Nicole Seaman

Director of FRM Operations
Staff member
Learning objectives: Explain and describe the mechanics of spot quotes, forward quotes, and futures quotes in the foreign exchange markets; distinguish between bid and ask exchange rates. Calculate a bid-ask spread and explain why the bid-ask spread for spot quotes may be different from the bid- ask spread for forward quotes. Compare outright (forward) and swap transactions. Define, compare, and contrast transaction risk, translation risk, and economic risk.


22.15.1. Consider the following exchange rate quotes for the spot market and three of the corresponding forward contracts. As these quotes follow proper forex quote convention, the first currency in the pair (i.e., USD) is the base currency. Please assume "XYX" is one of the other major currencies; e.g., EUR, GBP, AUD, NZD, CAD, CHF, JPY.


Based on these quotes, which of the following statements is TRUE?

a. The forward quotes are unrealistic because they should never be negative
b. This quote is unnatural because the dollar should always be the quote currency in a currency pair
c. The magnitude of ask points is incorrect because their absolute value (aka, magnitude) should be larger than the magnitude of corresponding bid points
d. Compared to the spot market, dollars purchased with this quote currency are cheaper in the forward market, and the bid-ask spread increases with forward contract maturity

22.15.2. Let XYZ represent a fictional but significant currency. As the euro is always the natural base currency in a pair (i.e., EUR has the highest rank), we observe that the spot rate for EURXYZ is 1.3344 and the two-year EURXYZ forward rate is +290 basis points; aka, pips.

If we instead switch to the perspective where euro is the quote currency, the equivalent spot rate quote is given by 1/1.3344 = €0.7494 EUR. If XYZ is the base currency, which is nearest to the associated forward rate?

a. -446.3
b. -159.4
c. +290.0
d. +327.7

22.15.3. Parislaza Investment Corp is a French money manager who is offered the following (aka, underlying) investment opportunity: they can invest $10.0 million U.S. dollars (USD) into a dollar-denominated asset and earn an interest rate of 7.0% per annum over a six-year tenor. At the end of the six-year tenor, the $10.0 million principal will be returned, However, during that period Parislaza has a belief (i.e., a concern) that the dollar will depreciate against its own domestic currency, which is the euro (EUR).

The Fiber's spot exchange (FX) rate is $1.150 EURUSD and--simply for unrealistic convenience--we will assume that interest rates are comparable between the USD and EUR (including identical riskfree rates such that the FX forward curve is conveniently flat. Consequently, fixed-for-fixed currency swaps are available (with an initial zero value to both counterparties) at multiple tenors that swap the initial principal at the current spot rate; pay the same interest rate to both legs, and finally re-swap the same principal amounts at the end.

If Parislaza takes advantage of the U.S. dollar investment opportunity, which of the following derivatives is the best trade (in addition to the underlying investment) that expresses its specific belief that the dollar will depreciate against the EUR?

a. No additional trade because USD depreciation already favors the underlying investment
b. No additional trade, but only if Parislaza additionally believes that the EUR will appreciate against the USD
c. Enter into a fixed-for-fixed currency swap with principal of €8.70 million EUR to receive interest of €0.61 million EUR per annum
d. Enter into a fixed-for-fixed currency swap with principal of $10.0 million USD to receive interest of $0.70 million USD per annum

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