764) − (4,000,000 / 5.9364)] = 6,880 HKD.

tango_gs

Which of the following statements about exchange rates is most accurate?

A) The bid-ask spread is a function of breadth, depth, and volatility of the market for a currency.

B) Given the bid-ask spread between pesos and dollars is 6.0000-6.0025, and the bid-ask spread between pounds and dollars is 2.0000-2.0015, then the bid-ask spread between pesos and pounds is 2.875-2.934.

C) A bid of USD:MXN 8.000, means the bank will sell you 1 USD for 8 MXN.

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When the bank bids they are buying and you are selling. Spot exchange rates, forward exchange rates, and interest rates are closely linked. The bid-ask spread between pesos and pounds is 6.0000/2.0015 = 2.9978 and 6.0025/2.0000 = 3.0013.

tango_gs

Which of the following statements about exchange rates is least accurate?

A) In a perfect world, triangular currency arbitrage keeps exchange rates in equilibrium.

B) The gain or loss on a forward contract is directly related to the current spot rate.

C) Arbitrage cannot work effectively in the presence of government regulations hampering the flow of funds across borders.

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The gain or loss on a forward contract is unrelated to the spot rate. Gains or losses are measured relative to the forward contract rate, not the spot rate. Forward contracts call for delivery of a specified amount of a currency quoted against the dollar on a specific future date.

tango_gs

If the forward exchange rate is FCC 2 and the spot rate is FCC 1.9 when the foreign rate of return is 12% and the domestic return is 10%, which of the following statements would be most accurate?

A) Arbitrage is possible here, investors should borrow domestic, lend foreign.

B) Arbitrage is possible here, investors should borrow foreign, lend domestic.

C) The arbitrage possibilities cannot be determined with the data given.

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Question 1: Is there an arbitrage opportunity?
If the result of the following formula (derived from rearranging the interest rate parity condition) is not equal to 0, there is an arbitrage opportunity.
(1 + rdomestic) − [((1 + rforeign) × ForwardFCC)) / SpotFCC] = ?
Here, ( 1 + 0.10 ) − [ (( 1 + 0.12 ) × 2.0FCC ) / 1.9FCC ] = ( 1.10 − 1.18 ) = -0.08, which is not equal to 0. Arbitrage opportunities exist.
Question 2: Borrow Domestic (local) or Foreign? Here are some "rules" regarding where to start the arbitrage (where to borrow). These rules only work if there are no transaction costs and only if the currency is quoted in FCC terms.
Rule 1: If the sign on the result of question 1 is negative, borrow domestic. If the sign is positive, borrow foreign. Here, the sign is negative, so borrow domestic.
Rule 2: See table below.

(rd − rf) < (Forward − Spot) / Spot	Borrow Domestic
(rd − rf) > (Forward − Spot) / Spot	Borrow Foreign

Here, borrow domestic.

(rd − rf)		(Forward - Spot) / Spot
( 0.10 − 0.12 )		( 2.0FCC − 1.9FCC ) / 1.9FCC
-0.02	<	0.05

Summary: To take advantage of arbitrage opportunities, borrow domestic and lend foreign.

tango_gs

Which of the following would least likely be a participant in the forward market?

A) Long-term investors.

B) Arbitrageurs.

C) Traders.

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Forward contracts are for 30, 90, 180, and 360-day periods and would, therefore, be considered short-term investment choices. Other participants in the forward market are hedgers who use forward contracts to protect the home currency value of foreign currency denominated assets on their balance sheets over the life of the contracts involved.

tango_gs

Which of the following statements related to the foreign exchange market is least accurate?

A) The bid-ask spread is a function of trading volume, volatility, and term of the forward contract.

B) Foreign exchange brokers provide information, anonymity, and reduced trading time.

C) The settlement date in the spot market is two days after the trade. A Friday trade would be settled on Monday.

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In the spot market, currency trades are for immediate delivery, which is defined as two business days after the transaction.

tango_gs

Immediate delivery is assumed in which market?

A) Currency swap market.

B) Spot market.

C) Forward market.

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Forward markets are contracts for future delivery. Currency swaps involve a combination of spot and forward transactions.

tango_gs

Given the following information:

• 
  The U.S. interest rate is 6%.
• 
  The spot rate is USD:GBP 2.2000.
• 
  The forward rate is USD:GBP 2.0000.
• 
  The domestic Great Britain interest rate is 8%.

Which of the following statements is CORRECT?

A) Capital will flow into Great Britain.

B) If you start by borrowing 1,000 GBP, your arbitrage profits will be 116 GBP.

C) If you start by borrowing $1,000, your arbitrage profits will be $128.

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We know that arbitrage is possible because 2.2 × (1.08/1.06) = 2.2415 > 2.0. This means that the GBP is overvalued in the forward market (it takes too few of them to buy one USD), and should be sold forward. This means that we need to buy GBP today so that we have them to sell forward.Step 1: Borrow $1,000 at 6% (repay $1,060 in one year), convert the $1,000 at the spot rate to 2,200 GBP
Step 2: Lend out the GBP 2,200 at 8% (will receive GBP 2,376 in one year)
Step 3: Sell the GBP forward at the quoted forward rate, 2,376/2.0 = $1,188
Step 4: Repay loan, $1,188 − $1,060 = $128 profit