Forex Trading Advanced Topics 5 — Questions and Answers
Question 1: What is the 'efficient market hypothesis' (EMH) and how does it challenge technical analysis in forex?
- EMH states prices already reflect all available information, making consistent chart-based profits theoretically impossible (Correct answer)
- EMH argues that only fundamental analysis produces alpha
- EMH guarantees that algorithmic strategies always outperform manual trading
- EMH holds that central bank interventions have no effect on exchange rates
Correct answer: EMH states prices already reflect all available information, making consistent chart-based profits theoretically impossible
Under EMH, current prices incorporate all known information, meaning technical patterns should not persistently yield abnormal profits.
Question 2: What is 'purchasing power parity' (PPP) and its limitation as a forex trading tool?
- PPP predicts short-term rate movements based on inflation, but markets routinely deviate for years (Correct answer)
- PPP measures the cost of carry between two currencies
- PPP only applies to commodity-linked currencies like AUD and CAD
- PPP is used exclusively by central banks to set interest rates
Correct answer: PPP predicts short-term rate movements based on inflation, but markets routinely deviate for years
PPP states currencies should adjust so a basket of goods costs the same everywhere, but in practice exchange rates can diverge from PPP for extended periods.
Question 3: A forex trader uses a 'grid trading' strategy. What does this involve?
- Placing orders at fixed price intervals above and below the current price (Correct answer)
- Using a grid of technical indicators to confirm signals
- Copying trades from multiple signal providers simultaneously
- Dividing capital equally among 10 currency pairs
Correct answer: Placing orders at fixed price intervals above and below the current price
Grid trading places buy and sell orders at preset intervals, profiting from price oscillations but risking large drawdowns in strongly trending markets.
Question 4: What does 'quantitative easing' (QE) typically do to a country's currency?
- Strengthens the currency by increasing bond yields
- Weakens the currency by expanding money supply and lowering yields (Correct answer)
- Has no effect on currency value
- Immediately causes hyperinflation
Correct answer: Weakens the currency by expanding money supply and lowering yields
QE expands the money supply and compresses yields, making the currency less attractive to yield-seeking investors and typically depressing its value.
Question 5: In forex, what is 'basis risk' when hedging with currency futures?
- The risk that the futures price and spot price diverge unexpectedly, leaving a hedge imperfect (Correct answer)
- The credit risk of the futures clearinghouse defaulting
- The leverage risk inherent in futures contracts
- The risk that futures expire before the hedge period ends
Correct answer: The risk that the futures price and spot price diverge unexpectedly, leaving a hedge imperfect
Basis risk arises because futures prices don't always move exactly in line with spot prices, meaning a hedge may not perfectly offset the underlying exposure.
Question 6: What characterizes a 'black swan' event in forex markets?
- A predictable seasonal trend in currency markets
- An extremely rare, high-impact event outside normal expectations that causes massive price dislocations (Correct answer)
- A broker insolvency event triggered by overleveraged clients
- A coordinated G7 central bank intervention
Correct answer: An extremely rare, high-impact event outside normal expectations that causes massive price dislocations
Black swan events are unpredictable outliers with enormous impact, such as the 2015 Swiss franc flash crash when the SNB unexpectedly removed the EUR/CHF floor.
Question 7: What does 'theta' represent in a forex options position, and why does it matter for option sellers?
- Theta measures time decay of option premium, which benefits sellers who collect premium as it erodes (Correct answer)
- Theta measures the sensitivity of delta to underlying price changes
- Theta tracks changes in implied volatility over time
- Theta represents the overnight financing cost of the option
Correct answer: Theta measures time decay of option premium, which benefits sellers who collect premium as it erodes
Theta is the daily erosion of an option's time value; option sellers profit from this decay as long as the underlying doesn't move adversely.
Forex Trading Advanced Topics 5
What is the 'efficient market hypothesis' (EMH) and how does it challenge technical analysis in forex?