Level 1 CFA® Exam:
Currency Exchange Rates
The market for foreign exchange is the largest financial market in the world in terms of the value of daily transactions. Its participants are:
- international banks,
- corporations,
- investment funds,
- hedge funds,
- governments,
- central banks,
- sovereign wealth funds, and
- private investors.
A currency exchange rate is the value of one currency expressed in another currency.
Talking about a currency exchange rate, we should distinguish between 2 types of currencies:
- the base currency, and
- the price currency.
In a currency pair, the base currency is the currency that forms the basis for a specific exchange rate and the price currency is the currency in which the settlement is made. In other words, the exchange rate tells us about the cost of one unit of the base currency expressed in terms of the price currency.
In the table, you can see the most common currency pairs and their quote conventions.
| Name Convention | FX Quote Convention | Price Currency | Base currency |
|---|---|---|---|
| Euro | EUR | USD | EUR |
| Sterling | GBP | USD | GBP |
| Swiss Franc | CHF | CHF | USD |
| Dollar-yen | JPY | JPY | USD |
| Euro-sterling | EURGBP | GBP | EUR |
| Euro-Swiss | EURCHF | CHF | EUR |
| Euro-yen | EURJPY | JPY | EUR |
You should know that in different countries people may assume different currencies as the base and price currency in a given currency pair.
There are 2 conventions available:
- direct quote,
- indirect quote.
According to the direct quote, the price currency is domestic currency, whereas as far as the indirect quote is concerned the price currency is foreign currency. However, currency pairs presented in the table are always used in the conventions specified in the table no matter where the trader comes from.
We can divide currency rates into different criteria.
For example, we can talk about:
- spot exchange rates, and
- forward exchange rates.
A spot exchange rate is a rate for immediate delivery, while a forward exchange rate is the rate of an exchange that will occur in the future.
Yet another important division of exchange rates is into:
- nominal exchange rates, and
- real exchange rates.
A nominal exchange rate doesn’t take the inflation in both countries into consideration, whereas a real exchange rate is a measure of relative purchasing power.
We have the currency pair euro-sterling, where the British pound is the price currency and the euro is the base currency. The real exchange rate for the euro-sterling equals the nominal exchange rate for euro-sterling times the CPI for the Eurozone divided by the CPI for the United Kingdom.
Assume that the nominal exchange rate for the euro-sterling increases by 20% and the inflation in the United Kingdom is 3% and in the Eurozone, it equals 5%. What is the change in the real exchange rate?
(...)
Assume that the euro-sterling exchange rate fell from 0.75 to 0.70. Decide which currency depreciates and which appreciates and by how much.
(...)
Currency cross-rate can be calculated e.g. when we know euro-dollar and euro-sterling and we calculate the sterling-dollar cross-rate.
Assume that:
- euro-dollar is 1.3875,
- euro-sterling is 0.8251.
What is the sterling-dollar currency cross-rate?
(...)
Assume that:
- sterling-dollar is 1.4150, and
- dollar-Polish zloty is 3.0156.
What is the sterling-Polish zloty currency cross-rate?
(...)
Now let’s see how to convert forward quotations that are expressed in points or as a percentage into an outright forward quotation and vice versa.
In foreign exchange markets, forward exchange rates are usually expressed in points. The points reflect the difference between the forward exchange rate and the spot exchange rate.
If the forward exchange rate is higher than the spot exchange rate, we are talking about a forward premium. If it’s lower, there is a forward discount. The forward exchange rate can be also represented as a percentage.
What is the point value if the forward exchange rate is 1.3458 and the spot exchange rate is 1.3123?
(...)
What is the forward exchange rate if the quotation of the forward exchange rate is presented as a percentage: + 2.55% and the spot exchange rate equals 1.3123?
(...)
If the forward exchange rate doesn’t reflect the difference in interest rates of the two currencies, arbitrage is possible. If you borrow one currency, exchange it for another at the spot rate and then invest these funds and exchange the currency at the forward rate in the future, you will be able to generate profit without risk.
There is one condition that must be met to prevent arbitrage:
The euro-dollar spot rate is 1.4 and the risk-free interest rate in the United States amounts to 2% and in the Eurozone to 4%. What is the forward rate that implies that arbitrage is not possible?
(...)
The euro-dollar spot rate and euro-dollar forward rate are both equal to 1.4 and the risk-free interest rate in the United States amounts to 2% and in the Eurozone to 4%.
What is the available arbitrage profit?
(...)
We distinguish between exchange rate regimes of countries that don’t have their own currencies and those that have their own currencies.
The exchange rate regimes of countries that don’t have their own currencies include:
- dollarization - when one country uses the currency of another country,
- monetary union – when all members have a common currency.
The exchange rate regimes of countries that have their own currencies are as follows:
- currency board system – when one currency is exchanged for a specific currency at a fixed exchange rate, which is supported by an explicit legislative commitment; it requires maintaining 100% foreign currency reserves against the monetary base;
- fixed parity – when one currency is exchanged for a specific currency at the fixed exchange rate of ±1%; there is no explicit legislative commitment; the target level of foreign exchange reserves is discretionary;
- target zone - when one currency is exchanged for a specific currency or a basket of currencies while maintaining a wider range of fluctuations in the exchange rate than fixed parity (up to ±2%);
- crawling peg – when the exchange rate is adjusted periodically, e.g. to keep pace with increasing inflation;
- fixed parity with crawling bands - when the scope of permissible fluctuations of the exchange rate increases over time;
- managed floating rates – when a supervisory institution influences the exchange rate in response to changes in certain economic indicators;
- independently floating rates – when the exchange rate depends on market factors.
Important:
The ideal currency regime doesn’t exist because it’s impossible to meet 3 properties of the ideal currency regime at the same time. These properties are:
- Fixed exchange rates between any currency pairs (so there is no uncertainty),
- Unrestricted capital flows and conversion of currencies,
- Any country can undertake a fully independent monetary policy.
Unfortunately, if any 2 of the properties above hold, the 3rd condition cannot be met.
CFA Exam: Impact of Exchange Rates on Capital Flows & International Trade
star content check off when doneIf:
- (X - M) > 0 - trade surplus,
- (X - M) < 0 - trade deficit.
If there is a trade surplus, it means that the country saves more than it needs to fund investments.
If there is a trade deficit, it means that the country saves less than it needs to fund investments.
There are 2 approaches to analyzing the impact of the exchange rate on capital flows and international trade:
- elasticities approach, and
- absorption approach.
Two things happen when a domestic currency (e.g. USD) depreciates in comparison with some foreign currency (e.g. EUR):
(...)
Also, shares of exports and imports in total trade are important. For example, if the trade is balanced (\(w_X = w_M\)), then the above condition takes the following form:
This is called the classic Marshall-Lerner condition.
According to the absorption approach, to reduce a trade deficit the depreciation of the domestic currency should increase GDP relative to domestic expenditures (or increase national savings relative to investments in new plant and equipment). The effect of the depreciation depends on whether an economy is at full employment or whether there is excess capacity in the economy:
- full employment: if the expenditure doesn’t decline >> depreciation puts upward pressure on domestic prices >> higher price level >> trade balance back to the initial value >> no reduction in the trade deficit,
- excess capacity in the domestic economy: more demand for domestic products >> higher income >> higher savings >> lower trade deficit.
- A currency exchange rate is the value of one currency expressed in another currency.
- The base currency is the currency that forms the basis for a specific exchange rate.
- The price currency is the currency in which the settlement is made.
- According to the direct quote, the price currency is domestic currency, whereas as far as the indirect quote is concerned, the price currency is foreign currency.
- A spot exchange rate is a rate for immediate delivery, while a forward exchange rate is the rate of an exchange that will occur in the future.
- A nominal exchange rate doesn’t take inflation in both countries into consideration, whereas a real exchange rate is a measure of relative purchasing power.
- Currency cross-rate can be calculated e.g. when we know euro-dollar and euro-sterling and we calculate the sterling-dollar cross-rate.
- If the forward exchange rate doesn’t reflect the difference in interest rates of two currencies, arbitrage is possible.
- Exchange rate regimes of countries that don’t have their own currencies include dollarization and a monetary union.
- Exchange rate regimes of countries that have their own currencies include currency board system, fixed parity, target zone, crawling peg, fixed parity with crawling bands, managed floating rates, and independently floating rates.