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74 Cards in this Set

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  • Back

Forward Rate

Price at which foreign exchange is quoted for delivery at a specified future date

Foreign Currency Demand

Derived from the demand for foreign country's goods, services, and financial assets

How Do Exchange Rates Change (3 ways)

1. Increased demand as more foreign goods are demanded more foreign currency is demanded

2. the price of the foreign currency in local currency increases

3. Home currency Depreciation

Home Currency Depreciation

Foreign currency more valuable than the home currency

What are the 3 factors affecting exchange rates?

1.Inflation Rates

2. Interest rates

3. GNP growth rates

Currency Appreciation Formula

(e1 - e0)/ e0

e0 = old currency value

e1 = new currency value

What is the law of one price?

Identical goods sell for the same price worldwide

Also known as "no arbitrage condition", "no free lunch", "Arbitrage free market"

What are the 5 parity conditions?

1. Purchasing Power Parity (PPP)

2. Fisher Effect (FE)

3. International Fisher Effect (IFE)

4. Interest Rate Parity (IRP)

5. Unbiased Forward Rate (UFR)

Define Purchasing Power Parity (PPP)

states that a unit of home currency should have the same purchasing power around the world. (absolute version of PPP)

Purchasing Power Parity Equation

e(t) (1 + i(h))^t


e(0) (1 + i(f)) ^t

Where e(t) = future spot rate

e(0) = spot rate

i (h) = home inflation

i (f) = foreign inflation

t = the time period

PPP relationship to inflation

The currency with the higher inflation rate is expected to depreciate relative to the currency with the lower rate of inflation

real exchange rate (PPP)

e'(t) is the quoted or nominal rate e(t)* (P(f)/P(h))

Equation for e'(t)

e'(t) e(t) ((1 + i(f)) ^t

____ =_______________

(1+ i(h) )^t

Fisher Effect (FE) definition

states that nominal interest rates (r) are a function of the real interest rate (a) and a premium (i) for inflation expectations

The fisher effect definition formula

r = a +i

What does the Fisher Effect say about countries inflation rates and interest rates

According to the fisher effect: countries with higher inflation rates have higher interest rates

The International Fisher Effect Defined

The spot rate adjusts to the interest rate differential between to countries

IFE = PP + FE equation


e(t) (1 + r(h))^t


e(o) (1 + r(f) ) ^t

What did fisher postulate

1. The nominal interest rate differential should reflect the inflation rate differential

2. Expected rates of return are equal in the absence of government intervention

What is the Simplified IFE equation (approximation) if r(f) is really small

e(1) - e(o)

r(h) - r(f) = -----------


Implications of IFE (2 things)

1. currency with lower interest rate is expecte to appreciate relative to the one with higher rate

2. Financial market arbitrage insures interest rate differential is an unbiased predictor of change in future spot rate

Interest Rate Parity Theory

the forward rate (F) differs from the spot rate (S) at equalibrium by an amount equal to the interest differential r(h) - r(f) between two countries

Interest rate parity theory reationship between premium and discount

The forward premium or discount equals the interest rate differential

Interest Rate Parity Theory equation

(F-S)/S = r(h) - r(f)

Where r(h) = the home rate

r(f) = the foreign rate


Covered interest Arbitrage

conditons required: interest rate differential des not equal the forward premium or discount

funds will move to a country with a more attractive rate

Interest rate Parity Theory

Interest rates and discounts

Higher interest rates on a currency are offset by forward discounts

Lower interest rates are offset by forward premiums

Define the Unbiased Forward Rate

if the forward rate (f(t)) is unbiased, then it should reflect the expected future spot rate (e(t))

f(t) = e(t)

Define the Currency Market

a place where money denominated in one currency is bought and sold with money denmiated in another currency

International Trade and Capital transaction

Facilitated with the ability to transfer purchasing power between countries

Currency Market Location

Otc-type, no specific location

Most trades by phone

Breakdown of participants at foreign exchange markets

Wholesale level 95% Major Banks

retail level (business consumers)

Foreign Exchange Markets

2 types of currency markets

Spot Market

-immediate transaction, recorded by 2nd business day

Forward Market

- transactions take place at a specified future date

Participants in spot and forward markets 7

Commercial banks


customers of commercial and central banks





What are the different types of quotes

1. spot price

2. 30 day

3. 90 day

4. 180 day

Direct quote structure

gives home currency price in numerator


= the price bank will sell currency


= price at which the bank is willing to buy

Percentage spread formula (PS)

Ask - Bid

PS = -------------------- x 100


Cross Rates

exchange rate between 2 non - US$ currencies

Currency Arbitrage definition

1. Possible if the cross rates differ from one financial center to another

2. Buy cheap in one int'l market, sell at a higher price in another

3. The critical role of Available information

Settlement date/ value date

date that monies are due

2nd working day after date of original transaction

What risk is there in exchage markets

Banks are middle men

1. Incurring risk of adverse exchange rate moves

2. increased uncertainty about future exchange rate requires

A. Demand for higher risk premium

B Bankers widen die ask spread

What are the steps to a spot transaction

1. Currency transaction: verbal agreement, U.S. importer specifies

2. Bank sends importer contract note including

3. Settlement

Forward contract definition

an agrrement between a bank and a customer to deliver a specified amount of currency against another currency

- at a specified future date

- at a fixed exchange rate

What is the purpose of forward contract


what is hedging

the act of reducing exchange rate risk

How so you quote a forward rate

1. Outright Rate

2. swap rate

Definition Outright Rate

quoted to commercial customers

Swap Rate

quoted in the inter-bank market as a discount or premium

What is the equation for forward premium/discount

= F-S * 12 * 100


s n

Forward rate equation what is F, S, N

F = the forward rate of exchange

S = the pot rate of exchange

N = the number of months in the forward contract

Future contract definition

contracts written requiring a standard quantity of an available currency as a fixed exchange rate at a set delivery date

What are the two futures contracts safeguards

Maximim price movement rules

Maintenance margins

What is the maximum price movement rules

contracts set daily to a price limit that restricts maximum daily upward and downward movement

Maintenance Margins

when the account balance falls below the maintenance margin, a margin call may be necessary to maintain the minimum balance

6 futures markets exchanges

1. IMM International Monetary Market

2.) Liffe london international financial futures exchange

3.) CBOT chicago Board of Trade

4.) SIMEX Singapore international Monetary Exchange

5) DTB Deutsche Termin Bourse

6) HKFE Hong Kong Futures Exchange

2 Advantages to futures contracts

1) Easy liquidation

2) well organized and stable market

Disadvatages of futures

1. limited to 7 currencies

2. limited dates of delivery

3. rigid contract sizes

Currency option definition

a contract writer (seller) gives the right not the obligation to the holder (the buyer) to buy or sell a standard amount of an available currency at a fixed exchange rate for a fixed time period

Currency Option 2 types



what is a call

give the owner the right to buy the currency


give the owner the right to sell the currency

What is "in the money"

Call: Spot > strike

Put: Spot < strike

Out of the money

Call: Spot < strike

Put: Spot > strike

At the money

Spot = the strike

2 reasons why you should use currency options

1. for a firm hedging foreigh exchange risk when a future event is very uncertain

2. for speculators who profit from favorable exchange rate changes

Define Interest rate swaps

an agreement between 2 parties to exchange US$ interest payments for a specific maturity on an agreed notional amount

define Notional principal

reference amount used only to calculate interest expense but never repaid

Maturity duration

Maturity is less than 1 to over 15 years

What are the 2 types of swaps

Coupon Swap

Basis sawp

coupon swap

basis Swap


most important reference rate in a swap

Swap Usage

to reduce risk potential and costs