How Level II tests FX quotations, bid-offer spreads, forward premiums, triangular arbitrage, and mark-to-market value.
Level II economics often begins with what looks like FX market vocabulary and quickly turns into a pricing problem. The exam wants to know whether you can read the quotation correctly, identify which side of the market applies, and decide whether the currency relationship is merely quoted differently or is actually mispriced.
Candidates usually lose points here in two ways:
The stronger answer slows down and reads the trade direction first.
| What to identify first | Why it matters |
|---|---|
| Base currency and price currency | Tells you what one unit of the base currency costs |
| Bid and offer side | Tells you whether you are selling or buying the base currency |
| Spot versus forward quote | Tells you whether the question is about immediate exchange or a future commitment |
The exam often hides the real work inside quotation format rather than difficult arithmetic.
For a quoted currency pair:
The bid-offer spread is:
$$ \text{Spread} = \text{Offer} - \text{Bid} $$
| If you want to… | Use the… |
|---|---|
| Buy the base currency | Offer |
| Sell the base currency | Bid |
| Measure transaction cost in quote form | Bid-offer spread |
That sounds basic, but Level II still tests it because one wrong side of the market ruins the rest of the vignette.
A common annualized approximation is:
$$ \text{Forward premium or discount} \approx \left(\frac{F_0}{S_0}-1\right)\frac{12}{n} $$
where (n) is the number of months to maturity.
| If the forward is above spot | The base currency is at a forward premium |
|---|---|
| If the forward is below spot | The base currency is at a forward discount |
Level II often tests interpretation rather than memorization. The candidate has to explain what the forward relationship implies, not just compute the sign.
Three exchange-rate quotations should be mutually consistent. If they are not, the candidate should be able to identify a sequence of exchanges that locks in a profit.
| Step | What to check |
|---|---|
| 1 | Start with one currency and translate through the quoted pairs using the correct bid or offer at each step |
| 2 | Return to the original currency through the third pair |
| 3 | Compare the ending amount to the starting amount |
If the ending amount is larger after respecting the quoted dealing sides, an arbitrage opportunity exists.
The exam often gives rates that look close enough to lull the candidate into skipping the chain.
At initiation, a forward contract is typically set near zero value. Later, as spot and forward conditions move, the contract gains or loses value.
For a long position, a common intuition is:
$$ V_t = \text{current forward value of what is received} - \text{present value of the contracted payment} $$
The exact computation can be framed in several equivalent ways, but the exam is mainly testing whether you understand the distinction between:
A vignette gives three dealer quotes for USD/EUR, EUR/JPY, and USD/JPY. A candidate plugs the midpoint quotes into a cross-rate comparison and concludes that arbitrage exists.
That answer is weak because it ignores the trading side of the market.
A stronger answer applies bid and offer prices consistently through the entire exchange chain. On Level II, the direction of the trade is part of the question, not just a footnote.
An investor wants to buy the base currency in a quoted pair. Which dealer price applies?
Best answer: The offer.
Why: The dealer sells the base currency at the offer, so the investor buying it must transact on that side of the market.