CHAPTER 5 The Market for Foreign Exchange
Function and Structure of the FX Market
International Finance in Practice: The Mouse Takes Over the Floor
FX Market Participants
Correspondent Banking Relationships
International Finance in Practice: Where Money Talks Very Loudly
The Spot Market
Spot Rate Quotations
The Bid-Ask Spread
Spot FX Trading
Cross-Exchange Rate Quotations
Alternative Expressions for the Cross-Exchange Rate
The Cross-Rate Trading Desk
Triangular Arbitrage
Spot Foreign Exchange Market Microstructure
The Forward Market
Forward Rate Quotations
Long and Short Forward Positions
Forward Cross-Exchange Rates
Swap Transactions
Forward Premium
Summary
MINI CASE: Shrewsbury Herbal Products, Ltd.
Function and Structure of the FX Market
1The world’s largest foreign exchange trading center is:
a)New York
b)Tokyo
c)London
d)Hong Kong
Answer: c)
2On average, worldwide daily trading of foreign exchange is
a)impossible to estimate
b)$15 billion
c)$504 billion
d)$1.88 trillion
Answer: d)
3The foreign exchange market closes
a)Never
b)4: EST (New York time)
c)4: GMT (London time)
d)4: (Tokyo time)
Answer: a)
FX Market Participants
4Most foreign exchange transactions are for:
a)Intervention by central banks
b)Interbank trades between international banks or nonbank dealers
c)retail trade
d)purchase of hard currencies
Answer: b)
5The difference between a broker and a dealer is
a)Dealers sell drugs, brokers sell houses.
b)Brokers bring together buyers and sellers, but carry no inventory. Dealers stand ready to buy and sell from their inventory.
c)Brokers transact in stocks and bonds; currency is bought and sold through dealers.
d)None of the above
Answer b)
Rationale: if someone complains about a) being correct, ask them who would sell a crack house or a meth lab.
6Most Interbank trades are
a)Speculative or arbitrage transactions
b)Simple order processing for the retail client
c)Overnight loans from one bank to another
d)Brokered by dealers
Answer a)
7At the wholesale level
a)Most trading takes place OTC between individuals on the floor of the exchange
b)Most trading takes place over the phone
c)Most trading flows over Reuters and EBS platforms
d)Most trading flows through specialized “broking” firms
Answer: c)
8Intervention in the foreign exchange market is the process of:
a)A central bank requiring the commercial banks of that country to trade at a set price level.
b)Commercial banks in different countries coordinating efforts in order to stabilize one or more currencies.
c)A central bank buying or selling its currency in order to influence its value.
d)The government of a country prohibiting transactions in one or more currencies.
Answer: c)
Correspondent Banking Relationships
9Consider a U.S. importer desiring to purchase merchandise from a Dutch exporter invoiced in euros, at a cost of €512,100. The U.S. importer will contact his U.S. bank (where of course he has an account denominated in U.S. dollars) and inquire about the exchange rate, which the bank quotes as €1.0242/$1.00. The importer accepts this price, so his bank will ____________the importer’s account in the amount of ____________.
a)Debit, $500,000
b)Credit, €512,100
c)Credit, $500,000
d)Debit €512,100
Answer: a)
Rationale: debit, since the importer is paying. $500,000 = €512,100×$1.00/€1.0242
The Spot Market
10The spot market
a)Involves the almost-immediate purchase or sale of foreign exchange.
b)Involves the sale of futures, forwards, and options on foreign exchange
c)Takes place only on the floor of a physical trading floor
d)All of the above.
Answer: a)
11Spot foreign exchange trading
a)accounts for about 5 percent of all foreign exchange trading
b)accounts for about 20 percent of all foreign exchange trading
c)accounts for about 35 percent of all foreign exchange trading
d)accounts for about 70 percent of all foreign exchange trading
Answer: d)
Spot Rate Quotations
Country
U.S. $ equiv.
Currency per U.S. $
Tuesday
Monday
Tuesday
Monday
Britain (Pound) £62,500
1.6000
1.6100
0.625
0.6211
1 Month Forward
1.6100
1.6300
0.6211
0.6173
3 Months Forward
1.6300
1.6600
0.6173
0.6024
6 Months Forward
1.6600
1.7200
0.6024
0.5814
12 Months Forward
1.7200
1.8000
0.5814
0.5556
12Using the table shown, what is the most current spot exchange rate shown for British pounds? Use a direct quote
a)$1.61 = £1.00
b)$1.60 = £1.00
c)$1.00 = £0.625
for the saled)$1.72 = £1.00
Answer: b)
13It is common practice among currency traders worldwide to both price and trade currencies against the U.S. dollar. In fact, BIS statistics indicate that about __ percent of currency trading in the world involves the U.S. dollar on one side of the transaction

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