READING NO.

20
CURRENCY EXCHANGE RATES

Disclaimer: Certain materials contained within this text are the copyright property of CFA
Institute. The following is the source for these materials: “CFA® Program Curriculum
Level I Volume 2, Page No. 455 to 460”
READING NO. 20
CURRENCY EXCHANGE RATES
Concept No. 1: Meaning of currency exchange rates
Concept No. 2: Base currency and price currency

Concept No. 3: Appreciation and depreciation of currency

Concept No. 4: Direct quote and indirect quote
Concept No. 5: Buy/sell transaction
Concept No. 6: Cross rate
Concept No. 7: Forward quotations

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• [Example: Cross rate computation]The spot exchange rate between the
Swiss franc (CHF) and the USD is CHF/USD = 1.7285, and the spot
exchange rate between the New Zealand dollar (NZD) and the U.S. dollar
is NZD/USD = 2.2725.Calculate the CHF/NZD spot rate.
• [Example: Forward exchange rates in points] The AUD/EUR spot
exchange rate is 0.7247 with the 1-year forward rate quoted at +2.7 points.
What is the 1-year forward AUD/EUR exchange rate?
• [Example: Forward exchange rates in percent] The AUD/EUR spot rate is
quoted at 0.7247 and the 90-day forward exchange rate is given as 0.022%.
What is the 90-day forward AUD/EUR exchange rate?

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Concept No. 8: Spot versus Forward Exchange Rates
Spot exchange rates (S) are quotes for transactions that call for immediate delivery. For most currencies,
immediate delivery means “T + 2” delivery i.e., the transaction is actually settled 2 days after the trade is agreed
upon by the parties.
Forward exchange rates (F) are quotes for transactions that are contracted (agreed upon) today, but settled at a pre-
specified date in the future (settlement occurs after a longer period than the two days for spot transactions).
Concept No. 9: Nominal exchange and real exchange rate
Concept No. 10: Forward rate, spot rate and interest rate
Concept No. 11: Functions of the Foreign Exchange Market
Facilitate international trade
Allow investors to convert between currencies in order to move funds into (or out of) foreign assets.
Enable market participants who face exchange rate risk to hedge their risks.
Allow investors to speculate on currency values.

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Concept No. 12: Market Participants
Sell Side: Banks
Buy Side: Corporate accounts, Governments, Central banks, Individuals,
Investment accounts

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An exchange rate:
A. is most commonly quoted in real terms.
B. is the price of one currency in terms of another.
C. between two currencies ensures they are fully convertible.

B is correct. The exchange rate is the number of units of

the price currency that 1 unit of the base currency will
buy. Equivalently, it is the number of units of the price
currency required to buy 1 unit of the base currency.

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In order to minimize the foreign exchange exposure on a euro-denominated
receivable due from a German company in 100 days, a British company
would most likely initiate a:
A. spot transaction.
B. forward contract.
C. real exchange rate contract.
B is correct. The receivable is due in 100 days. To
reduce the risk of currency exposure, the British
company would initiate a forward contract to sell
euros/buy pounds at an exchange rate agreed to today.
The agreed-upon rate is called the forward exchange
rate.
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Which of the following counterparties is most likely to be considered a sell-
side foreign-exchange market participant?
A. A large corporation that borrows in foreign currencies.
B. A sovereign wealth fund that influences cross-border capital flows.
C. A multinational bank that trades foreign exchange with its diverse client
base.
C is correct. The sell side generally consists of large
banks that sell foreign exchange and related instruments
to buy-side clients. These banks act as market makers,
quoting exchange rates at which they will buy (the bid
price) or sell (the offer price) the base currency.

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What will be the effect on a direct exchange rate quote if the domestic
currency appreciates?
A. Increase
B. Decrease
C. No change

B is correct. In the case of a direct exchange rate, the domestic currency is the price currency (the
numerator) and the foreign currency is the base currency (the denominator). If the domestic currency
appreciates, then fewer units of the domestic currency are required to buy 1 unit of the foreign
currency and the exchange rate (domestic per foreign) declines. For example, if sterling (GBP)
appreciates against the euro (EUR), then euro–sterling (GBP/EUR) might decline from 0.8650 to
0.8590.

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An executive from Switzerland checked into a hotel room in Spain and was
told by the hotel manager that 1 EUR will buy 1.2983 CHF. From the
executive’s perspective, an indirect exchange rate quote would be:
A. 0.7702 EUR per CHF.
B. 0.7702 CHF per EUR.
C. 1.2983 EUR per CHF.
A is correct. An indirect quote takes the foreign country as the price currency
and the domestic country as the base currency. To get CHF—which is the
executive’s domestic currency—as the base currency, the quote must be stated
as EUR/CHF. Using the hotel manager’s information, the indirect exchange
rate is (1/1.2983) = 0.7702.

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Over the past month, the Swiss Franc (CHF) has depreciated 12 percent
against pound sterling (GBP). How much has the pound sterling appreciated
against the Swiss Franc?
A. 12%
B. Less than 12%
C. More than 12%

C is correct. The appreciation of sterling against the Swiss franc is simply the
inverse of the 12% depreciation of the Swiss franc against Sterling: [1/(1 –
0.12)] – 1 = (1/0.88) – 1 = 0.1364, or 13.64%.

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A BRL/MXN spot rate is listed by a dealer at 0.1378. The 6-month forward
rate is 0.14193. The 6-month forward points are closest to:
A. –41.3.
B. +41.3.
C. +299.7.

B is correct. The number of forward points equals the forward rate minus the
spot rate, or 0.14193 – 0.1378 = 0.00413, multiplied by 10,000: 10,000 ×
0.00413= 41.3 points. By convention, forward points are scaled so that ±1
forward point corresponds to a change of ±1 in the last decimal place of the
spot exchange rate.

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A three-month forward exchange rate in CAD/USD is listed by a dealer at
1.0123. The dealer also quotes 3-month forward points as a percentage at
6.8%. The CAD/USD spot rate is closest to:
A. 0.9478.
B. 1.0550.
C. 1.0862.
A is correct. Given the forward rate and forward points as a percentage, the
unknown in the calculation is the spot rate. The calculation is as follows:
Spot rate × (1 + Forward points as a percentage) = Forward rate
Spot rate × (1 + 0.068) = 1.0123
Spot = 1.0123/1.068 =0.9478

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Using the expenditure approach,
GDP = C + I + G + (X – M)
where: C = consumption spending, I = business investment (capital equipment,
inventories), G = government purchases, X = exports, M = imports
Under income approach
 GDP = C + S + T
 where: C = consumption spending, S = household and business savings, T = net taxes

C + I + G + (X – M) = C + S + T
X – M = (S – I) + (T – G)

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Concept No. 13: Explain the effects of exchange rates on countries’ international trade and capital flows.
In theory, currency depreciates,
 Import becomes expensive
 Export becomes cheap

Thus, trade deficit improves.

However, in practical life, changes in quantity demanded is a function of elasticity of demand.
Following goods generally will have a high elasticity of demand:
 Luxury goods
 Goods with close substitute
 Goods on which consumer spends large proportion of income.

If export portfolio of a country has high elasticity of demand, trade deficit will improve, however if elasticity of
demand is low, trade deficit will not improve.
If import portfolio of a country has high elasticity of demand, trade deficit will improve, however if elasticity of
demand is low, trade deficit will not improve.

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As per Marshall-lerner condition, trade deficit will improve if:
 WX εX + WM (εM – 1) > 0
where:
Wx = proportion of total trade that is exports
Wm = proportion of total trade that is imports
εX = price elasticity of demand for exports
εm = price elasticity of demand for imports

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J curve effect
Currency depreciates, for short term, there
is committed level of imports and exports,
thus trade deficit will increase
However, in long run, it will improve

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The Absorption Approach
Economy is operating below full employment
Currency depreciations, leads to imported goods expensive, now domestic
producer will produce more, income will increase, savings will increase, thus
trade deficit improves.
Economy is at full capacity level
Trade deficit will not improve

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Concept No. 14: Describe exchange rate regimes.
Exchange rate regimes for countries that do not have their own currency:
 With formal dollarization, a country uses the currency of another country.
 In a monetary union, several countries use a common currency.
Exchange rate regimes for countries that have their own currency:
 A currency board arrangement is an explicit commitment to exchange domestic
currency for a specified foreign currency at a fixed exchange rate. A fixed exchange
rate in which monetary authority is legally required to hold foreign exchange reserves
backing 100% of its currency issuance.
 In a conventional fixed peg arrangement, a country pegs its currency within margins of
±1% versus another currency.

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Target zone, similar to a fixed‐rate system. The only difference is that the monetary authority aims to
maintain the exchange rate within a slightly broader range(e.g., ±2 %).
Active and Passive Crawling Pegs
 Under a passive crawling peg system the exchange rate is adjusted frequently in line with the rate of
inflation.
 Under an active crawling peg system the exchange rate is pre‐announced for the coming weeks and
changes are made in small steps.
With management of exchange rates within crawling bands, the width of the bands that identify
permissible exchange rates is increased over time.
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.
When a currency is independently floating, the exchange rate is market determined.

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The policy framework adopted by a country’s central bank to manage its
currency’s exchange rate is called an exchange rate regime. An ideal
currency regime should have the following properties:
The exchange rate between any two currencies should be credibly fixed in
order to eliminate currency‐related uncertainty regarding the prices of goods
and services, and values of real and financial assets.
All currencies should be fully convertible to ensure unrestricted flow of
capital.
Each country should be able to undertake fully independent monetary policy
in pursuit of domestic objectives, such as growth and inflation targets.

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