Currency Exchange Rates and Foreign Exchange Market

These flashcards cover key concepts related to currency exchange rates, foreign exchange market dynamics, bid-ask spreads, and forward exchange rates.

What is a currency exchange rate?

The rate used to exchange one currency for another.

What is a direct quote in currency exchange?

A direct quote indicates how much of the domestic currency is needed to purchase one unit of foreign currency.

What does an indirect quote represent?

An indirect quote shows how much foreign currency can be acquired for one unit of the domestic currency.

How do direct and indirect quotes react to currency appreciation?

They move in opposite directions; direct quote increases while indirect quote decreases.

What does currency appreciation signify?

A strengthening of the currency.

What is a cross-rate?

An exchange rate between two currencies inferred from their exchange rates with a third currency.

What are the two components of the worldwide foreign exchange market?

1. A wholesale market with major banks and specialized currency dealers, and 2. A retail market where investors and corporations deal with local banks.

What is the main characteristic of the foreign exchange market?

It operates 24 hours a day, 5 days a week, and is over-the-counter.

What is the difference between bid price and ask price?

Bid price is the price a dealer is willing to pay for a currency, while ask price is the price at which a dealer is willing to sell it.

What does the spread represent in currency exchange?

The difference between the bid and ask price.

What is a pip in foreign exchange?

The smallest fluctuation in the price of a currency.

What is no-arbitrage condition in exchange rates?

If riskless arbitrage is possible, quotes will quickly align to eliminate the opportunity.

What is a forward exchange rate?

The rate agreed upon today for a currency exchange that will occur in the future.

What is interest rate parity (IRP)?

A relationship linking spot exchange rates, forward exchange rates, and interest rates.

What does a forward discount indicate?

When the forward exchange rate is lower than the spot exchange rate.

How is the annualized forward premium or discount calculated?

((forward rate - spot rate) / spot rate) x (12 / number of months forward) x 100%.

What are the three transactions involved in constructing a forward contract?

1. Spot foreign exchange transaction, 2. Borrowing in the two currencies, 3. Lending in the two currencies.