🔹 FX & Rates Sales and Trading – 30 Technical Questions

🧠 Macro and Market Fundamentals

1. What are the main drivers of currency exchange rates?

2. How does interest rate differential affect FX spot and forward rates?
3. What is the impact of central bank policy on FX and rates markets?
4. Explain how inflation data affects bond yields.
5. How does quantitative easing impact FX and government bond markets?
6. What is the yield curve and what does its shape tell you about the economy?
7. What does an inverted yield curve indicate?
8. How do geopolitical risks affect FX markets?
9. How do trade balances influence currency values?
10. What are real vs nominal interest rates, and why do they matter?

📈 FX Products and Pricing

11. What is a spot FX trade, and how is it settled?

12. Explain how forward FX rates are calculated.
13. What is a currency swap?
14. What is triangular arbitrage in FX?
15. What is the difference between a pip and a basis point?
16. How do you hedge FX risk using forward contracts?
17. What is a non-deliverable forward (NDF)?
18. What are the key differences between G10 and EMFX markets?

💰 Fixed Income & Rates Instruments

19. What is a government bond and how is it priced?

20. How does duration affect a bond’s sensitivity to interest rate changes?
21. What is convexity in bonds?
22. What is DV01 and how is it used in rates trading?
23. What is a swap and how do interest rate swaps work?
24. What is the difference between OIS and LIBOR?
25. What is the breakeven inflation rate?

📊 Trading Concepts and Market Mechanics

26. What’s the difference between bid, ask, and spread?

27. What is liquidity and why is it important in FX and rates trading?
28. How do you manage risk on a trading desk?
29. What metrics are used to measure PnL and risk on FX/rates trades?
30. How does a central bank rate hike affect FX and bond markets in the short term?

Macro and Market Fundamentals

1. Main Drivers of Currency Exchange Rates

Currency exchange rates are driven by:

 Interest rate differentials: Higher rates attract capital, strengthening a currency.

 Inflation: Lower inflation typically strengthens a currency due to preserved purchasing
power.
 Economic growth: Strong GDP growth signals a robust economy, boosting currency
demand.
 Trade balances: Surpluses strengthen a currency; deficits weaken it.
 Political stability: Stable governments enhance currency confidence.
 Central bank policies: Monetary tightening or easing impacts currency value.
 Market sentiment: Risk-on (weaker safe-haven currencies) vs. risk-off (stronger safe-
haven currencies like USD, JPY).

2 & 3. Interest Rate Differentials and Central Bank Policy on FX Spot and
Forward Rates

 Interest Rate Differentials: Higher interest rates in a country attract foreign capital,
increasing demand for its currency and strengthening spot FX rates. Forward rates are
derived from spot rates adjusted by the interest rate differential (covered interest rate
parity). For example, if US rates > Euro rates, USD forward rates trade at a discount
relative to spot.
o Formula: Forward rate = Spot rate × (1 + Domestic interest rate) / (1 + Foreign
interest rate).
 Central Bank Policy: Tightening (rate hikes) strengthens a currency by attracting capital
and reducing money supply. Easing (rate cuts or QE) weakens it by increasing money
supply and lowering yields. Policy signals (e.g., forward guidance) also impact market
expectations, affecting both spot and forward rates. Central banks like the Fed or ECB
influence volatility through policy announcements.

4. Inflation Data and Bond Yields

Higher inflation data increases bond yields because:

 Investors demand higher yields to offset reduced purchasing power.

 Central banks may raise rates to combat inflation, pushing yields up.
 Inflation expectations shift the yield curve upward.
Conversely, lower inflation reduces yields as investors accept lower returns in a stable
price environment.

5. Quantitative Easing (QE) Impact on FX and Government Bond Markets

 FX Markets: QE increases money supply, lowering interest rates and weakening the
currency as capital seeks higher yields elsewhere.
  Government Bond Markets: QE involves central banks buying bonds, increasing
demand and lowering yields. This flattens the yield curve and reduces borrowing costs
but may signal inflationary pressures long-term.

6 & 7. Yield Curve and Inverted Yield Curve

 Yield Curve: Plots yields of bonds (typically government) with different maturities.
Shapes include:
o Normal (upward-sloping): Longer maturities have higher yields, signaling
economic growth and inflation expectations.
o Flat: Similar yields across maturities, indicating uncertainty or transition.
o Inverted: Short-term yields exceed long-term yields, often signaling recession
fears as investors expect rate cuts.
 Inverted Yield Curve: Indicates market expectations of economic slowdown or
recession. Historically (e.g., US 2y/10y inversion), it has preceded recessions, reflecting
lower future growth and inflation expectations.

8. Geopolitical Risks and FX Markets

Geopolitical risks (e.g., conflicts, sanctions) increase market uncertainty, driving:

 Capital flight to safe-haven currencies (USD, JPY, CHF).

 Weakness in currencies of affected regions due to reduced investor confidence.
 Volatility spikes, impacting carry trades and speculative positions.

9. Trade Balances and Currency Values

 Trade Surplus: Exports > imports, increasing demand for the domestic currency
(strengthens it).
 Trade Deficit: Imports > exports, increasing demand for foreign currency (weakens
domestic currency).
Persistent imbalances signal structural economic issues, affecting long-term currency
trends.

10. Real vs. Nominal Interest Rates

 Nominal Interest Rate: The stated rate on a bond or loan, unadjusted for inflation.
 Real Interest Rate: Nominal rate minus inflation (Real = Nominal - Inflation).
 Why They Matter: Real rates reflect true borrowing costs and investment returns.
Higher real rates attract capital, strengthening currencies and increasing bond yields.
Central banks monitor real rates to gauge policy effectiveness.

FX Products and Pricing

11. Spot FX Trade and Settlement
  Spot FX Trade: An agreement to exchange currencies at the current market rate,
typically settled T+2 (two business days).
 Settlement: Banks exchange principal amounts via correspondent accounts (e.g., through
CLS for major currencies) to mitigate settlement risk.

12. Forward FX Rates Calculation

Forward rates are calculated using covered interest rate parity:

 Forward rate = Spot rate × (1 + Domestic interest rate × Days/360) / (1 + Foreign interest
rate × Days/360).
 Example: If USD/EUR spot is 1.10, US 1-year rate is 3%, Euro rate is 1%, the 1-year
forward rate is ~1.1018, reflecting the interest rate differential.

13. Currency Swap

A currency swap involves exchanging principal and interest payments in one currency for those
in another, typically for hedging or funding needs. Example: A US firm borrows EUR, swaps
into USD, pays USD interest, and receives EUR interest, reversing at maturity.

14. Triangular Arbitrage in FX

Triangular arbitrage exploits price inefficiencies across three currency pairs (e.g., USD/EUR,
EUR/GBP, USD/GBP). If cross-rates don’t align (e.g., USD/EUR × EUR/GBP ≠ USD/GBP),
traders buy/sell to profit from the discrepancy, restoring equilibrium.

15. Pip vs. Basis Point

 Pip: Smallest price move in FX, typically 0.0001 for most pairs (e.g., USD/EUR from
1.1000 to 1.1001 = 1 pip).
 Basis Point: 0.01% (1/100th of a percent), used in rates markets (e.g., 1% = 100 bps). 1
pip = 1 bp for FX quotes with four decimal places.

16. Hedging FX Risk with Forward Contracts

Forward contracts lock in an exchange rate for a future date, mitigating FX risk. Example: A US
importer expecting to pay EUR 1M in 3 months buys a 3-month EUR/USD forward, fixing the
rate to avoid adverse movements.

17. Non-Deliverable Forward (NDF)

An NDF is a forward contract settled in cash (usually USD) rather than physical currency
delivery, used in restricted or emerging market currencies (e.g., CNY, BRL). The difference
between the contracted rate and spot rate at maturity is settled.
18. G10 vs. EMFX Markets

 G10 FX: Major, liquid currencies (e.g., USD, EUR, JPY) with low volatility, tight
spreads, and high transparency. Traded 24/5 with deep liquidity.
 EMFX: Emerging market currencies (e.g., MXN, INR) with higher volatility, wider
spreads, and lower liquidity. Often subject to capital controls or geopolitical risks.

Fixed Income & Rates Instruments

19. Government Bond and Pricing

 Government Bond: A debt security issued by a government, promising periodic interest

(coupon) and principal repayment at maturity.
 Pricing: Present value of future cash flows (coupons + principal), discounted at the yield
to maturity (YTM). Price = Σ(Coupon / (1+YTM)^t) + (Face Value / (1+YTM)^T).
Lower yields increase prices, and vice versa.

20. Duration and Bond Sensitivity

Duration measures a bond’s price sensitivity to interest rate changes. It’s the weighted average
time to receive cash flows, expressed in years.

 Macaulay Duration: Time-weighted cash flows.

 Modified Duration: % change in price for a 1% change in yield (≈ Macaulay Duration /
(1+YTM)).
Higher duration = greater sensitivity to rate changes.

21. Convexity in Bonds

Convexity measures the curvature of a bond’s price-yield relationship, capturing non-linear price
changes as yields shift. Positive convexity means price rises more when yields fall than it falls
when yields rise, beneficial for bondholders.

22. DV01 (Dollar Value of a 1 Basis Point Move)

DV01 measures the dollar change in a bond’s price for a 1 bp (0.01%) change in yield. DV01 =
Modified Duration × Price × 0.0001. Used in rates trading to quantify interest rate risk.

23. Swaps and Interest Rate Swaps

 Swap: An agreement to exchange cash flows over time.

 Interest Rate Swap: One party pays a fixed rate, the other pays a floating rate (e.g.,
SOFR), on a notional principal. Used to hedge rate exposure or speculate. Example: A
firm swaps fixed 3% payments for floating SOFR to benefit from falling rates.
24. OIS vs. LIBOR

 OIS (Overnight Index Swap): A swap based on an overnight rate (e.g., SOFR in the
US), reflecting risk-free borrowing costs.
 LIBOR: Interbank lending rate, incorporating credit risk. Phased out in favor of OIS-
based rates (e.g., SOFR) due to manipulation concerns. OIS is now the standard for
discounting and pricing.

25. Breakeven Inflation Rate

The difference between nominal and inflation-linked bond yields (e.g., US TIPS). Breakeven rate
= Nominal yield - Real yield. It reflects market expectations of future inflation. Example: 10y
Treasury yield (3%) - 10y TIPS yield (1%) = 2% breakeven inflation.

Trading Concepts and Market Mechanics

26. Bid, Ask, and Spread

 Bid: Price a buyer is willing to pay.

 Ask: Price a seller is willing to accept.
 Spread: Difference between bid and ask, reflecting liquidity and transaction costs.
Narrower spreads indicate higher liquidity.

27. Liquidity and Its Importance

 Liquidity: Ease of buying/selling an asset without significant price impact. In FX and

rates:
o High liquidity (e.g., G10 FX, Treasuries) ensures tight spreads and low costs.
o Low liquidity (e.g., EMFX, corporate bonds) increases volatility and trading
costs.
Liquidity is critical for efficient execution and risk management.

28. Managing Risk on a Trading Desk

 Market Risk: Hedge with derivatives (e.g., forwards, swaps) or offsetting positions.
 Credit Risk: Monitor counterparties, use collateral or clearinghouses (e.g., CLS for FX).
 Operational Risk: Automate processes, ensure robust systems.
 Limits: Set position, VaR, and stop-loss limits.
 Stress Testing: Simulate extreme scenarios to assess portfolio resilience.

29. Metrics for PnL and Risk

 PnL Metrics: Daily/weekly PnL, mark-to-market, realized vs. unrealized gains/losses.

 Risk Metrics:
o VaR (Value at Risk): Potential loss over a time horizon at a confidence level.
 o DV01: Interest rate risk.
o Delta/Gamma: FX option sensitivity to underlying price changes.
o Stress Tests: Loss under extreme scenarios.

30. Central Bank Rate Hike Impact (Short Term)

 FX Markets: Currency strengthens as higher rates attract capital inflows, increasing

demand.
 Bond Markets: Yields rise as bond prices fall (inverse relationship). Short-term bonds
are most sensitive due to immediate rate repricing. Volatility may spike around
announcements.