2015, Study Session # 6, Reading # 21

“CURRENCY EXCHANGE RATES”

LOS 21.a

Exchange rate: The price or cost of one currency (DC or FC) in terms of another (FC or DC)
e.g.
DC/FC = Domestic currency per unit of foreign currency
$ 2.510/£ = 2.510 Dollars per one unit of pound.

Nominal Exchange Rate: $2.510/£ means one pound unit can purchase 2.510 units of U.S. dollars.
Real Exchange: It shows the dollar cost of purchasing same unit of goods/services based on
relative price levels among two countries & the current dollar/pound exchange rate.
Real exchange rate (d/f) = nominal exchange rate (d/f) ×
All else constant:
(↓) ↑ CPIFC → (↓) ↑ real exchange rate (DC/FC)
(↓) ↑ CPIDC → (↑) ↓ real exchange rate
(↓) ↑ nominal exchange rate → (↓) ↑ real exchange rate
Spot exchange rate: The exchange rate for immediate delivery
Forward exchange rate: The exchange rate for delivery sometime in future.

LOS 21.b
Foreign Exchange Market

Functions Participants in foreign exchange market

Facilitate companies & individuals
that purchase or sell goods/services
denominated in foreign currencies
Currency risk can be reduced or
eliminated through forward currency
contracts.
Large multinational banks are primary
dealers & originators of forward contracts
Buyers include:
i) Corporations
ii) Investment accounts
a) Real money accounts: refer to accounts
managed mutual funds, insurance
companies and other institutional
investors that don’t use derivatives
b) Leverage accounts: they refer to the
professional trading community that do
use derivatives.
iii) Governments & Government entities
iv) Retail accounts
Central banks

LOS 21.c

i) Direct Quote:

Base Currency: The currency which is represented by
one unit
Price currency: The currency represented by more or
ii) Indirect Quote: less than one unit is called price currency.

Indirect Quote =
! "# $% #

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 2015, Study Session # 6, Reading # 21

LOS 21.d

For Direct Quote:

34
%∆ Exchange rate = 54
3
−1
5

If, % >0; FC appreciated

% <0; FC depreciated.

LOS 21.e

Cross rate:
It’s the exchange rate between two
currencies derived from a third
common currency.
£ ;<= £
= ×
9:! 9:! ;<=

LOS 21.f.g Forward exchange rate is quoted in two ways

i) Unit of points: Note: ii) Percentage terms:

It’s the last decimal place in the spot If Forward rate > Spot rate, £ is Continuing with our example;
?.?? ?A
exchange rate quote. trading at a forward premium Forward premium = × 100
E.FG
For example: If Forward rate < Spot rate, £ is = 0.0286%
?.A
+10.2→ = 0.00102 trading at a forward discount or 0.029%
?,???
Suppose,
S0 =3.561 USD/£
Forward rate = 3.561 + 0.00102
= 3.56202 USD/£

LOS 21.h

Interest rate parity (for DC/FC):

H IJ K N OPQRSTU
=
LM # N VPWRXYSZ
N OPQRSTU
⇒ forward = spot × [ \
N VPWRXYSZ
If,
N OPQRSTU
Market forward rate ≠ spot rate × [ \
N VPWRXYSZ
⇒ Arbitrage is possible

LOS 21.i Exchange Rate Regimes

Countries That Don’t Have Their Own Currency: Countries That Have Their Own Currency:
i. Use currency of another country as its own (formal i. Currency board arrangement
dollarization). ii. Conventional fixed peg arrangement
ii. Use of a common currency (Participating in a iii. Crawling peg (active and passive)
monetary union) iv. Management of fixed exchange rate with crawling
bands
v. Managed floating exchange rates.
vi. Independently floating rates

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 2015, Study Session # 6, Reading # 21

LOS 21.j

Exports – Imports = (Private Savings – Investment in physical capital) + (Tax

revenue – govt. spending)
X – M = (S – I) + (T – G)
Trade surplus (X > M) must be reflected in a fiscal surplus (T > G), an excess
savings (S > I) or both.

LOS 21.j

Elasticities Approach:
^_`abcd
] =
^_`abcd + fg`abcd
fg`abcd
]< =
^_`abcd + fg`abcd
Marshall – Lerner condition where depreciation of DC → ↓ Trade deficit (X –
M)
WX EX + WI (EI – 1) >0

The J-Curve:
Short-term ↑ in deficit followed by ↓ when Marshall-Lerner condition is met is
referred to as the J-Curve

Absorption Approach:
Focuses on capital account & can be represented by:
BT = Y – E
Where,
BT: Balance of Trade
Y: National Income
E: Domestic expenditure

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