Foreign Exchange and Currency Risk
Foreign exchange and currency risk tests quotation mechanics, exposure identification, instrument selection and forward pricing. Numerical questions are common, and marks are lost on the wrong side of the spread.
Quotation conventions
Base/quote: EUR/USD 1.0850 means one euro buys 1.0850 dollars. A pip is 0.0001, or 0.01 on pairs quoted to two decimals such as USD/JPY. Spot settles T+2, with USD/CAD at T+1. The three exposures are transaction (a known future cash flow), translation (accounting consolidation) and economic (competitive position).
Pricing forwards
Forward points are the interest differential, not a forecast. F = S × (1 + i_quote × days/basis) ÷ (1 + i_base × days/basis), using 360 for USD and EUR and 365 for sterling. Ascending points mean the base currency is at a forward premium: add. Descending points: subtract. Never cross the spread.
Worked example
EUR/USD spot 1.0850/1.0860, three-month points 25/35. Outright forward: 1.0875/1.0895. An exporter holds USD 1,000,000 and sells USD forward. The bank sells EUR to the customer, so the offer side applies: 1.0895. The exporter locks in 1,000,000 ÷ 1.0895 ≈ EUR 917,852. Had the points been quoted 35/25, the forward would be 1.0815/1.0835 and the same exporter would receive about EUR 922,936 - more euros, because the euro is then at a forward discount.
Instruments and traps
Forwards are binding. FX swaps manage funding and do not remove a net exposure. NDFs hedge restricted currencies and settle in USD. Options cost a premium but preserve upside. Watch for netting claims - offsetting flows only net where amounts and dates truly match - and for confusing translation exposure with transaction exposure.