VOCABULARY

1. What is foreign exchange?

Foreign Exchange (forex or FX) is the trading of one currency for another.
Foreign Exchange : money or currency of a foreign country

For example, one can swap the U.S. dollar for the euro. Foreign exchange transactions
can take place on the foreign exchange market, also known as the forex market.

2. Explain how the gold standard represented the beginning of a foreign

exchange system.

A country that uses the gold standard sets a fixed price for gold and buys and sells gold at
that price. That fixed price is used to determine the value of the currency.

Gold Standard : A monetary system used in the nineteenth and early twentieth centuries
whereby the value of currencies could, on request of the owner (holder), be converted
into gold at a country's central bank. As all currencies had a gold value, they also had a
certain value in relation to each other. This was the beginning of a foreign exchange
system.

3. Name three functions of a country’s central bank. Who owns it?

- regulates the commercial banks and

- holds gold and foreign currency reserves.

- actively intervenes by buying and selling its own currency in the foreign exchange
markets so that the currency will keep a certain value.

- government owns it
+ Monetary policy

+ Reserve
management

+ Banking supervision

4. Under a floating exchange rate system, what normally determines the value
of currencies?

A floating exchange rate refers to an exchange rate system where a country’s currency
price is determined by the relative supply and demand of other currencies.

5. What is a spot transaction? When does delivery take place?

 A spot trade, also known as a spot transaction, refers to the purchase or sale of a
Foreign currency, financial instrument, or commodity for instant delivery on a

specified spot date. Most spot contracts include the physical delivery of the
currency, commodity, or instrument; the difference in the price of a future or
forward contract versus a spot contract takes into account the time value of the payment,
based on interest rates and the time to maturity. In a foreign exchange spot trade, the
exchange rate on which the transaction is based is referred to as the spot exchange rate

6. On the forward transaction, when is the payment made? When is the delivery of
funds made?

On the forward transaction, payment and delivery are made at that future date.

Example of an unconditional forward transaction: A cocoa farmer hopes to sell his stock
of cocoa beans at the highest possible profit. A chocolate producer in Switzerland wants
to buy the cocoa beans at the lowest possible cost. On January 1, the farmer and the
chocolate factory agreed to a purchase of 100 kilograms of cocoa beans at a price of 25
francs per 10 kilos. They both agree that delivery and payment will occur on February 15.
Thanks to the forward deal, the farmer has the security of knowing that they have a
guaranteed sale of cocoa beans worth 250 francs. The chocolate producer has the security
of knowing that the cocoa will be delivered at the agreed-upon price exactly 6 weeks
after they sign the deal. Any fluctuations in cocoa prices which occur after the agreement
is signed are no longer relevant for either party.
7. Define hedging

Hedging is an advanced strategy that tries to limit risks in financial assets

For example, if you own a home in a flood-prone area, you will want to protect that asset
from the risk of flooding4to hedge it, in other words4by taking out flood insurance. In
this example, you cannot prevent a flood, but you can plan ahead of time to mitigate the
dangers in the event that a flood did occur.

8. What does premium mean? How is it determined? What is the opposite of

premium?

Premium is the additional amount it will cost to buy or sell a currency at a given future
date. Premium rate is calculated by this formula:

Forward Premium = ((Forward Rate – Spot Rate) / Spot Rate) *100

The opposite of premium is discount

Premium is an amount paid periodically to the insurer by the insured for covering
his risk. The premium is a function of a number of variables like age, type of
employment, medical conditions, etc. The actuaries are entrusted with the
responsibility of ascertaining the correct premium of an insured

9. What is involved in arbitraging? How many markets are entered?

Arbitrage is a trading strategy whereby you simultaneously buy and sell similar
securities, currencies, or other assets in two different markets at two different prices or
rates to capitalize on the differential between the markets. Arbitrage is trading that
exploits the tiny differences in price between identical assets in two or more markets.

Types of arbitrage include risk, retail, convertible, negative, statistical, and triangular,
among others.

Arbitrage exists as a result of market inefficiencies and it both exploits those

inefficiencies and resolves them. (An inefficient market is one that does not succeed in
incorporating all available information into a true reflection of an asset's fair price.
Arbitrage may take place when:

- the same asset does not trade at the same price on all markets

- two assets with identical cash flows do not trade at the same price

- an asset with a known price in the future does not today trade at its future price
discounted at the risk-free interest rate

READING

1. Name a payment mechanism used in earlier times. What was it later replaced by?

The currencies were related to one another through a system called the gold standard.
It was later replaced by supply and demand.

2. Briefly describe the importance of the gold standard.

The gold standard system determined the value of all currencies based on gold. This
meant the values of different currencies could be compared in terms of one another.

3. Under the gold standard, currencies were convertible into gold. This
convertibility was abolished for most currencies. Which currency remained
convertible into gold until 1971?

US Dollar

4. What is the system of fixed exchange rates? Which conference agreed upon this
system?

A given currency could, therefore, never rise above nor below fixed points, which are
called intervention points. There are the prices beyond which the central bank
intervenes. This is called the system of fixed exchange rates.

Bretton Woodsagreed upon this system

5. What does devaluation mean? Name the countries in the Western

industrialized world that devalued their currencies between 1967 and 1973.

The reduction in the official value of a currency in relation to other currencies: England in
1967, France in 1969, and the United States in 1971 and 1973, devalued their currencies.

6. Name two countries that revalued their currencies in the early 1970s

Countries such as West Germany and Holland revalued their currencies

7. Are intervention points applicable in a system of floating exchange rates?
Explain your answer

What is the snake? Why is it called the snake and which Common
Marketmembers are outside it?

The snake in the tunnel was a system of European monetary cooperation in the 1970s
which aimed at limiting fluctuations between different European currencies.

This system became known as the snake since these currencies move up and down
together against currencies outside the snake. The British and the Italians, now members
of the Common Market, are expected to eventually join their currencies to the snake.

8. Where and how does the foreign exchange market take place?

The foreign exchange market is the mechanism through which foreign currencies are
traded. A system of telephone of telex communications between banks, customers,
and middlemen

9. What is the function of a foreign exchange broker?

Brokers often trade on behalf of banks or corporations

10. Name at least five active participants in the foreign exchange market

Active participants in the foreign exchange market include tourists, investors,

exporters and importers, and governments

11. When does delivery of the foreign exchange take place in a spot transaction and
why?

When a French father transfers money to his son in New York, a typical spot transaction
occurs. The French father buys the dollar spot 3 for immediate delivery - although
business practice allows two days for actual delivery.

12. When does payment and delivery of foreign exchange take place in a
forward transaction? At what point is the exchange rate determined?

A forward transaction means that delivery of a currency if specified to take place at a

future date. Forward rates are usually quoted on a 30-, 90-, or 180-day basis, but major
currencies can have any maturity up to a year and sometimes longer

13. What causes an open position?

Dealers, having concluded a forward contract, should always hedge with an offsetting
contract, so as not to leave the position open

14. An open position is either long or short. Describe both types.

If they buy currency forward without selling forward at the same time, this position is
known as long. If they sell a currency forward without buying forward at the same time,
this is called short
15. What is the difference between a bid and an offer?

A bid is the price dealers will pay to acquire pounds.

An offer is the price they will sell the pounds for.

16. What is arbitrage? Is this usually a very profitable transaction for a bank?

Arbitrage is the practice of transferring funds from one currency to another to benefit
from rate differentials.

No. Such arbitraging makes sense only if transaction costs (cable, paperwork, etc.) are
covered and a small profit if realized. Opportunities to realize big profits do not
exist in this type of arbitrage, since communication systems today make the price,
and therefore profit opportunities, available to everyone.

17. Give an example of interest arbitrage. In which case is interest arbitrage

not possible?

Interest rates in England are 2 percent higher than in the United States money market, a
United States investor would do well to change United States dollars into pounds sterling
and then invest the sterling at the English interest rate.

Such transactions can only be realized in the absence of foreign exchange regulations,
such as capital transfer limitations, which are sometimes imposed by governments

EXERCISE 1:

1. Bartering is based on the exchange of GOODS for goods.

2. The Bretton Woods Agreement stipulated that all members would express their
currencies in GOLD.

3. When central banks intervene in the foreign exchange markets at the intervention
points, this is called the system of FIXED exchange rates. The opposite is called the
system of FLOATING exchange rates.

4. If dealers buy currencies forward but do not sell forward simultaneously, their position
is said to be LONG.
5. Dealers using two foreign exchange markets to benefit from rate differentials are said
to engage in ARBITRAGING.

EXERCISE 2:

1. Most industrialized countries switched to a system of floating rates. However,

governments and central banks occasionally attempted to influence exchange rates by
intervening in the markets. So there was a system of managed floating exchange rates.
1973

2. The Bank of England lost over £5 billion in one day attempting to protect the value of
the pound sterling. After this, governments and central banks intervened much less, so
there was almost a freely floating System. 1992

3. A fixed exchange rate system was started. The values of many major currencies were
pegged to the value of the US dollar. The American central bank, the Federal Reserve,
guaranteed that it could exchange anounce of gold for $35. 1944

4. Twelve states of the European Union introduced a single currency, the euro, to replace
their national currencies. 2022

5. Gold convertibility ended because the Federal Reserve no longer had enough gold to
go back to the dollar, due to inflation. 1971

EXERCISE 3: Matching

1.

2.

3.

4.

5.

6.
18.
What is the snake? Why is it called the snake and which Common
Marketmembers are outside it?

The snake in the tunnel was a system of European monetary cooperation in the 1970s
which aimed at limiting fluctuations between different European currencies.

This system became known as the snake since these currencies move up and down
together against currencies outside the snake. The British and the Italians, now members
of the Common Market, are expected to eventually join their currencies to the snake.

19. Where and how does the foreign exchange market take place?

The foreign exchange market is the mechanism through which foreign currencies are
traded. A system of telephone of telex communications between banks, customers,
and middlemen

20. What is the function of a foreign exchange broker?

Brokers often trade on behalf of banks or corporations

21. Name at least five active participants in the foreign exchange market

Active participants in the foreign exchange market include tourists, investors,

exporters and importers, and governments

22. Briefly describe spot and forward transactions. Give an example of each

23. When does delivery of the foreign exchange take place in a spot transaction and
why?

When a French father transfers money to his son in New York, a typical spot transaction
occurs. The French father buys the dollar spot 3 for immediate delivery - although
business practice allows two days for actual delivery.

24. When does payment and delivery of foreign exchange take place in a
forward transaction? At what point is the exchange rate determined?

A forward transaction means that delivery of a currency if specified to take place at a

future date. Forward rates are usually quoted on a 30-, 90-, or 180-day basis, but major
currencies can have any maturity up to a year and sometimes longer

25. What causes an open position?

Dealers, having concluded a forward contract, should always hedge with an offsetting
contract, so as not to leave the position open

26. An open position is either long or short. Describe both types.

If they buy currency forward without selling forward at the same time, this position is
known as long

If they sell a currency forward without buying forward at the same time, this is called
short

27. What is the difference between a bid and an offer?

A bid is the price dealers will pay to acquire pounds.

An offer is the price they will sell the pounds for.

28. What is arbitrage? Is this usually a very profitable transaction for a bank?

Arbitrage is the practice of transferring funds from one currency to another to benefit
from rate differentials.

No. Such arbitraging makes sense only if transaction costs (cable, paperwork, etc.) are
covered and a small profit if realized. Opportunities to realize big profits do not
exist in this type of arbitrage, since communication systems today make the price,
and therefore profit opportunities, available to everyone.

29. Give an example of interest arbitrage. In which case is interest arbitrage

not possible?

Interest rates in England are 2 percent higher than in the United States money market, a
United States investor would do well to change United States dollars into pounds sterling
and then invest the sterling at the English interest rate.

Such transactions can only be realized in the absence of foreign exchange regulations,
such as capital transfer limitations, which are sometimes imposed by governments

EXERCISE 1:

6. Bartering is based on the exchange of GOODS for goods.

7. The Bretton Woods Agreement stipulated that all members would express their
currencies in GOLD.
8. When central banks intervene in the foreign exchange markets at the intervention
points, this is called the system of FIXED exchange rates. The opposite is called the
system of FLOATING exchange rates.

9. If dealers buy currencies forward but do not sell forward simultaneously, their position
is said to be LONG.
10. Dealers using two foreign exchange markets to benefit from rate differentials are
said to engage in ARBITRAGING.

EXERCISE 2:

6. Most industrialized countries switched to a system of floating rates. However,

governments and central banks occasionally attempted to influence exchange rates by
intervening in the markets. So there was a system of managed floating exchange rates.
1973

7. The Bank of England lost over £5 billion in one day attempting to protect the value
of the pound sterling. After this, governments and central banks intervened much less,
so there was almost a freely floating System. 1992

8. A fixed exchange rate system was started. The values of many major currencies
were pegged to the value of the US dollar. The American central bank, the Federal
Reserve, guaranteed that it could exchange anounce of gold for $35. 1944

9. Twelve states of the European Union introduced a single currency, the euro, to
replace their national currencies. 2022

10. Gold convertibility ended because the Federal Reserve no longer had enough
gold to go back to the dollar, due to inflation. 1971