Foreign exchange market Study Guide

📖 Core Concepts Foreign‑exchange (FX) market – Global, over‑the‑counter market where currencies are bought and sold 24 h a day, 5 days a week. Base vs. counter currency – In a pair XXX/YYY, XXX is the base (the unit being priced) and YYY is the counter (the currency used to pay). Spot vs. forward – Spot: delivery ≈ 2 business days; price is today’s market rate. Forward: contract that fixes today’s rate for a future settlement date. Floating vs. fixed regimes – Floating: rates set by supply‑and‑demand. Fixed: government sets an official rate (often defended with reserves). Carry trade – Borrow low‑rate currency, invest in high‑rate currency; profit = interest‑rate differential (but exposed to exchange‑rate risk). --- 📌 Must Remember Market hours: 22:00 UTC Sun (Sydney) → 22:00 UTC Fri (New York); no weekend trading. Major participants: interbank dealers (≈ 51 % of volume), central banks, corporations, investment managers, retail traders. Key indicator: US Dollar Index (DXY) = weighted basket of major currencies vs. USD. Bid‑ask spread: difference between highest price a dealer will buy (bid) and lowest price they will sell (ask). Interest‑rate parity (IRP): forward rate ≈ spot × (1 + rdomestic)/(1 + rforeign). Purchasing‑power parity (PPP): exchange rate ≈ price level domestic / price level foreign. --- 🔄 Key Processes Executing a Spot Trade Choose pair → receive quote (bid/ask). Agree on size → trade settles in 2 business days. Setting a Forward Contract Obtain spot rate S. Apply IRP to compute forward rate F = S × (1+rd)/(1+rf). Lock F for the agreed future date. Carry‑Trade Execution Identify low‑rate currency (funding) and high‑rate currency (target). Borrow funding currency, convert at spot, invest in target currency assets. Earn interest differential; monitor for adverse FX moves. Central‑Bank Intervention (FX) Detect undesirable currency move → sell (or buy) domestic currency using reserves. Aim to shift supply‑demand balance; effect may be temporary. --- 🔍 Key Comparisons Spot vs. Forward Spot: immediate (2‑day) delivery, no rate guarantee beyond settlement. Forward: rate fixed today for any future date, no physical delivery needed for NDFs. Floating vs. Fixed Regime Floating: price set by market; responsive to macro & political news. Fixed: official rate set by government; requires large reserves to defend. Carry Trade vs. Speculative Trade Carry: profit from interest‑rate differential; risk mainly from exchange‑rate swing. Speculative: profit from price movement direction; may ignore fundamentals. FX Swap vs. Currency Swap FX Swap: simultaneous spot and forward legs; used for short‑term funding. Currency Swap: long‑term exchange of cash‑flows (principal + interest) in different currencies. --- ⚠️ Common Misunderstandings “Higher inflation always strengthens a currency.” – Actually, high inflation erodes purchasing power and usually depreciates the currency; only expected inflation spikes that signal future rate hikes can cause temporary appreciation. “The bid‑ask spread is the fee you pay.” – It’s the implicit cost of transacting; brokers may add separate commissions or roll‑over (swap) fees. “Fixed‑rate regimes eliminate exchange‑rate risk.” – Governments may still de‑value or re‑value, and reserves can run out, creating sudden jumps. “Carry trade is risk‑free because interest differential is locked.” – The underlying spot rate can move dramatically, wiping out the interest gain. --- 🧠 Mental Models / Intuition Currency as a “price tag” on a country’s economy – Think of an exchange rate as the price you pay for a basket of that country’s goods, services, and financial assets. Supply‑and‑demand seesaw – When a country exports more (or its assets become attractive), demand for its currency rises → price goes up; opposite for imports or capital outflows. Interest‑rate differential = “rent” on money – Holding a high‑rate currency is like renting a house that pays you monthly; the rent can be lost if the house’s market value (exchange rate) falls. --- 🚩 Exceptions & Edge Cases Non‑Deliverable Forwards (NDFs) – Used for restricted currencies; settlement is cash‑based on the difference between agreed forward rate and prevailing spot at maturity. Safe‑haven spikes – During crises, even a low‑interest‑rate currency (e.g., USD, CHF) can appreciate despite its fundamentals because investors seek safety. Interest‑rate parity breakdown – In markets with capital controls or extreme risk premia, forward rates may deviate from IRP. --- 📍 When to Use Which Spot – Need immediate conversion (e.g., paying an invoice). Forward – Hedge future cash flow or lock a rate for known future transaction. FX Swap – Obtain short‑term funding in another currency while keeping the original exposure. Futures – Prefer standardized contract, daily margining, and exchange clearing. Options – Want upside potential while limiting downside (protective hedge or speculative bet). Carry Trade – Deploy when interest‑rate differential is wide and you have confidence the exchange rate will stay relatively stable. --- 👀 Patterns to Recognize Same‑base currency pairs move together (positive correlation). Risk‑off news → USD/CHF, USD/JPY, and gold rise (flight‑to‑quality). Rising inflation + unchanged rates → currency weakness. Central‑bank rate hike expectations → immediate currency appreciation (forward‑looking). --- 🗂️ Exam Traps Choosing “fixed” because a country has a peg – Remember pegs can be suspended; test may ask about hidden de‑valuation risk. Assuming “higher interest = stronger currency” – Look for the inflation or risk‑premium context. Confusing bid and ask – A common distractor swaps the definitions; remember bid = what dealer buys, ask = what dealer sells. Treating forward rate as “future spot” – Forward includes interest‑rate differential; the actual future spot may differ. Mix‑up between FX swap and currency swap – Swaps in the exam often refer to the short‑term FX‑swap (spot + forward leg). ---