ECONOMICS: MICROECONOMICS AND

MACROECONOMICS

CURRENCY EXCHANGE RATES

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OR WARRANT THE ACCURACY OF THE PREPARATORY
SOURCES OFFERED BY LOMONOSOV MOSCOW STATE
UNIVERSITY OR VERIFY OR ENDORSE THE PASS RATES
CLAIMED BY LOMONOSOV MOSCOW STATE UNIVERSITY.

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READING 20 CURRENCY EXCHANGE RATES 2

EXCHANGE RATE: NOMINAL AND REAL EXCHANGE RATES AND SPOT AND FORWARD
EXCHANGE RATES

 The foreign exchange (FX) market is the market for trading currencies against
each other
 The FX market is the world’s largest market
 The FX market facilitates world trade
 The FX participants buy and sell currencies needed for trade, but also
transact to hedge and speculate on currency exchange rates
 An exchange rate is the price of a country’s currency in terms of another
country’s currency

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EXCHANGE RATE: NOMINAL AND REAL EXCHANGE RATES AND SPOT AND FORWARD
EXCHANGE RATES
 Currencies are referred to by their
ISO code (e.g., USD, CHF, EUR)
 Exchange rate: The number of units
of one currency (the price currency)
that one unit of another (the base
currency) will buy
 Convention for exchange rate:
A/B = Number of units of A that
one unit of B will buy.
A = Price currency
B = Base currency
Price/Base = Unit of Base currency
in number of units of Price
currency
READING 20 CURRENCY EXCHANGE RATES
 Example:
61.965 USD/INR = 1
This means that one Indian rupee will
buy 61.965 US dollars.
 If this exchange rate falls to 60.5, the
rupee will buy fewer US dollars. That
means that it will take fewer US
dollars to buy a rupee. In other
words,
 The rupee is depreciating relative to
the US dollar or
 The US dollar is appreciating relative
to the rupee
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EXCHANGE RATE: NOMINAL AND REAL EXCHANGE RATES AND SPOT AND FORWARD
EXCHANGE RATES

 A real exchange rate is an exchange rate that has been adjusted for the relative
purchasing power of the two currencies’ home countries
 Quoted exchange rates are nominal exchange rates
 We calculate a real exchange rate by adjusting the exchange rates for the
relative price levels of the countries in the pair
 The real exchange rate, using AUD and USD, is the spot rate adjusted for the
relative price levels:
𝑆𝐴𝑈𝐷/𝑈𝑆𝐷 ×𝑃𝑈𝑆𝐷 𝑃
 Real exchange rate𝐴𝑈𝐷/𝑈𝑆𝐷 = = 𝑆𝐴𝑈𝐷/𝑈𝑆𝐷 × 𝑃 𝑈𝑆𝐷
𝑃𝐴𝑈𝐷 𝐴𝑈𝐷

where
𝑆𝐴𝑈𝐷/𝑈𝑆𝐷 is the nominal or spot exchange rate and
𝑃𝑈𝑆𝐷
is the relative price level
𝑃𝐴𝑈𝐷

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EXCHANGE RATE: NOMINAL AND REAL EXCHANGE RATES AND SPOT AND FORWARD
EXCHANGE RATES

 A spot exchange rate is an exchange rate for an immediate delivery (that is,
exchange) of currencies
 A forward exchange rate is an exchange rate for the exchange of currencies at
some specified, future point in time

 Interest rate parity

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 FUNCTIONS OF AND PARTICIPANTS IN THE FOREIGN EXCHANGE MARKET
Participants
 Corporations that regularly engage
in cross-border transactions
 Investment accounts: mutual funds,
pension funds, insurance
companies, hedge funds
 Governments and government
entities, including sovereign wealth
funds, pension funds and central
banks
 The retail market: households and
relatively small institutions
READING 20 CURRENCY EXCHANGE RATES
Purposes
 Companies and individuals transact
for the purpose of the international
trade of goods and services
 Capital market participants transact
for the purpose of moving funds into
or out of foreign assets
 Hedgers, who have an exposure to
exchange rate risk, enter into
positions to reduce this risk
 Speculators participate to profit
from future movements in foreign
exchange
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 PERCENTAGE CHANGE IN A CURRENCY RELATIVE TO ANOTHER CURRENCY
 A direct currency quote uses the
domestic currency as the price
currency and the foreign currency as
the base currency.
 An indirect currency quote uses the
domestic currency as the base
currency and the foreign currency as
the price currency.
READING 20 CURRENCY EXCHANGE RATES
Example
Consider the quote USD/BRL = 2.3638.
 The base currency is the Brazilian
real (BRL)
 The price currency is the US dollar
(USD)
 USD/BRL is a direct currency quote
from the US perspective
 USD/BRL is an indirect currency
quote from the Brazilian perspective
From the Brazilian perspective, we can
convert the USD/BRL into the direct
quote of BRL/USD by inverting:
1
BRL/USD = 2.3638 = 0.4230
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 PERCENTAGE CHANGE IN A CURRENCY RELATIVE TO ANOTHER CURRENCY

Appreciation or depreciation is with Example:

respect to the base currency relative to Suppose USD/CZK is 20.2000 and
the price currency increases to 20.3258
 Appreciation is a gain in value of one  The percentage change is
currency relative to another 20.3258
− 1 = 0.6228%
currency 20.2000
 Depreciation is the loss in value of  This means that the Czech koruna
one currency relative to another (CZK) appreciated 0.6228% against
currency the US dollar
 The percentage change is the ratio  It takes more US dollars to buy each
of the exchange rates minus one: koruna
𝐴
𝐵 𝑁𝑒𝑤  This also means that the US dollar
% change = 𝐴 −1
𝐵 𝑂𝑙𝑑 depreciated by
1
20.3258 − 1 = 0.0492 − 1 = −0.0061%
1 0.0495
20.2000
relative to the Czech koruna
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 CURRENCY CROSS-RATES

Given three currencies, a currency cross-rate is the implied exchange rate of

a third country pair given the exchange rates of two pairs of three currencies
that have a common currency.
 If arbitrage is possible, cross-rates will be consistent.
Example 1: Suppose you have the following quotes:
AUD/USD = 0.8812 USD/DKK = 5.5027
What is the AUD/DKK exchange rate?
AUD USD AUD
× = = 0.8812 × 5.5027 = 4.8490
USD DKK DKK
Example 2: Suppose you have the following quotes:
ILS/USD = 3.4885 NOK/USD = 6.1706
What is the ILS/NOK exchange rate?
ILS USD ILS 1
× = = 3.4885 × = 0.5589
USD NOK NOK 6.1706

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FORWARD QUOTATION EXPRESSED ON A POINTS BASIS OR IN PERCENTAGE TERMS –
AN OUTRIGHT FORWARD QUOTATION

 Forward exchange rates are quoted Example: Using pips

in terms of points (pips: points in
percentage)
 If forward rate > spot rate,
the base currency is trading at a
forward premium
 If forward rate < spot rate,
the base currency is trading at a
forward discount
 Points are 1:10,000 (move the
decimal place four places)
 Forward quotes can be specified as
the number of pips from the spot
rate or as a percentage of the spot
rate
READING 20 CURRENCY EXCHANGE RATES
Suppose that the USD/EUR spot rate is
1.3559 and that the one-month forward
is 1.47 pips. Therefore, the forward rate
is
Forward rate = 1.3559 + 1.47 10,000
= 1.3559 + 0.000147
= 1.356047
Example: Using a percentage
Suppose that the spot rate of USD/CHF
is 0.9105 and that the one-month
forward points as a percentage of the
spot rate is 0.02%. The one-month
forward rate is
Forward rate = 0.9105 x 1.0002
= 0.9106821
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ARBITRAGE RELATIONSHIP BETWEEN SPOT RATES, FORWARD AND INTEREST RATES

No-arbitrage relation (interest rate parity):

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 FORWARD DISCOUNT OR PREMIUM

 The relationship between forward Example

and spot rates: Suppose that the AUD/USD spot rate is
𝑖𝑓 − 𝑖𝑑 0.8808 and that the one-month forward
𝐹𝑓 𝑑 − 𝑆𝑓 𝑑 = 𝑆𝑓 𝑑 τ
1 + 𝑖𝑑 τ rate is 0.8789.
where Therefore,
𝐹𝑓 𝑑 = Forward rate 𝐹𝑓 𝑑 = 0.8789,
𝑆𝑓 𝑑 = Spot rate 𝑆𝑓 𝑑 = 0.8808, and
𝑖𝑑 = Domestic interest rate τ = 30/360.
𝑖𝑑 = Foreign interest rate There is a forward discount of
τ = Time (in years) 0.8808 – 0.8789 = – 0.0019
This means that any premium or or 19 pips, so 𝑖𝑓 < 𝑖𝑑
discount is a function of the interest
rates (domestic, 𝑖_𝑑, and foreign, 𝑖_(𝑓 ))
and time, τ

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 FORWARD RATE CONSISTENT WITH THE SPOT RATE

𝑖𝑓 − 𝑖𝑑
Using 𝐹𝑓 𝑑 − 𝑆𝑓 𝑑 = 𝑆𝑓 𝑑 τ,
1+𝑖𝑑 τ
we can calculate a forward rate based on 𝑆𝑓 𝑑 , 𝑖𝑓 , 𝑖𝑑 ,and τ.
Example:
Suppose we have the spot exchange rate of the CAD/USD of 1.0969. If the
one-year T-bill interest rate in the United States is 0.109% and the Canadian
one-year Treasury rate is 0.95%, what is the one-year forward rate?
𝑖𝑓 − 𝑖𝑑
𝐹𝑓 𝑑 = 𝑆𝑓 𝑑 + 𝑆𝑓 𝑑 τ
1 + 𝑖𝑑 τ
0.0095 − 0.00109
𝐹𝑓 𝑑 = 1.0969 + 1.0969 1 = 1.0969 + 0.0092 = 1.1061
1 + 0.00109
The estimated forward rate is 1.1061, which means that the forward rate
should be trading at a premium of 1.1061 – 1.0969 = 92 pips.

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 EXCHANGE RATE REGIMES

 An exchange rate regime is the policy framework for foreign exchange.

 The ideal currency regime (which does not exist) would consist of the
following circumstances:
 Exchange rate is credible and fixed
 All currencies are fully convertible
 All countries undertake independent monetary policy for domestic
objectives

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 EXCHANGE RATE REGIMES

Regime Type Description

No separate legal Fixed Dollarization: Use another nation’s currency as the
tender medium of exchange (USD).
Shared currency Fixed Monetary union: Use a currency of a group of
countries as the medium of exchange.
Currency board Fixed Use another currency in reserve as the monetary base,
system maintaining a fixed parity.
Fixed parity or fixed Fixed Use another currency or basket of currencies in
rate system reserve, but with some discretion (parity bands).
Target zone Fixed Fixed parity (peg) with fixed horizontal intervention
bands.

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 EXCHANGE RATE REGIMES

Regime Type Description

Active and passive Peg Adjust the exchange rate against a single currency,
crawling pegs with adjustments for inflation (passive) or announced
in advance (active).
Fixed parity with Peg Similar to target zone, but bands can be widened.
crawling bands
Managed float Float Allow exchange rate to float, but intervene to manage
it toward targets.
Independently floating Float Exchange rate is market determined (supply and
rates demand).

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 THE IMPACT OF EXCHANGE RATES ON COUNTRIES’ INTERNATIONAL TRADE
AND CAPITAL FLOWS
The net effect of imports and exports affects a country’s capital flows:
Trade deficit → Capital account surplus
Trade surplus → Capital account deficit

Using the national accounts relationship, we see the relationship between

trade and expenditures/savings and taxes/government spending:
X–M = (S – I) + (T – G)
↑ ↑ ↑
Exports less imports Savings less Taxes less government
investment spending
↑ ↑
Trade surplus or deficit Fiscal surplus or deficit

The potential flow of financial capital in or out of a country is mitigated by

changes in asset prices and exchange rates.

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 THE IMPACT OF EXCHANGE RATES ON COUNTRIES’ INTERNATIONAL TRADE
AND CAPITAL FLOWS

Marshall–Lerner theory
 The effectiveness of currency devaluations or depreciation on trade depends
on the price sensitivities (that is, price elasticities) of the goods and services
 If the goods and services are highly elastic, trade responds to devaluation or
depreciation, improving the domestic economy
 If the goods and services are inelastic, trade is less responsive to devaluation
or depreciation
Generalized Marshall-Lerner condition: depreciation of the domestic currency will
decrease a trade deficit if

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 THE IMPACT OF EXCHANGE RATES ON COUNTRIES’ INTERNATIONAL TRADE
AND CAPITAL FLOWS

The Absorption Approach

 If there is devaluation the change in the exchange rate must increase income
relative to expenditures to improve the economy (decrease a trade deficit)
 This affects national income through the wealth effect: more savings and
buying financial assets from foreigners

READING 20 CURRENCY EXCHANGE RATES 20

 HOMEWORK ASSIGNMENT
READING
CFA® Level I Curriculum (2019) Volume II  Reading 20

PRACTICE PROBLEMS
CFA® Level I Curriculum (2019) Volume II  Reading 20  Practice Problems
MOODLE  CFA® Level I 2019  TESTS  Economics #1

READING 20 CURRENCY EXCHANGE RATES 21