Chapter 9 - Foreign Exchange Markets (FRM Part 1 - Book 3)
Chapter 9 - Foreign Exchange Markets
Chapter 9 - Foreign Exchange Markets
1. How is the bid-ask spread for a spot currency quote calculated?
A. The difference between the spot bid rate and the forward bid rate
B. The difference between the ask rate of the base and quote currency
C. The difference between the bid rate and the ask rate for the spot quote
D. The difference between the spot rate and the forward rate
The bid-ask spread for a spot currency quote is the difference between the bid rate (the rate at which a dealer buys currency) and the ask rate (the rate at which the dealer sells currency).
2. If a CADUSD spot quote has a bid of 0.7535 and an ask of 0.7541, what is the bid-ask spread?
A. 0.0006
B. 0.0004
C. 0.0008
D. 0.0012
The bid-ask spread is calculated as the ask rate minus the bid rate. In this case, 0.7541 - 0.7535 = 0.0006.
3. What factor contributes to a wider bid-ask spread in a foreign exchange transaction?
A. Larger amounts of currency being traded
B. Smaller amounts of currency being traded
C. Increased dealer competition
D. A more stable market environment
A wider bid-ask spread typically occurs when smaller amounts of currency are traded, as liquidity is reduced, leading to greater risk for the dealer.
4. How is the bid-ask spread for a forward currency quote determined?
A. It is based on the spot quote alone
B. The spread is determined by the dealer’s profit margin
C. It is calculated by subtracting the spot quote from the forward quote
D. It is calculated by adding or subtracting points from the spot quote
The bid-ask spread for forward quotes is calculated by adding or subtracting forward points to the spot quote. The points represent the difference between the forward and spot rates.
5. What typically happens to the bid-ask spread as the term of a forward contract increases?
A. The bid-ask spread tends to widen
B. The bid-ask spread tends to narrow
C. The bid-ask spread remains constant
D. The bid-ask spread is unaffected by the term length
The bid-ask spread tends to widen as the term of the forward contract increases, due to greater uncertainty and risk associated with longer periods.
6. If a CADUSD three-month forward quote has a bid of 90.11 and an ask of 93.91, what is the forward bid-ask spread?
A. 0.0006
B. 0.0004
C. 0.00098
D. 0.0012
The forward bid-ask spread is calculated as the difference between the forward ask and forward bid. Here, 0.763491 - 0.762511 = 0.00098.
7. If the bid/ask points are negative for a forward quote, what happens to the forward rate compared to the spot rate?
A. The forward rate will be less than the spot rate
B. The forward rate will be greater than the spot rate
C. The forward rate will be the same as the spot rate
D. The forward rate will fluctuate randomly in relation to the spot rate
If the bid/ask points are negative for a forward quote, the forward rate will be less than the spot rate. The negative ask points are smaller in magnitude than the negative bid points, leading to a wider bid-ask spread for forward quotes compared to spot quotes.
8. How are futures quotes related to forward quotes?
A. Futures quotes are equal to forward quotes
B. Futures quotes are the inverse of forward quotes
C. Futures quotes are quoted in the same way as spot quotes
D. Futures quotes are higher than forward quotes by a fixed margin
Futures quotes are the inverse of forward quotes. For example, if a forward quote for USDEUR is 0.8700, the futures quote would be 1 / 0.8700 = 1.1494 USD per EUR.
9. What is the primary base currency for forex futures traded by the CME Group?
A. EUR
B. GBP
C. JPY
D. USD
Forex futures traded by the CME Group use USD (U.S. Dollar) as the base currency. This means all futures contracts are quoted in terms of USD per unit of the foreign currency.
10. If a forward quote for USDEUR is 0.8700, what would be the corresponding futures quote?
A. 1.1500
B. 0.8700
C. 1.1494
D. 0.9520
The futures quote is the inverse of the forward quote. If the forward quote for USDEUR is 0.8700, the futures quote would be 1 / 0.8700 = 1.1494 USD per EUR.
11. What is the key difference between an outright (forward) FX transaction and an FX swap transaction?
A. An outright (forward) FX transaction involves a single step, whereas an FX swap involves two steps: a spot market transaction and a forward market transaction
B. An FX swap transaction only occurs in the spot market
C. An outright (forward) FX transaction is more complex than an FX swap
D. An FX swap transaction does not involve forward contracts
The key difference is that an outright (forward) FX transaction involves a single transaction at a future date, whereas an FX swap involves two steps: a spot market transaction followed by a forward market transaction.
12. What does an FX swap transaction typically involve?
A. A one-step transaction that involves the purchase or sale of a currency at a future date
B. A spot market transaction only
C. A spot market transaction followed by a forward market transaction
D. A contract to exchange currencies at the present time
An FX swap involves two steps: (1) an FX buy/sell in the spot market and (2) an FX sell/buy in the forward market.
13. In an FX swap transaction, what is the typical purpose of the second step, the forward market transaction?
A. To lock in the spot price for the currency
B. To generate profit by speculating on currency fluctuations
C. To convert the foreign currency into the local currency
D. To offset the initial spot market transaction and manage currency exposure
The forward market transaction in an FX swap is used to offset the initial spot market transaction and manage currency exposure, such as financing operations or hedging.
14. How does an FX swap help a Canadian company financing its U.S. operations in the example provided?
A. It allows the company to borrow USD in the spot market
B. It allows the company to borrow in CAD and use FX swaps to convert CAD to USD and back to CAD in the future
C. It locks in a specific exchange rate for all future U.S. transactions
D. It allows the company to speculate on the future exchange rate between USD and CAD
In the example, the Canadian company borrows in CAD and uses an FX swap to convert CAD to USD in the spot market and then back to CAD in the future, effectively financing its U.S. operations in CAD.
15. What is transaction risk in foreign exchange?
A. The risk that the currency will appreciate in the future
B. The risk that currency exchange rates will remain the same
C. The risk that cash flow in one currency will need to be exchanged for another at a future date
D. The risk that the future exchange rate will be better than the current rate
Transaction risk occurs when a company needs to exchange cash flow from one currency to another at a future date, which exposes it to exchange rate fluctuations.
16. In the example of a U.K. company paying CAD 100 million in six months, why is the spot exchange rate not relevant?
A. The CAD 100 million is already in the U.K. company’s possession
B. The company wants to lock in the exchange rate in the future
C. The exchange rate is fixed and does not change
D. The company does not need the CAD until the payment date, so the spot rate is not relevant
The spot exchange rate is not relevant because the U.K. company does not need the CAD until the payment date, so it can use the forward market to lock in the exchange rate.
17. If a U.S. exporter is at risk of receiving EUR and the EUR depreciates, what type of position does the exporter hold?
A. A short position in EUR
B. A long position in EUR
C. A short position in USD
D. A long position in USD
Since the exporter will receive EUR, they hold a long position in EUR, which can be hedged by selling EUR forward to protect against depreciation.
18. How can a U.K. company hedge its transaction risk in the example involving CAD 100 million?
A. By selling the CAD forward
B. By purchasing more CAD in the spot market
C. By buying CAD forward in the forward market
D. By borrowing GBP and converting it to CAD immediately
The U.K. company can hedge its risk by buying CAD forward, locking in the future exchange rate and protecting itself from the risk of CAD appreciation.
19. In the example of the U.S. exporter receiving EUR 9 million, why is the forward exchange rate relevant?
A. Because the exporter has already received the EUR
B. Because the spot rate is locked in for future transactions
C. Because the exporter is uncertain of the future value of the EUR
D. Because the exporter has not yet received the EUR and can lock in the rate to hedge against depreciation
The forward exchange rate is relevant because the exporter has not yet received the EUR and can lock in the exchange rate to hedge against depreciation risk.
20. What is translation risk in foreign exchange?
A. The risk that the currency will appreciate in the future
B. The risk that cash flow in one currency will need to be exchanged for another at a future date
C. The risk that financial statements in a foreign currency must be converted to a different domestic currency
D. The risk that a company’s assets will lose value over time
Translation risk arises when a company needs to convert its financial statements from a foreign currency into its domestic currency, potentially leading to foreign exchange gains or losses.
21. How do foreign exchange gains or losses from translation risk affect a company’s financial performance?
A. They directly affect cash flow and earnings
B. They reflect real economic gain or loss
C. They do not affect reported earnings
D. They affect reported earnings but do not reflect real economic gain or loss
Foreign exchange gains or losses from translation risk affect reported earnings but do not represent real economic gains or losses since they do not influence cash flows.
22. If a U.S. company borrows from a Canadian bank and the CADUSD exchange rate increases, what effect does this have on the company's financials?
A. The company incurs a foreign exchange gain due to the appreciation of the USD
B. The company incurs a foreign exchange loss due to the appreciation of the CAD
C. There is no effect on the company's financials
D. The company incurs a foreign exchange loss due to the depreciation of the USD
When the CADUSD exchange rate increases, the CAD appreciates, which leads to a foreign exchange loss for the U.S. company as its debt in CAD becomes more expensive in USD terms.
23. How can a company hedge translation risk effectively?
A. By holding assets in foreign currencies without any liabilities
B. By using futures contracts to offset foreign exchange rate movements
C. By financing foreign assets with borrowings in the same foreign currency
D. By keeping its foreign currency exposures unhedged
To hedge translation risk, a company should finance its foreign assets with borrowings in the same currency. This way, any gains or losses on assets are offset by corresponding losses or gains on liabilities.
24. What is the best way to hedge the foreign exchange gains or losses related to foreign borrowings?
A. By increasing the foreign borrowings amount
B. By converting all foreign borrowings into USD
C. By borrowing in the company’s home currency
D. By matching the foreign borrowings with assets in the same foreign currency
The best way to hedge foreign exchange gains or losses on foreign borrowings is by matching the borrowings with assets in the same foreign currency, so that any exchange rate fluctuations affect both sides of the balance sheet equally.
25. What does economic risk refer to in the context of a firm?
A. Risk of an increase in market share
B. Risk arising from currency volatility affecting cash flows or competitive standing
C. Risk due to market dominance of local competitors
D. Risk of regulatory changes in the domestic market
Economic risk occurs when currency fluctuations impact the firm's cash flow or competitive position in the domestic or international market.
26. How might a decline in USD value benefit Disney World in the United States?
A. It would reduce the cost of operating in the United States
B. It would decrease the number of foreign visitors to the United States
C. It could lead to an increase in foreign visitors, boosting revenue
D. It would make Disney World less competitive in the global market
A decline in USD value relative to other currencies may make the US a more attractive destination for foreign tourists, potentially increasing Disney World’s revenue.
27. What effect can currency fluctuations have on a Canadian firm's competitiveness?
A. They may allow foreign competitors to enter the market and impact the Canadian firm
B. They can only increase the firm’s local sales
C. They will help maintain the firm's competitive advantage within Canada
D. They have no effect on competition at all
Currency fluctuations can make it easier for foreign competitors to enter the market, negatively impacting the competitiveness of domestic firms, such as the Canadian firm in this example.
28. What strategy might a firm use to hedge economic risk?
A. Diversifying product offerings only within the domestic market
B. Focusing solely on increasing domestic sales
C. Limiting expansion to the local area
D. Relocating production facilities or expanding sales overseas
A firm might hedge economic risk by relocating production to a foreign market or expanding sales overseas, helping mitigate currency volatility’s effects.
29. How does currency volatility affect a firm’s cash flows?
A. It can either increase or decrease the firm’s cash flows, depending on the exchange rate movement
B. It only affects cash flows negatively
C. It has no effect on cash flows unless the firm operates internationally
D. It only affects the cash flows of firms operating in non-dollar currencies
Currency volatility can impact cash flows in various ways, either benefiting or harming the firm depending on the direction of the exchange rate movement.
30. What is a common operational way to hedge against economic risk?
A. Selling all products only within the home country
B. Relocating production facilities to countries with more stable currencies
C. Ignoring international markets
D. Increasing the prices of products in international markets
A common operational strategy to hedge against economic risk is to move production facilities to countries with more stable or favorable currencies, thereby reducing exposure to currency fluctuations.
31. Why does a multinational firm face risk from multiple currencies?
A. Because exchange rates between countries are always stable
B. Because of the correlation between different currencies being +1
C. Because the currencies have a correlation of less than +1, reducing portfolio risk
D. Because the risk of one currency change impacts all other currencies equally
A multinational firm faces risk from multiple currencies because their exchange rates have a correlation of less than +1, reducing portfolio currency risk compared to a single currency.
32. What is the primary advantage of using options over forwards for hedging currency risk?
A. Options offer no risk, while forwards have significant risk
B. Options offer a one-sided protection, while forwards offer a two-sided protection
C. Options provide downside protection but allow upside potential, while forwards neutralize potential profit or loss
D. Forwards are more flexible than options for multi-currency hedging
The main advantage of using options over forwards is that options provide both downside protection and the potential for profit from favorable exchange rate movements, while forwards merely neutralize potential profit or loss.
33. What is one less costly hedging alternative for multi-currency risk?
A. Purchasing individual options for each currency
B. Purchasing a basket option in the over-the-counter (OTC) market
C. Using forward contracts for each currency
D. Relying solely on long-term contracts with foreign firms
A less costly hedging alternative is the purchase of a basket option in the OTC market, which targets specific currencies and is more economical than buying individual options for each currency.
34. What is the drawback of purchasing options with monthly maturities for multi-currency hedging?
A. They are relatively costly
B. They do not provide adequate protection for long-term currency risks
C. They are inflexible and cannot be customized
D. They are only useful for firms with short-term foreign exchange exposure
Purchasing options with monthly maturities can be costly, which may not be the most efficient solution for firms looking to manage multi-currency risk cost-effectively.
35. How do Asian options differ from traditional options in currency hedging?
A. Asian options have fixed strike prices based on daily exchange rates
B. Asian options are only useful for hedging a single currency risk
C. Asian options have strike prices based on the average exchange rate during the year, making them a less costly alternative
D. Asian options are purchased in the futures market, not the OTC market
Asian options are different from traditional options in that their strike price is based on the average exchange rate over a period (like a year), which makes them a more affordable hedging option.
36. What primarily drives exchange rates?
A. Government regulations and trade wars
B. Stock market performance and investor sentiment
C. Balance of payments and trade flows, monetary policy, and inflation
D. Only the foreign exchange reserves held by a country
Exchange rates are primarily driven by factors like balance of payments and trade flows, monetary policy, and inflation.
37. How does an increase in a country's money supply affect its currency?
A. It appreciates the currency
B. It has no effect on the currency
C. It causes the currency to become more stable
D. It results in a depreciation of the currency
When a country's money supply increases, the currency depreciates because more of that currency is required to purchase the same amount of goods.
38. If the EURUSD exchange rate changes from 1.1500 to 1.1300, what happens to the euro?
A. The euro has appreciated relative to the dollar
B. The euro remains unchanged
C. The euro has depreciated relative to the dollar by 1.74%
D. The euro is unaffected because exchange rates do not impact currencies in this range
The euro has depreciated relative to the dollar because the EURUSD exchange rate has fallen from 1.1500 to 1.1300, indicating the euro buys fewer dollars.
39. When calculating the percentage appreciation of the USD, what is the correct method?
A. Simply subtract the ending EURUSD value from the starting value
B. Flip the EURUSD quotes to USDEUR, then calculate the percentage change
C. Use only the EURUSD exchange rates and assume no conversion is necessary
D. Multiply the change in EURUSD by 100 to get the percentage change
To calculate the percentage appreciation of the USD, you need to flip the EURUSD exchange rate to USDEUR and then compute the percentage change.
40. What is the percentage appreciation of the USD relative to the EUR when the EURUSD changes from 1.1500 to 1.1300?
A. 1.77%
B. 1.74%
C. 2.56%
D. 3.89%
The percentage appreciation of the USD is calculated as +1.77%, based on the change in the USDEUR exchange rate from 0.8696 to 0.8850.
42. What does the Purchasing Power Parity (PPP) theory suggest?
A. Exchange rate changes offset inflation differences
B. Interest rates should always remain equal
C. GDP growth rate is always equal in both countries
D. Government spending remains equal across nations
PPP suggests that exchange rates should adjust to offset inflation differences between two countries, maintaining equal purchasing power.
43. If Country A has an inflation rate of 8% and Country B has 5%, what is the expected change in Country A’s currency value?
A. Appreciation by 3%
B. Depreciation by 3%
C. No change
D. Appreciation by 8%
Using PPP: %ΔS = inflation(foreign) − inflation(domestic) = 5% − 8% = −3%. This means depreciation by 3%.
44. Which of the following equations represents the PPP formula?
A. %ΔS = GDP(foreign) − GDP(domestic)
B. %ΔS = interest(domestic) − interest(foreign)
C. %ΔS = inflation(foreign) − inflation(domestic)
D. %ΔS = exports − imports
The correct PPP formula is: %ΔS = inflation(foreign) − inflation(domestic).
45. Which of the following statements is TRUE about PPP in the short term?
A. PPP holds perfectly at all times
B. Exchange rates never deviate from inflation differences
C. There are no discrepancies in exchange rates
D. There may be major discrepancies from PPP
PPP may not hold in the short term due to various market factors, leading to discrepancies in exchange rates.
46. What are the two components of a nominal interest rate?
A. Exchange rate and inflation
B. Real interest rate and expected inflation rate
C. Capital flow and demand for imports
D. Currency appreciation and depreciation
The nominal interest rate is made up of the real interest rate and the expected inflation rate.
47. According to the Fisher equation, how is the nominal interest rate calculated approximately?
A. Nominal = Real / Inflation
B. Nominal = Real × Inflation
C. Nominal ≈ Real + Expected Inflation
D. Nominal = Real − Expected Inflation
The linear approximation of the Fisher equation is: nominal interest rate ≈ real interest rate + expected inflation rate.
48. What effect does a high real interest rate in a country have on its currency?
A. It attracts capital, increasing currency demand and causing appreciation
B. It reduces investment inflows and depreciates the currency
C. It results in trade deficits and currency depreciation
D. It increases inflation and causes depreciation
Higher real interest rates attract foreign capital, increasing demand for the currency and causing it to appreciate.
49. If a country has higher inflation than its trading partners, what is the likely impact on its currency?
A. Currency demand increases and it appreciates
B. There is no impact on currency value
C. Currency appreciates due to export demand
D. Currency demand decreases and it depreciates
Higher inflation reduces the purchasing power of the domestic currency, decreasing its demand and causing depreciation.
50. What does the Fisher equation imply about diversification in multicurrency portfolios?
A. Diversification increases currency volatility
B. Imperfect correlation in interest and inflation rates leads to FX risk reduction
C. All currencies behave identically
D. Multicurrency portfolios offer no benefits
Since real interest rates and inflation rates are not perfectly correlated globally, multicurrency portfolios provide diversification benefits.
51. What does the Interest Rate Parity (IRP) theory state?
A. Spot and forward rates always remain equal
B. Higher domestic rates always attract investment
C. Arbitrage opportunities always exist in FX markets
D. Hedged returns on foreign and domestic investments must be equal
Interest Rate Parity (IRP) states that the return from a foreign investment hedged in the forward market must equal the domestic return to avoid arbitrage.
52. What happens if forward foreign exchange rates deviate from those predicted by IRP?
A. Arbitrage opportunities will arise
B. Currency demand will stabilize
C. The spot rate remains unaffected
D. There is no change in interest rates
When the actual forward rate differs from what IRP suggests, riskless profit (arbitrage) becomes possible until market forces restore equilibrium.
53. Which formula represents the Interest Rate Parity condition?
A. forward = spot × (1 + inflation rate)
B. forward = spot × (base rate ÷ quote rate)
C. forward = spot × [(1 + rYYY) / (1 + rXXX)]T
D. forward = spot + interest differential
The IRP equation is forward = spot × [(1 + interest rate of quote currency) ÷ (1 + interest rate of base currency)]T.
54. If forward rate < IRP implied rate, what strategy gives arbitrage profit?
A. Borrow in quote currency, invest in base currency
B. Borrow in base currency, invest in quote currency
C. Sell spot, buy forward
D. Wait for inflation to adjust
If the forward rate is undervalued, arbitrageurs can borrow in base currency, convert to quote currency, invest there, and lock in gains using a forward contract.
55. In the IRP equation, what does the exponent “T” represent?
A. Time to maturity (tenor) of the forward contract
B. Transaction size in base currency
C. Tax rate applied to currency gains
D. Treasury bill yield
The exponent “T” indicates the time to maturity (usually in years) over which the interest rate parity is being calculated.
56. If the CHFNZD rate falls from 0.79005 to 0.78726, what does this indicate?
A. CHF is appreciating in the forward market
B. NZD is weakening in the forward market
C. NZD is strengthening in the forward market
D. There is no change in currency strength
Since fewer NZD are required to buy 1 CHF, the NZD is stronger in the forward market compared to the spot market.
57. A falling CHFNZD forward rate implies which of the following about the Swiss Franc?
A. Swiss Franc is appreciating in forward market
B. Swiss Franc is appreciating in spot market
C. Swiss Franc is unaffected by forward rates
D. Swiss Franc is weaker in the forward market
A decrease in the CHFNZD rate means that the Swiss franc is cheaper in terms of NZD, implying that it has weakened in the forward market.
58. What does it mean if it takes fewer units of a quote currency to buy one unit of base currency in the forward market?
A. The quote currency is stronger in the forward market
B. The base currency is stronger in the forward market
C. The currencies have equal strength
D. There is no implication on currency strength
If fewer units of the quote currency are needed to buy one unit of base currency, the quote currency has appreciated in the forward market.
59. What is the main difference between covered and uncovered interest rate parity?
A. CIRP uses expected spot rates, while UCIRP uses forward contracts
B. CIRP involves the use of forward contracts to hedge exchange rate risk, while UCIRP does not
C. UCIRP ensures arbitrage opportunities while CIRP does not
D. CIRP does not consider interest rate differences
CIRP is based on arbitrage and uses forward contracts to eliminate currency risk. UCIRP is based on expected returns without forward contracts.
60. Under uncovered interest rate parity, which of the following is assumed?
A. The forward rate equals the future spot rate
B. Arbitrage is not possible
C. Expected exchange rate changes offset interest rate differentials
D. Interest rates in all countries are equal
UCIRP assumes that expected exchange rate movements offset interest rate differentials so that returns are equalized across currencies.
61. If CIRP and UCIRP both hold true, what can be concluded?
A. The forward rate equals the expected future spot rate
B. Arbitrage opportunities will exist in all markets
C. Interest rates will differ significantly
D. Exchange rate risk cannot be hedged
When both CIRP and UCIRP hold, it implies that the forward rate is an unbiased predictor of the future spot rate.
62. What is likely to happen to a country's currency if it exports more than it imports?
A. Its currency will depreciate due to trade surplus
B. Its money supply will decrease
C. Its currency will appreciate due to increased demand
D. Its inflation rate will rise
A country that exports more creates demand for its currency as buyers exchange foreign currencies to pay for its goods, causing appreciation.
63. Which of the following actions would typically lead to a depreciation of a country's currency?
A. Increasing the money supply
B. Increasing interest rates
C. Running a trade surplus
D. Reducing inflation expectations
An increase in a country's money supply typically leads to depreciation due to the inflationary effect and lower interest rates.
64. Which type of foreign exchange risk is considered the most difficult to hedge?
A. Transaction risk
B. Translation risk
C. Political risk
D. Economic risk
Economic risk relates to long-term impacts on a company’s market value due to currency fluctuations, making it harder to identify and hedge effectively.
