Foreign Exchange
What this domain tests
The FX market is the largest and most liquid market, operating largely over-the-counter around the clock across time zones. You must understand exchange rates as the price of one currency in terms of another, the base/quote convention, and how to read a quote such as GBP/USD 1.25 (one pound buys 1.25 dollars).
Concepts to master
- Spot versus forward rates: spot settles typically T+2; forwards lock in a rate for future delivery.
- Appreciation and depreciation: a currency strengthens when it buys more of another.
- Bid/offer in FX and the spread as a transaction cost.
- Drivers of exchange rates: interest-rate differentials, inflation, trade balances, economic growth, political stability, central-bank policy.
- Hedging FX exposure: importers/exporters and investors with foreign assets use forwards or options to manage currency risk.
- Cross rates and the role of the US dollar as the dominant vehicle currency.
Traps
The biggest trap is direction. A higher GBP/USD number means sterling has strengthened against the dollar (buys more dollars), not weakened. Confusion also arises with base/quote: the base currency is the one being priced. Questions may test that a forward rate reflects the interest-rate differential (higher-yielding currency typically trades at a forward discount).
Rule of thumb
If the exchange rate rises (e.g. GBP/USD from 1.20 to 1.30), the base currency (GBP) has appreciated; exporters benefit from a weaker domestic currency, importers from a stronger one.
Worked example: A UK exporter will receive $100,000 in three months. Spot is GBP/USD 1.25, so it is worth £80,000. Fearing a stronger pound, it locks in a forward at 1.28, guaranteeing £78,125. If sterling instead weakens to 1.20, the spot value would be £83,333 - the forward cost £5,208 versus spot, the price of certainty.