Alan Greenspan spent half a century forecasting exchange rates and called the experience humbling. The exam does not ask you to beat the market. It asks you to price the quotes correctly and rank the forces that pull a currency toward long-run value.
An exchange rate is the price of the base currency stated in units of the price currency. Written P/B, a USD/EUR rate of 1.1650 means one euro costs 1.1650 US dollars. Spot deals settle on the second business day after the trade (T + 2), with CAD/USD the main exception at T + 1.
Dealers quote two prices. The bid is what the dealer pays to buy one unit of the base currency. The offer (ask) is what the dealer charges to sell one unit of the base currency. The offer always exceeds the bid, and the difference is the dealer's compensation for supplying liquidity. The client requesting the quote has the option, not the obligation, to deal.
Common mistakes
- Mixing sides when building a cross. Multiplying a bid by an offer produces a nonsense cross. Bid times bid, offer times offer, after you have aligned both quotes so the common currency cancels.
- Inverting without swapping. Turning USD/GBP 1.2302/1.2304 into GBP/USD requires reciprocals and an exchange of sides: 1/1.2304 = 0.81274 becomes the bid, 1/1.2302 = 0.81288 the offer. Keeping the original order manufactures a bid above the offer.
- Discounting a mark in the wrong currency. Example 2's cash flow is in AUD, so it discounts at the AUD rate. Using the GBP rate is the single most common mark-to-market error.
Bottom line
- Quotes: P/B means price of one base currency unit; offer above bid; bid and offer always refer to the base currency
- Spread drivers: currency pair liquidity, time of day, volatility, transaction size, dealer-client relationship, plus contract term for forwards
- Cross rates: bid times bid, offer times offer, after inverting and swapping sides where the common currency is in both numerators
- Covered interest rate parity is the only parity condition enforced by arbitrage; forward premium is proportional to spot, to the interest differential, and roughly to time
Exam shortcut
Before touching a cross-rate vignette, write the chain so the common currency cancels, then lock one side and never switch. If the question asks you to sell the base currency, every number you touch is a bid. Answer sets almost always include the mirrored-side value as the distractor.
The full lesson (about 3,605 words, 24 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- currency exchange rates
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