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Sem 5 Prep
← Money & BankingThe foreign exchange market

Formulas for this chapter

Reading and inverting a quote

Pair BASE/QUOTE = n means 1 unit of BASE costs n units of QUOTE Base to quote: multiply by n Quote to base: divide by n Indirect quote = 1 / direct quote

Every conversion. Name the base currency before touching the arithmetic, and sanity-check the answer's size against the weaker currency.

BASE
First currency in the pair, the single unit being priced
QUOTE
Second currency, how much of it buys one base unit

Bid-ask spread

Spread % = ((Ask - Bid) / Ask) x 100 Dealer's earnings = (Ask - Bid) x quantity

Whenever two rates are quoted. Divide by the ask. A narrow spread means high liquidity and low transaction cost; a wide one means lower liquidity or higher risk.

Bid
Rate at which the bank buys foreign exchange, the lower rate
Ask (offer)
Rate at which the bank sells, the higher rate

Covered interest rate parity

Forward rate = Spot rate x (1 + r_quote) / (1 + r_base)

To find the no-arbitrage forward rate, or to test whether a quoted forward is mispriced. Convert annualised rates to the forward's tenor first: halve for 180 days, quarter for 90.

r_quote
Risk-free rate on the quote currency, for the forward's tenor
r_base
Risk-free rate on the base currency, for the same tenor

Appreciation and depreciation

Change % = (new value - old value) / old value x 100 For the other currency: invert both rates first, then apply the same formula

Any question about how much a currency has moved. The two currencies' percentages are never equal, so compute each on its own denominator.

old value
Starting rate, expressed in the units of the currency whose change you want
Step 3 of 28
The real wordsPractical

The professor's Johnny example

Johnny lives in Canada, carries only Canadian dollars, and is going to New York. The exchange store tells him USD/CAD = 1.3.

Read it with the rule: USD is the base, CAD is the quote, so $1 USD is equivalent to $1.3 CAD.

He can exchange $1.3 of CAD for every $1 of USD. Turning it round: each CAD buys 1/1.3 = 0.769 USD.

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