Explanation:
Answer: D
Analysis of each option:
(a) Incorrect: Forward points can absolutely be negative. Negative forward points indicate that the base currency (USD) is trading at a forward discount, meaning the forward rate is lower than the spot rate. This is a normal market phenomenon driven by interest rate differentials.
(b) Incorrect: There is no rule that the dollar must always be the quote currency. In this case, the quote convention places USD as the base currency, which is common when USD/XYZ > 1 (i.e., the dollar is stronger than the other currency). The currency pair convention is determined by market convention and liquidity, not by a fixed rule.
(c) Incorrect: In proper quote convention, the bid points should have a LARGER absolute value than the ask points. This is because the bid price is LOWER than the ask price, so subtracting a larger number (bid points) gives a lower forward bid rate, and subtracting a smaller number (ask points) gives a higher forward ask rate. The quotes shown (e.g., -4.31 bid vs. -2.74 ask) follow this correct convention.
(d) CORRECT: Since the forward points are negative, the forward rate is lower than the spot rate, meaning dollars buy LESS of XYZ in the forward market. Therefore, dollars are "cheaper" in terms of XYZ in the forward market. Additionally, the bid-ask spread widens with maturity: at 1 week it's |-4.31 - (-2.74)| = 1.57 pips, at 2 weeks it's 3.61 pips, and at 1 year it's 6.97 pips, confirming the spread increases with maturity (greater uncertainty over longer periods).
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22.15.1. Consider the following exchange rate quotes for the spot market and three of the corresponding forward contracts. As these quotes follow proper forex quote convention, the first currency in the pair (i.e., USD) is the base currency. Please assume "XYZ" is one of the other major currencies, e.g., EUR, GBP, AUD, NZD, CAD, CHF, JPY.
| Bid | Ask | |
|---|---|---|
| USD/XYZ Spot Exchange Rate | 0.7962 | 0.7981 |
USD/XYZ Forward Quotes
| Bid | Ask | |
|---|---|---|
| 1 Week | -4.31 | -2.74 |
| 2 Weeks | -6.81 | -3.20 |
| ... | ||
| 1 Year | -67.90 | -60.93 |
Based on these quotes, which of the following statements is TRUE?
a) The forward quotes are unrealistic because they should never be negative b) This quote is unnatural because the dollar should always be the quote currency in a currency pair c) The magnitude of ask points is incorrect because their absolute value (aka, magnitude) should be larger than the magnitude of corresponding bid points d) Compared to the spot market, dollars purchased with this quote currency are cheaper in the forward market, and the bid-ask spread increases with forward contract maturity
A
The forward quotes are unrealistic because they should never be negative
B
This quote is unnatural because the dollar should always be the quote currency in a currency pair
C
The magnitude of ask points is incorrect because their absolute value (aka, magnitude) should be larger than the magnitude of corresponding bid points
D
Compared to the spot market, dollars purchased with this quote currency are cheaper in the forward market, and the bid-ask spread increases with forward contract maturity
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