Foreign Exchange Market: Participants, Spot/Forward Rates, Quotations, Cross Rates and Arbitrage Questions

Question 1

Define foreign exchange market.

Accepted Answer

**Foreign exchange market** is the network/system where currencies are bought and sold for international trade, investment, and other cross-border payments.

Question 2

What is spot rate?

Accepted Answer

**Spot rate** is the exchange rate applicable for immediate/near-immediate settlement of a currency transaction.

Question 3

What is forward rate?

Accepted Answer

**Forward rate** is the exchange rate agreed today for exchange of currencies at a specified future date.

Question 4

What is bid-ask spread?

Accepted Answer

**Bid-ask spread** is the difference between the dealer’s ask (selling) rate and bid (buying) rate.

Question 5

What is a cross rate?

Accepted Answer

**Cross rate** is an exchange rate between two currencies derived using a third currency (often USD).

Question 6

Expand FX.

Accepted Answer

**FX** = **Foreign Exchange**.

Question 7

Explain participants in forex market (any five).

Accepted Answer

Participants in the forex market (any five):

- **Commercial banks**: main dealers; provide quotes and execute trades.
- **Central bank**: intervenes to stabilize currency and manage reserves.
- **Importers and exporters**: convert currencies for trade settlements.
- **MNCs**: manage international cash flows and exposures.
- **Institutional investors**: invest across borders (funds, FIIs).
- **Speculators/traders**: take positions to profit from currency movements.
- **Brokers**: match buyers and sellers and provide market access.

Thus, participants include trade users, investors, and dealers who provide liquidity.

Question 8

Explain functions of forex market (any three points).

Accepted Answer

Functions of forex market (any three):

- provides **currency conversion** for trade and investment.
- helps transfer **purchasing power** between countries.
- provides **hedging** facilities to manage exchange rate risk.
- supports price discovery (exchange rate determination).

Therefore, forex market supports global trade and capital flow by enabling smooth currency exchange and risk management.

Question 9

Differentiate spot and forward market (any three points) with a table.

Accepted Answer

### **Spot vs Forward Market**

- **Spot** deals with immediate/near settlement; **forward** deals with future settlement.
- spot rate reflects current market; forward rate is fixed today for future date.
- forward is commonly used for **hedging** future exposures.

Table:

| Basis | Spot | Forward |
|---|---|---|
| Settlement | immediate/near | future date |
| Rate | spot rate | forward rate |
| Use | instant conversion | **hedging** & planning |

Thus, forward contracts reduce uncertainty in future foreign currency cash flows.

Question 10

Explain bid and ask rate and spread (any three points) with a small table.

Accepted Answer

### **Bid, Ask and Spread**

- **Bid**: rate at which dealer **buys** the base currency (customer sells base).
- **Ask/Offer**: rate at which dealer **sells** the base currency (customer buys base).
- **Spread** = Ask − Bid; it is the dealer’s margin for providing liquidity.

Table:

| Term | Dealer action | Customer action |
|---|---|---|
| **Bid** | buys base | sells base |
| **Ask** | sells base | buys base |

Hence, customers typically buy at ask and sell at bid.

Question 11

Explain direct and indirect quotation (any three points) with examples.

Accepted Answer

### **Direct vs Indirect Quotation**

- **Direct quote**: home currency per 1 unit of foreign currency (e.g., **INR per USD**).
- **Indirect quote**: foreign currency per 1 unit of home currency (e.g., **USD per INR**).
- Direct and indirect quotes are **reciprocals** of each other (ignoring bid-ask spread).

Examples (India perspective):
- Direct: USD/INR = 83.20 means **1 USD = INR 83.20**.
- Indirect: INR/USD = 0.0120 means **1 INR = USD 0.0120**.

Thus, identifying the quote convention is essential before doing any calculations.

Question 12

Explain base currency and quote currency (any three points) with a small table and example.

Accepted Answer

### **Base Currency and Quote Currency**

- In a currency pair **A/B**, **A** is the **base currency** and **B** is the **quote currency**.
- The rate tells how many units of quote currency equal **1 unit of base currency**.
- Understanding base/quote helps interpret bid/ask correctly.

Example: USD/INR = 83.20
- base = USD
- quote = INR
- meaning: **1 USD = 83.20 INR**

Table:

| Pair | Base | Quote | Meaning |
|---|---|---|---|
| USD/INR | USD | INR | 1 USD = INR rate |

Hence, always read the pair carefully before hedging or computing cross rates.

Question 13

Explain cross rate and show a simple calculation method (exam-style) with a mini example.

Accepted Answer

### **Cross Rate — Exam-Style**

**Meaning:** A **cross rate** is the exchange rate between two currencies derived using a third currency (often USD) when a direct quote is not available.

#### **Method (unit cancellation approach)**
- write rates as fractions so units cancel correctly.
- multiply/divide to obtain the required pair.

Mini example:
- Suppose **USD/INR = 83.00** and **USD/EUR = 0.92**.
- We want **EUR/INR**.

Step:
- EUR/INR = (EUR/USD) × (USD/INR)
- EUR/USD = 1 / (USD/EUR) = 1 / 0.92 = 1.0869
- Therefore, EUR/INR ≈ 1.0869 × 83.00 ≈ 90.21

Mini table:

| Given | Convert | Result |
|---|---|---|
| USD/EUR | take reciprocal | EUR/USD |
| EUR/USD and USD/INR | multiply | EUR/INR |

**Conclusion:** Cross rates maintain consistency among currency pairs and are widely used in banking quotes.

Question 14

Explain arbitrage in forex and how it helps market efficiency (exam-style) with a flowchart.

Accepted Answer

### **Forex Arbitrage and Market Efficiency — Exam-Style**

**Meaning:** **Arbitrage** is earning (near) risk-free profit by exploiting **rate differences** across markets.

#### **How it works (concept)**
- if an actual market cross-rate differs from the implied cross-rate, a trader can:
  - buy currency via the cheaper route
  - sell via the costlier route
- these trades increase demand for undervalued route and increase supply for overvalued route.

#### **Why it improves efficiency**
- reduces rate inconsistencies
- pushes rates toward equilibrium
- improves correct price discovery

Flowchart:

```text
Rate inconsistency → arbitrage trades → buy undervalued path + sell overvalued path → rates adjust → consistency restored
```

**Conclusion:** Arbitrage is a self-correcting mechanism that keeps currency rates aligned across markets.

Question 15

Explain forward premium and forward discount (exam-style) with a small table.

Accepted Answer

### **Forward Premium and Forward Discount — Exam-Style**

Forward premium/discount compares the **forward rate** with the **spot rate** for the same currency pair (as per the quote convention).

- If **Forward rate > Spot rate**, the currency is at **forward premium**.
- If **Forward rate < Spot rate**, the currency is at **forward discount**.

Mini example table (quote: USD/INR):

| Spot (USD/INR) | Forward (USD/INR) | Interpretation |
|---:|---:|---|
| 83.00 | 83.80 | USD at **premium** |
| 83.00 | 82.50 | USD at **discount** |

**Conclusion:** Premium/discount reflects market expectations and is often related to interest rate differences (covered interest parity concept in later chapters).

Foreign Exchange Market: Participants, Spot/Forward Rates, Quotations, Cross Rates and Arbitrage

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