Question

a) What are the tiers of the foreign exchange market?

b) Why are Credit default swaps seen as a form of gambling?

c) What’s a spot transaction in the inter-bank market?

d) What are the assumptions underlying the law of one price?

e) Under purchasing power parity, what’s the correlation between the inflation rate and the exchange rate?

f) What happens to the option price in case the option expires worthless and in case the investor chooses to exercise it?

Answer 1

As per the guidline I'd only be able to answer first 4.

a) What are the tiers of the foreign exchange market?

The foreign exchange market has majortwo tiers: retail and wholesale. The retail tier is where the small agents buy and sell foreign exchange, orienting themselves to the reference rates of such agencies which are adjusted to actual events happening in the market. The wholesale tier is an informal network of more than 1000 banks and currency brokerage firms that deal with each other and with large corporations. When the financial press talks about the foreign exchange market in general it refers to the wholesale tier.

b) Why are Credit default swaps seen as a form of gambling?

According to many experts, naked CDSs should be banned, comparing them to buying fire insurance on your neighbor's house, which creates a huge incentive for arson. Short selling is also viewed as gambling and the CDS market as a casino. Another reason is the size of the CDS market. Because naked credit default swaps are synthetic, there is no limit to how many can be sold. The total amount of CDSs is more than that of all real corporate bonds and loans outstanding. As a result, the risk of default is magnified leading to concerns about systemic risk.

c) What’s a spot transaction in the inter-bank market?

A spot transaction refers to the purchase or sale of a foreign currency, financial instrument or commodity for instant delivery on a specified spot date. Most spot transactions settle two business days after execution; the major exception being the U.S. dollar vs. the Canadian dollar, which settles the next day as far as the inter-bank market is concerned.

d) What are the assumptions underlying the law of one price?

Followings are the some assumptions for the law of one price -

free competition in the markets

The absence of trade restrictions

price flexibility

Wide applicability