CFA® Level I – Economics

Currency Exchange Rates

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 Contents and Introduction
1. Introduction

2. The Foreign Exchange Market

3. Currency Exchange Rate Calculations

4. Exchange Rate Regimes

5. Exchange Rates, International Trade, and Capital Flows

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 2. The Foreign Exchange Market
• Currency Codes

• Exchange Rate
 Price Currency
 Base Currency

• Currency Appreciation

• Currency Depreciation

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 Nominal and Real Exchange Rates
• Nominal exchange rate

• Real exchange rate measures the relative purchase power of one currency
compared with another
 Increasing function of nominal exchange rate
 Increasing function of price level in base currency
 Decreasing function of price level in price currency

RP/B = SP/B x PB / PP

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 Example 1 – Nominal and Real Exchange Rates
An investment adviser located in Sydney, Australia, is meeting with a local client who is looking to diversify her domestic bond
portfolio by adding investments in fixed-rate, long-term bonds denominated in HKD. The client frequently visits Hong Kong, and
many of her annual expenses are denominated in HKD. The client, however, is concerned about the foreign currency risks of
offshore investments and whether the investment return on her HKD-denominated investments will maintain her purchasing
power—both domestically (i.e., for her AUD-denominated expenses) and in terms of her foreign trips (i.e., denominated in HKD,
for her visits to Hong Kong). The investment adviser explains the effect of changes in nominal and real exchange rates to the
client and illustrates this explanation by making the following statements:
1. All else equal, an increase in the nominal AUD/HKD exchange rate will lead to an increase in the AUD- denominated value of
your foreign investment.
2. All else equal, an increase in the nominal AUD/HKD exchange rate means that your relative purchasing power for your Hong
Kong trips will increase (based on paying for your trip with the income from your HKD-denominated bonds).
3. All else equal, an increase in the Australian inflation rate will lead to an increase in the real exchange rate (AUD/ HKD). A
higher real exchange rate means that the relative purchasing power of your AUD-denominated income is higher.
4. All else equal, a decrease in the nominal exchange rate (AUD/HKD) will decrease the real exchange rate (AUD/HKD) and
increase the relative purchasing power of your AUD-denominated income.
To demonstrate the effects of the changes in inflation and nominal exchange rates on relative purchasing power, the adviser uses
the following scenario: “Suppose that the AUD/HKD exchange rate increases by 5 percent, the price of goods and services in Hong
Kong goes up by 5 percent, and the price of Australian goods and services goes up by 2 percent.”

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 Example 1 (Cont…)
1. All else equal, an increase in the nominal AUD/HKD exchange rate will lead to an increase in
the AUD- denominated value of your foreign investment. (True or False)

2. All else equal, an increase in the nominal AUD/HKD exchange rate means that your relative
purchasing power for your Hong Kong trips will increase (based on paying for your trip with the
income from your HKD-denominated bonds). (True or False)

3. All else equal, an increase in the Australian inflation rate will lead to an increase in the real
exchange rate (AUD/ HKD). A higher real exchange rate means that the relative purchasing
power of your AUD-denominated income is higher. (True or False)

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 Example 1 (Cont…)
4. All else equal, a decrease in the nominal exchange rate (AUD/HKD) will decrease the real
exchange rate (AUD/HKD) and increase the relative purchasing power of your AUD-
denominated income. (True or False)

5. Based on the adviser’s scenario and assuming that the HKD value of the HKD bonds remained
unchanged, the nominal AUD value of the client’s HKD investments would:

6. Based on the adviser’s scenario, the change in the relative purchasing power of the client’s
AUD-denominated income is closest to:

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 2.1 Market Function
• Several motivations for FX transactions

• Hedging versus speculating

• Spot transactions

• Forward contracts

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 Example 2 – Spot and Forward Exchange Rates
The investment adviser based in Sydney, Australia, continues her meeting with the local client who has diversified
her domestic bond portfolio by adding investments in fixed-rate, long-term bonds denominated in HKD. Given
that the client spends most of the year in Australia, she remains concerned about the foreign exchange risk of her
foreign investments and asks the adviser how these might be managed. The investment adviser suggests the
following investment strategy to the client: “You can exchange AUD for HKD in the spot exchange market, invest in
a risk-free, one-year HKD-denominated zero coupon bond, and use a one-year forward contract for converting the
proceeds back into AUD.”

Spot rate (AUD/HKD) = 0.1429; one-year HKD interest rate = 7.00%; one-year forward rate (AUD/HKD) = 0.1402

Which of the following statements is most correct? Over a one-year horizon, the exchange rate risk of the client’s
investment in HKD- denominated bonds is determined by uncertainty over:
A. today’s AUD/HKD forward rate.
B. the AUD/HKD spot rate one year from now.
C. the AUD/HKD forward rate one year from now.

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 Example 2 – Spot and Forward Exchange Rates
To reduce the exchange rate risk of the Hong Kong investment, the client should:
A. sell AUD spot.
B. sell AUD forward.
C. sell HKD forward.

Over a one-year horizon, the investment proposed by the investment adviser is most likely:
A. risk free.
B. exposed to interest rate risk.
C. exposed to exchange rate risk.

To set up the investment proposed by the adviser, the client would need to:
A. sell AUD spot; sell a one-year, HKD-denominated bond; and buy AUD forward.
B. buy AUD spot; buy a one-year, HKD-denominated bond; and sell AUD forward.
C. sell AUD spot; buy a one-year, HKD-denominated bond; and buy AUD forward.

The return (in AUD) on the investment proposed by the investment adviser is closest to:
A. 5.00 percent.
B. 6.00 percent.
C. 7.00 percent.

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 2.2 Market Participants
Diverse range of market participation

Sell Side: Buy Side:

• Large FX trading banks such as Deutsche Bank, • Clients who use banks to undertake FX
Citigroup, UBS and HSBC transactions
• Other banks fall into the second and third tier • Corporate accounts
of the FX market • Real money accounts
• Leveraged accounts
• Retail accounts
• Governments
• Central banks
• Sovereign wealth funds

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 2.3 Market Size and Composition
Exhibit 3 - FX Turnover by Instrument Exhibit 4 - FX Flows by Counterparty
Spot 36% Interbank 39%
OTC forwards 12 Financial clients 48
Exchange-traded derivatives 4 Non-financial clients 13
Swaps 44
OTC options 4

EXAMPLE 3 MARKET PARTICIPANTS AND COMPOSITION OF TRADES

True or False:

Foreign exchange transactions for spot settlement see the most trade volume in terms of average
daily turnover because the FX market is primarily focused on settling international trade flows.

The most important foreign exchange market participants on the buy side are corporations
engaged in international trade; on the sell side they are the local banks that service their FX
needs.

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 3. Currency Exchange Rate Calculations

• Exchange Rate Quotations

• Cross-Rate Calculations

• Forward Calculations

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 3.1 Exchange Rate Quotations
Given this quote 1.4000 USD/EUR

Price currency: USD

Base currency: EUR

Direct quote takes domestic currency as the price currency

Indirect quote takes domestic currency as the base currency
From a German investor perspective, is the above a direct quote?

Bid-Ask: 1.3990 - 1.4010 USD/EUR

Appreciation of one currency is the depreciation of the other

Say the USD/EUR rate changed from 1.4000 to 1.5000
What is the appreciation/depreciation of each currency?

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 Example 4 – Exchange Rate Conventions
A dealer based in New York City provides a spot exchange rate quote of 12.4035
MXN/USD to a client in Mexico City. The inverse of 12.4035 is 0.0806.

1. From the perspective of the Mexican client, what is the direct exchange rate?

2. If the bid/offer quote from the dealer was 12.4020 ~ 12.4060 MXN/USD, what is
the bid/offer quote in USD/MXN terms

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 3.2 Cross-Rate Calculations
Given two exchange rates and three currencies it is possible to determined the third
exchange rate.

Given the two exchange rates below, what is the INR/PKR cross rate?

Ratio Spot Rate

PKR/USD 100.00
INR/USD 60.00

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 Example 5 – Cross Exchange Rates and Percentage Changes

What is the spot CHF/EUR cross-rate? Spot Rate Expected

Spot Rate
USD/EUR 1.3960 1.3863

What is the spot GBP/EUR cross-rate? CHF/USD 0.9585 0.9551

USD/GBP 1.5850 1.5794

Is the EUR expected to appreciate or

depreciate against the USD? By how much?

Which currency is expected to be the strongest

over the next year?

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 3.3 Forward Calculations
Forward exchange rates are generally quoted in terms of points or pips

Maturity Sport Rate or Forward Points

What is the 12-month forward rate?
Spot 1.2875

One week –0.3

One month –1.1

Three months –5.5

Six months –13.3

At times forward points are expressed
Twelve months –26.5 as a percentage of the spot rate.

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 More on Forward Points
If the JPY/USD spot exchange rate = 100.55 and the 6-month forward rate is 100.40,
the 6-month forward points would be closest to?

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 Link Between Spot Rates, Forward Rates and Interest
Rates
FP/B= SP/B (1 + iP) / (1+iB)

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 Link Between Spot Rates, Forward Rates and Interest
Rates
FP/B= SP/B (1 + iP) / (1+iB)

• The currency with the higher (lower) interest rate will always
trade at a discount (premium) in the forward market.

• This relationship ensures that there is no arbitrage

• If the forward contracts is for x days, make an adjustment

based on x/360 convention unless told otherwise

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 Curriculum Example 6
A French company has recently finalized a sale of goods to a U.K.-based client and expects to receive a
payment of GBP 50 million in 32 days. The corporate treasurer at the French company wants to hedge
the foreign exchange risk of this transaction and receives the following exchange rate information from
a dealer: GBP/EUR spot rate = 0.8752; one-month forward points = –1.4

Given the above data, the treasurer could hedge the foreign exchange risk by:
A. buying EUR (selling GBP) at a forward rate of 0.87380.
B. buying EUR (selling GBP) at a forward rate of 0.87506.
C. selling EUR (buying GBP) at a forward rate of 0.87506.

The best interpretation of the forward discount shown is that:

A. the euro is expected to depreciate over the next 30 days.
B. one-month U.K. interest rates are higher than those in the Eurozone.
C. one-month Eurozone interest rates are higher than those in the United Kingdom.

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 Curriculum Example 6
If the 12-month forward rate is 0.87295 GBP/EUR, then based on the data the 12-month forward points are
closest to:

If a second dealer quotes GBP/EUR at a 12-month forward discount of 0.30 percent on the same spot rate, the
French company could:
A. trade with either dealer because the 12-month forward quotes are equivalent.
B. lock in a profit in 12 months by buying EUR from the second dealer and selling it to the original dealer.
C. lock in a profit in 12 months by buying EUR from the original dealer and selling it to the second dealer.

If the 270-day LIBOR rates (annualized) for the EUR and GBP are 1.370% and 1.325%, respectively, and the spot
GBP/EUR exchange rate is 0.8489, then the number of forward points for a 270-day forward rate (FGBP/EUR) is:

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 4. Exchange Rate Regimes
Every exchange rate is managed to some degree by central banks; policy
framework adopted by a central bank is called the ‘exchange rate regime’

• Properties of an ideal exchange rate regime

An ideal
1. The exchange rate between any two currencies would be credibly fixed exchange rate
2. All currencies would be fully convertible regime is NOT
3. Each country would be able to undertake fully independent monetary policy possible

• Historical perspective on currency regimes

• Regimes range from ‘dollarization’ to ‘independent float’

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 4.3 A Taxonomy of Current Regimes
• Arrangements with no separate legal tender
 Dollarization
 Monetary union

• Currency board system – an explicit legislative commitment to exchange domestic

currency for a specified foreign currency at a fixed exchange rate; does allow for a small
band

• Fixed parity – a country pegs its currency within a band of 1% versus another currency
 No legislative commitment
 Level of foreign exchange reserves are discretionary

• Target zone – like fixed parity but with wider bands (+/- 2%)
 Gives monetary authority more flexibility

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 4.3 A Taxonomy of Current Regimes
• Active and passive crawling peg – currency pegged against another currency
 Exchange rate adjusted frequently to keep pace with inflation (passive crawl)
 Exchange rate pre-announced for coming weeks (active crawl)

• Fixed parity with crawling bands

 Allows for gradual exit strategy from fixed parity

• Managed float
 Exchange rate policy based on either internal or external policy targets—intervening or not to
achieve trade balance, price stability, or employment objectives.

• Independently floating rates

 Exchange rate is left to market determination and the monetary authority is able to exercise
independent monetary policy aimed at achieving such objectives as price stability and full
employment

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Exhibit 8 - Exchange Rate
Regimes for Selected
Markets As of 30 April 2008

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 Example 7 – Currency Regimes (Excerpt)
The client and her adviser discuss potential investments in Hong Kong, Panama, and Canada. The
adviser notes that the currency regimes of these countries are a currency board, dollarization, and a
free float, respectively. The adviser tells his client that these regimes imply different degrees of foreign
exchange risk for her portfolio.

1. Based solely on the exchange rate risk the client would face, what is the correct ranking (from most
to least risky) of the following investment locations?

2. Based solely on their foreign exchange regimes, which country is least likely to import inflation or
deflation from the United States?

3. True or false: a fixed parity regime means a constant exchange rate and is more credible than a
currency board.

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5. Exchange Rates, International Trade Balance, and
Capital Flows
Impact of exchange rates and other factors on the trade balance must be mirrored by their impact
on capital flows

A trade surplus reflects an excess of domestic savings over investment spending

Capital flows – potential and actual – are the primary determinant of exchange rate movements in
the short-to-intermediate term

Impact of exchange rate on trade balance can be examined using the elasticities approach and the
absorption approach

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5.1 Exchange Rates and Trade Balance: The Elasticities Approach
The Marshall–Lerner condition describes combinations of export and import demand elasticities such
that depreciation (appreciation) of the domestic currency will move the trade balance toward surplus
(deficit). If ωX εX + ωM (εM − 1) > 0, a currency depreciation will reduce the trade deficit.

Domestic Trading Assumptions Exports Imports

country partner
Demand elasticity 0.75 0.65
Italy (€) U.S.
Percent price change
In domestic currency (€) 0 10%
In foreign currency –10% 0

Results Initial value (€) Change (€)

Exports 400,000,000 30,000,000
ωX εX + ωM (εM − 1) > 0 Imports 600,000,000 21,000,000
Trade balance –200,000,000 9,000,000
Total trade 1,000,000,000 51,000,000

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 More on the Elasticities Approach
When currency depreciates trade deficit reduces if ωX εX + ωM (εM − 1) > 0

Impact depends on elasticities

Trade Balance
Devaluation

What does elasticity depend on?

J-Curve

Time

Example 8
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 Absorption Approach
• In order to move the trade balance toward surplus (deficit), a change in the exchange rate must
decrease (increase) domestic expenditure (also called absorption) relative to income. Equivalently, it
must increase (decrease) domestic saving relative to domestic investment.

• If there is excess capacity in the economy, then currency depreciation can increase output/income
by switching demand toward domestically produced goods and services. Because some of the
additional income will be saved, income rises relative to expenditure and the trade balance
improves.

• If the economy is at full employment, then currency depreciation must reduce domestic
expenditure in order to improve the trade balance. The main mechanism is a wealth effect: A
weaker currency reduces the purchasing power of domestic-currency-denominated assets
(including the present value of current and future earned income), and households respond by
reducing expenditure and increasing saving.

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 Summary
• Nominal and real exchange rates

• Direct and indirect exchange rates

• Appreciation and depreciation

• Spot rates and forward rates

• Cross rates

• Currency rate regimes

• Impact of exchange rates on trade and capital flows

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 Conclusion
• Read summary

• Review learning objectives

• Examples

• Practice problems

• Practice questions from other sources

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