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LE Paper 7 · Topic 5
Paper 7 tests the FX market in two ways: numbers and mechanisms. Expect to read a two-way quote, build a cross rate, price a forward from an interest differential and label it a premium or discount. Expect also to explain how Hong Kong's Linked Exchange Rate System holds the Hong Kong dollar between 7.75 and 7.85, and where it sits among the world's exchange rate regimes. The second half of the topic turns to derivatives: what they are, what they are for, and how Hong Kong's derivatives market is structured, traded and cleared.
19 min read11 sections
Checked against HKMA pages on the Linked Exchange Rate System (How Does the LERS Work?, Components of the Monetary Base, Milestones of Monetary Reform, Transparency of Currency Board Operations), HKMA Hong Kong Currency: Notes, and the HKMA press release of 18 May 2005 on refinements to the LERS (hkma.gov.hk); the IMF 'Money Matters' exhibit and IMF de facto classification of exchange rate arrangements (imf.org); quotation, cross-rate and interest rate parity conventions are standard finance. As at October 2026. Checked against HKEX contract summaries for Hang Seng Index futures (updated 20 July 2026), Mini-HSI futures, HSI options, HSCEI futures, stock futures, stock options (updated 24 July 2026), USD/CNH futures (updated 7 October 2026) and MSCI Taiwan (USD) index futures; HKEX Listed Derivatives Clearing pages (Overview, Infrastructure, Margin, The Safeguards); OTC Clear eligible products; HKFE and stock options participantship criteria; HKATS and Orion Derivatives Platform pages; HKEX Group Principal Subsidiaries and Milestones (hkex.com.hk and hkexgroup.com), as at October 2026. Option and swap payoffs are standard finance. Independent prep, not endorsed by HKSI Institute or the SFC.
An exchange rate is the price of one currency in another. In a pair written EUR/USD 1.0850, the first currency (EUR) is the base currency and the second (USD) is the terms or quote currency: one euro costs 1.0850 US dollars. A rise in the number means the base currency has appreciated. A direct quote gives home currency per unit of foreign currency (HK$7.80 = US$1 for a Hong Kong resident); an indirect quote gives foreign currency per unit of home currency (about US$0.1282 per HK$1).
Dealers quote two-way prices. In EUR/USD 1.0850/1.0853 the bank buys the base currency at the bid (1.0850) and sells it at the offer (1.0853). The client always gets the worse side. A pip is the last quoted decimal: 0.0001 for most pairs, 0.01 for yen pairs, so this spread is 3 pips.
| Task | Method | Example |
|---|---|---|
| Cross rate, US dollar is base in both pairs | Divide | USD/JPY 150.00 / USD/HKD 7.8200 = 19.1816 yen per HK$ |
| Cross rate, US dollar is terms in one pair and base in the other | Multiply | EUR/USD 1.0850 x USD/HKD 7.8106 = EUR/HKD 8.4745 |
| Cross bid and offer, multiplying | Bid x bid; offer x offer | EUR/HKD 8.4745 / 8.4766 from 1.0850/1.0852 and 7.8106/7.8111 |
| Cross bid and offer, dividing |
Every note. Every question. One pass.
9 more sections of this note are part of Premium.
From ≈HK$49.83/mo on the Until-you-pass pass (12 months)
| Bid / other offer; offer / other bid |
| SGD/HKD offer = 7.8110 / 1.2900 = 6.0550 |
| Forward rate (interest rate parity) | Spot x (1 + terms rate x t) / (1 + base rate x t) | GBP/USD 1.2500 x 1.04 / 1.05 = 1.2381 (one year) |
| Annualised premium or discount | (Forward - spot) / spot x 12 / months | (1.2560 - 1.2500) / 1.2500 x 4 = 1.92% p.a. |
A spot deal settles two business days after the trade date (T+2); a few pairs such as USD/CAD settle T+1. Any later value date makes it a forward. Forward rates come from covered interest rate parity: a hedged deposit must earn the same in either currency, or dealers would borrow one currency, convert spot, deposit and sell forward for a riskless profit (covered interest arbitrage). So the currency with the lower interest rate trades at a forward premium and the higher-yielding one at a discount. Banks quote forward points: when the bid points are smaller than the offer points (25/28) add them to spot; when larger (42/38) subtract them.
Trap: candidates treat the forward rate as a forecast of the future spot rate, or put the interest rates the wrong way up. The forward is spot adjusted for the interest differential, and the terms currency's rate goes on top.
Takeaway: Bank buys base at bid, sells at offer. Lower interest rate means forward premium. Ascending points add, descending points subtract.
The IMF's history of the international monetary system gives four stages. Under the classical gold standard (1870s to the First World War) each country pegged its currency to gold at a constant rate, so exchange rates between them were fixed. At Bretton Woods in 1944, 44 countries agreed fixed but adjustable rates: currencies were fixed against the US dollar, and the dollar was convertible into gold at US$35 an ounce. On 15 August 1971 the United States stopped redeeming dollars for gold. After two dollar devaluations, fixed rates were abandoned in early 1973 and the major currencies were left to float.
| Hong Kong arrangement | Period | Rate |
|---|---|---|
| Silver standard | 1863 to 1935 | Value defined in silver |
| Sterling link | December 1935 to June 1972 | HK$16 = £1; HK$14.55 from November 1967 |
| US dollar peg | July 1972 to November 1974 | US$1 = HK$5.65, ±2.25% band; HK$5.085 from February 1973 |
| Free float | November 1974 to October 1983 | Market-determined |
| Linked Exchange Rate System | 17 October 1983 to date | US$1 = HK$7.80 |
Trap: candidates date general floating to 1971, or assume the LERS was Hong Kong's first US dollar peg. The gold window closed in 1971 but floating came in 1973, and Hong Kong pegged to the dollar from 1972 to 1974 before floating.
Takeaway: Gold standard, Bretton Woods 1944 (US$35 gold), gold window shut 15 August 1971, floating by 1973. Hong Kong: silver, sterling, dollar peg, float, LERS 1983.