xX R20 - Currency Exchange Rates Gdutors READING 20 CURRENCY EXCHANGE RATES Cited Pee ea) spot and forward exchange rates. CES cea a a ‘An exchange rate is simply the price or cost of units of one currency in terms of Exchange | another. rate Interpretation of exchange rate of &/$ = 62 = This means that 1$=% 62 & 1% = 1/62$ Base and | $ = Price currency Price currency | Note: All decisions you take is from the perspective of base currency. Nominal & Real exchange rate Spot exchange | A spot exchange rate is the currency exchange rate for immediate delivery. rate A forward exchange rate isa currency exchange rate for an exchange to be done in the future 2. A forwardis actually an agreement to exchange a specific amount of one Forward currency for a specific amount of another on a future date specified in exchange the forward agreement. rate Example: You agreed with SBI to pay @ 2/S = 62 for $ 1,100 payable to CFA Institute in 6 months from now. By doing this agreement, you have technically eliminated the currency risk. ‘outcome _| Describe functions of and participants in the foreign exchange ma 8 Foreign currency markets serve companies and individuals that purchase or sell Role of ole OF | foreign goods and services denominated in foreign currencies. An even larger FOREN | market, however, exists for capital flows. Foreign currencies are needed to purchase foreign physical assets as well as foreign financial securities. By entering into a forward currency contract any firm can reduce or eliminate ing | its foreign exchange risk associated with the transaction. When a firm takes a Hedging " . position in the foreign exchange market to reduce an existing risk, we say the firm is hedging its risk.€Edutors vove, Ech & Empower Speculation CFA Level 1 8y Gourav Kabra ‘When a transaction in the foreign exchange markets increases currency risk, we term ita speculative transaction or position. investors, companies, and financial institutions, such as banks and investment funds, all regularly enter into speculative foreign currency transactions. Buy side & Sell side Buy side Primary dealers & large multinational banks Sell side — Corporates, Investors etc. Buy side parties pail Rea) a ney. een ke ea Corporations regularly engage in cross-border transactions, purchase and sell foreign currencies as a result, and enter into FX forward contracts to hedge the risk of expected future receipts and payments denominated in foreign currencies. Investment accounts of many types transact in foreign currencies, hold foreign securities, and may both speculate and hedge with currency derivatives, Real money accounts refer to mutual funds, pension funds, insurance companies, and other institutional accounts that do not use derivatives, Leveraged accounts refer to the various types of investment. firms that do use derivatives, including hedge funds, firms that trade for their own accounts, and other trading firms of various types. Governments and government entities, including sovereign wealth funds and pension funds, acquire foreign exchange for transactional needs, investment, or speculation. Central banks sometimes engage in FX transactions to affect exchange rates in the short term in accordance with government policy. The retail market refers to FX transactions by households and relatively small institutions and may be for tourism, cross-border investment, or speculative trading, meen Cid Note _| Always calculate % change of the base currency in a foreign exchange quotation, What does a decrease in the USD/EUR exchange rate from 1.44 to 1.42 Mlustration represent? Outcome | Calculate and interpret currency cross-rates Cross rate The cross rate is the exchange rate between two currencies implied by their ‘exchange rates with a common third currency. Cross rates are necessary when there is no active FX market in the currency pair.7 dutors R20 - Currency Exchange Rates lf the MXN/USD quote is 12.3 and the USD/EUR quote is 1.45, then the MXN/EUR Mustration cross rate is closest to? Calculate spot USD/GBP cross rate using the following information: tmustration | 1 USO/EUR 1.5602 2. MXN/USD 2.0880 3. MxN/GBP 2.1097 PC er nn Pa ec ‘A forward exchange rate quote typically differs from the spot quotation and is expressed in terms of the difference between the spot exchange rate and the Point: oints | forward exchange rate. One way to indicate this is with points. The unit of points is the last decimal place in the spot rate quote. ttustration | Th¢ AUD/EUR spot exchange rate is 0.7313 with the 1-year forward rate quoted at +3.5 points, What is the 1-year forward AUD/EUR exchange rate? tustration | TR AUD/EUR spot rate is quoted at 0.7313, and the 120-day forward exchange rate is given as ~0.062%. What is the 120-day forward AUD/EUR exchange rate? Pree OURO eu SC COA Re Com UC Rod aa No arbitrage relation is also known as interest rate parity. Cee eo eee (discount) Consider two currencies, the ABE and the DUB. The spot ABE/DUB exchange rate is 4.5671, the 1-year riskless ABE rate is 5%, and the 1-year riskless DUB rate is 3%, What is the 1-year forward exchange rate that will prevent arbitrage profits? Also calculate forward premium/discount. Mlustration Solutiony dutors vove, Ech & Empower oo CFA Level 1 8y Gourav Kabra Pree ee te ecu ec Ce Rd PE llustration | To be done in class Arbitrage process CRE ee ee ace Countries that do not have their own currency Formal A country can use the currency of another country (formal doll in). The country cannot have its own monetary policy, as it does not create money/currency. ‘Monetary union A country can be a member of a monetary union in which several countries use a common currency. Within the European Union, for example, most countries use the euro. ‘While individual countries give up the ability to set domestic monetary policy, they all participate in determining the monetary policy of the European Central Bank, Countries that do not have their own currency Currency board arrangement A currency board arrangement is an explicit commitment to exchange domestic currency for a specified foreign currency at a fixed exchange rate. A notable example of such an arrangement is Hong Kong. In Hong Kong, currency is (and may be} only issued when fully backed by holdings of an ‘equivalent amount of U.S. dollars. The Hong Kong Monetary Authority can earn interest on its U.S. dollar balances. Withy R20 - Currency Exchange Rates Edutors Evoke, Eich & Empower dollarization, there is no such income, as the income is earned by the U.S. Federal Reserve when it buys interest- bearing assets with the U.S. currency it issues. While the monetary authority gives up the ability to conduct independent monetary policy and essentially imports the inflation rate of the outside currency, there may be some latitude to affect interest rates over the short term. Ina conventional fixed peg arrangement, a country pegs its currency within margins of +19 versus another currency or a basket that includes the currencies of its major trading or financial partners. The monetary authority can maintain exchange rates within the band by purchasing or selling foreign currencies in the foreign exchange markets (direct intervention). In addition, the country can use indirect intervention, including changes in interest rate policy, regulation of foreign exchange transactions, and convincing people to constrain foreign exchange activity. The monetary authority retains more flexibility to conduct monetary policy than with dollarization, a monetary union, or a currency board, However, changes in policy are constrained by the requirements of the peg. Conventional fixed peg arrangement In a system of pegged exchange rates within horizontal bands or a target zone, the permitted fluctuations in currency value relative to another currency or basket of currencies are wider (e.g., #2%). Compared to a conventional eg, the monetary authority has more policy discretion because the bands are wider. Target zone With a crawling peg the exchange rate is adjusted periodically, typically to adjust for higher inflation versus the currency used in the peg. This is termed a passive crawling peg, as opposed to an active crawling peg in which a series Countries that donot | Cling peg | of exchange rate adjustments over time is announced and fae atigte implemented. An active crawling peg can influence inflation expectations, adding some predictability to domestic own currency inflation. Monetary policy is restricted in much the same way itis with a fixed peg arrangement. With management of exchange rates within crawling bands, the width of the bands that identify permissible Management of | exchange rates is increased over time. This method can be exchange rates. | used to transition from a fixed peg to a floating rate when within crawling | the monetary authority's lack of credibility makes an bands immediate change to floating rates impractical. Again, the degree of monetary policy flexibility increases with the width of the bands,€Edutors vove, Ech & Empower Countries that do not have their own currency Introduction Cres CFA Level 1 8y Gourav Kabra With a system of managed floating exchange rates, the monetary authority attempts to influence the exchange rate in response to specific indicators such as the balance of payments, inflation rates, or employment without any specific target exchange rate or predetermined exchange rate path. Intervention may be direct or indirect. Such management of exchange rates may induce trading partners to respond in ways that reduce stability. Managed floating exchange rates ‘When a currency is independently floating, the exchange rate is market determined, and foreign exchange market intervention is used only to slow the rate of change and reduce short-term fluctuations, not to keep exchange rates ata target level. Independently floating in the effects of exchange rates on countries’ international trade and capital X-M=(S-1) +(T-G) When XM <0; there could be two possibilities: 1. S0 where: W.= proportion of total trade that is exports Wa= proportion of total trade that is imports x= price elasticity of demand for exports m= price elasticity of demand for imports In the case where import expenditures and export revenues are equal, Wx= Wa, this condition reduces to ex + em > 1, which is most often cited as the classic ‘Marshall-Lerner condition.y R20 - Currency Exchange Rates Edutors Evoke, Eich & Empower CONCLUSION The elasticities approach tells us that currency depreciation will result in a greater improvement in the trade deficit when either import or export demand is elastic. For this reason, the compositions of export goods and import goods are an important determinant of the success of currency depreciation in reducing trade deficit. Note: in general, elasticity of demand is greater for goods with close substitutes, ‘g00ds that represent a high proportion of consumer spending, and luxury goods in general. Goods that are necessities, have few or no good substitutes, or represent a small proportion of overall expenditures tend to have less elastic demand. Thus, currency depreciation will have a greater effect on the balance of trade when import or export goods are primarily luxury goods, goods with close substitutes, and goods that represent a large proportion of overall spending. The J-Curve Because import and export contracts for the delivery of goods most often require delivery and payment in the future, import and export quantities may be relatively insensitive to currency depreciation in the short run. This means that a currency depreciation may worsen a trade deficit initially thereafter the Marshall-Lerner conditions take effect and the currency depreciation begins to improve the trade balance. This short-term increase in the deficit followed by a decrease when the Marshall-Lerner condition is met is referred to as the J-curve. ‘SHORTCOMING OF ELASTICITIES APPROACH ‘One shortcoming of the elasticities approach is that it only considers the microeconomic relationship between exchange rates and trade balances. It ignores capital flows, which must also change as a result of a currency depreciation that improves the balance of trade. ‘ABSORPTION APPROACH The absorption approach is a macroeconomic technique that focuses on the capital account and can be represented as: The BT=Y-E Absorption | where: Approach jomestic production of goods and services or national income E = domestic absorption of goods and services, which is total expenditure BT= balance of trade Viewed in this way, we can see that income relative to expenditure must increase (domestic absorption must fall) for the balance of trade to improve in response to a currency depreciation. For the balance of trade to improve, domestic saving must increase relative to domestic investment in physical capital (which is a component of £}. Thus, for a depreciation of the domestic currency to improve the balance of trade towards surplus, it must increase national income relative to expenditure, We can also view this as a requirement that national saving increase relative to domestic investment in physical capital.xy dutors rv tev Evove, Ench & Empower FA Level y Gourav Kabra EFFECT OF CURRENCY DEPRECIATION Less than Full employment: ‘When an economy is operating at less than full employment, the currency depreciation makes domestic goods and assets relatively more attractive than foreign goods and assets. Resultantly, both expenditures and income will increase but national income will increase more than total expenditure, improving the balance of trade. Full employment: Ina situation where the economy is operating at full employment (capacity), an increase in domestic spending will translate to higher domestic prices, which can reverse the relative price changes of the currency depreciation, resulting ina return to the previous deficit in the balance of trade.