1. Chapter 9 Currency Exchange Rates
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2. 1. Introduction
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 reduce risk (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.
LOS: Define an exchange rate, and distinguish between nominal and real exchange rates and spot and forward exchange rates.
Page 466
Notes to the presenter:
The foreign exchange market, FX, is also referred to as the forex market.
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3. 2. The Foreign Exchange Market
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
Example:
INR/USD =
This means that one US dollar will buy Indian rupees.
If this exchange rate falls to 65, the dollar will buy fewer Indian rupees. In other words,
The US dollar is depreciating relative to the rupee or
The rupee is appreciating relative to the US dollar
LOS: Describe functions of and participants in the foreign exchange market.
Pages 467–470
Notes to the presenter:
There are many different conventions, but this presentation is using the conventions displayed by the authors in the chapters’ examples.
Important note : There are many different conventions that are used around the world, but this presentation is using the conventions displayed by the authors in the chapters’ examples.
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4. Real 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:
Real exchange rate 𝐴𝑈𝐷/𝑈𝑆𝐷 = 𝑆 𝐴𝑈𝐷/𝑈𝑆𝐷 × 𝑃 𝑈𝑆𝐷 𝑃 𝐴𝑈𝐷 = 𝑆 𝐴𝑈𝐷/𝑈𝑆𝐷 × 𝑃 𝑈𝑆𝐷 𝑃 𝐴𝑈𝐷
where
𝑆 𝐴𝑈𝐷/𝑈𝑆𝐷 is the nominal or spot exchange rate and
𝑃 𝑈𝑆𝐷 𝑃 𝐴𝑈𝐷 is the relative price level.
LOS: Define an exchange rate, and distinguish between nominal and real exchange rates and spot and forward exchange rates.
Pages 468–470
A nominal exchange rate is a quoted rate, whereas a real exchange rate is an exchange rate that has been adjusted for the relative purchasing power of the two currencies’ home countries.
Notes to the presenter:
Purchasing power parity (PPP) is a condition in which identical goods and services are priced the same in different markets.
It does not hold because of trade barriers, transaction costs, and limits to capital flows. This is not in the LOS, but many participants will be familiar with this situation.
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5. Spot and forward 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.
LOS: Define an exchange rate, and distinguish between nominal and real exchange rates and spot and forward exchange rates.
Pages 468–475
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.
Notes to the presenter:
The spot rate is sometimes also referred to as the benchmark rate because it is used as a base from which forward rates are calculated.
The settlement of a spot transaction may be in one (T + 1) or two (T + 2) days.
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6. The FX market Participants and 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.
Types of FX products
Currencies for immediate delivery (spot market).
Forward contracts, which are agreements for a future exchange at a specified exchange rate.
FX swaps, which are a combination of a spot contract and a forward contract, used to roll forward a position in a forward contract.
FX options, which are options to enter into an FX contract some time in the future at a specified exchange rate.
LOS: Describe functions of and participants in the foreign exchange market.
Pages 473–481
Companies and individuals transact for the purposes of the international trade of goods and services.
Capital market participants transact for the purposes of moving funds into or out of foreign assets.
Hedgers enter into positions to reduce exposure to exchange rate risk.
Speculators participate to profit from future movements in foreign exchange.
Notes to the presenter:
We can look at participants in terms of the type of transaction, as on this slide, or in terms of the buy and sell sides (next slide).
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7. FX participants Buy side Corporations Real money accounts
Leverage accounts
Retail accounts
Governments
Central banks
Sovereign wealth funds
Sell side
Large dealing banks
Other financial institutions
LOS: Describe functions of and participants in the foreign exchange market.
Pages 478–481
The participants on the sell side of the FX market are dealer banks and other financial institutions.
The buy side may be individuals, corporations, banks, governments, and funds.
Notes to the presenter:
The National Futures Association (NFA) authorizes FX dealers in the United States.
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8. 3. Currency Exchange Rate quotes
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.
Example
Consider the quote BRL/USD =
The base currency is the US dollar (USD).
The price currency is the Brazilian real (BRL).
BRL/USD is a direct currency quote from the Brazilian perspective.
BRL/USD is an indirect currency quote from the US perspective.
From the Brazilian perspective, we can convert the BRL/USD into indirect quote of USD/BRL by inverting:
USD/BRL = =
LOS: Calculate and interpret the percentage change in a currency relative to another currency.
Pages 484–486
A direct quote is a currency quotation in which the home currency is the price currency and the foreign currency is the base currency; an indirect quote is the inverse of a direct quote. In the direct quote A/B, the home currency is A and the base currency is B; we calculate the indirect quote as the inverse of the direct quote—that is, B/A.
Notes to the presenter:
Whether a quote is a direct or indirect quote depends on the perspective: which currency of the pair is the home currency?
Questions for participants:
Consider the quote ABC/DEF = 2.5
Is this a direct or an indirect currency quote?
Answer: This is a direct quote from the perspective of ABC. This is an indirect quote from the perspective of DEF.
How many DEF can be exchanged for one ABC?
Answer: 1/2.5 = 0.4
How many ABC can be exchanged for one DEF?
Answer: 2.5 ABC = 1 DEF
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9. FX Rate Quote Convention (Price currency/Base currency)
In practice
There are a number of conventions, which simply refer to a particular exchange rate [see Exhibit 9-6 for a more comprehensive list].
Dealers will quote a bid (at which the dealer will buy) and an offer price (at which the dealer will sell). [Note: bid < offer]
FX Rate Quote Convention
Name Convention
Actual Ratio
(Price currency/Base currency)
EUR
euro
USD/EUR
JPY
dollar–yen
JPY/USD
GBP
sterling
USD/GBP
Notes to the presenter:
The purpose of this slide is to emphasize that there are different conventions, which can be a source of confusion. (Pages 485–486)
The terminology uses “offer” for what we typically refer to as the “ask” price. (Page 486)
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10. Appreciating or depreciating
Appreciation or depreciation is with respect to the base currency relative to the price currency.
Appreciation is a gain in value of one currency relative to another currency.
Depreciation is the loss in value of one currency relative to another currency.
The percentage change is the ratio of the exchange rates minus one:
% change = 𝐴 𝐵 𝑁𝑒𝑤 𝐴 𝐵 𝑂𝑙𝑑 −1
Example:
Suppose CZK/USD is and increases to
The percentage change is − 1 = %
This means that the US dollar (USD), the ‘base’ currency in the quote, has appreciated % against the Czech koruna.
It takes fewer US dollars to buy each koruna.
This also means that the Czech koruna (invert the rate and treat CZK as the ‘base currency’) depreciated by
− 1 = − 1 = −0.8228%
relative to the US dollar.
LOS: Calculate and interpret the percentage change in a currency relative to another currency.
Pages 487–488
Appreciation is a gain in value of one currency relative to another currency.
Depreciation is a loss in value of one currency relative to another currency.
The percentage change is the ratio of the exchange rates minus one.
Notes to the presenter:
Appreciation and depreciation are different concepts from revaluation and devaluation.
Appreciation and depreciation are always relative to a given currency.
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11. ILS USD × USD NOK = ILS NOK = 3.8105 × 1 8.2210 = 0.4635
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:
DKK/USD = USD/AUD =
What is the DKK/AUD exchange rate?
DKK USD × USD AUD = DKK AUD = × =
Example 2: Suppose you have the following quotes:
ILS/USD = NOK/USD =
What is the ILS/NOK exchange rate?
ILS USD × USD NOK = ILS NOK = × =
LOS: Calculate and interpret currency cross-rates.
Pages 488–492
We calculate a cross-rate by solving algebraically for the unknown exchange rate given two other exchange rates that involve three currencies. A currency cross-rate is the implied exchange rate of a third country pair given the exchange rates of two pairs of these three currencies that have a common currency.
Notes to the presenter:
The cross-rate is not easy to define (requires three currencies, two given exchange rates), but it is easy to solve using algebra.
The process is what is involved in triangular arbitrage: if the relationships do not hold among these three securities, it would be possible to arbitrage these currencies to earn a profit.
Question for participants:
Suppose you have the following quotes: USD/EUR = and USD/NOK =
What is the EUR/NOK exchange rate?
Answer: EUR/NOK= 1/ x = × =
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12. Forward rate quotations
Forward exchange rates are quoted 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.
Example: Using pips Suppose that the USD/EUR spot rate is and that the one-month forward premium is 47 pips. Therefore, the forward rate is Forward rate = ,000 = = Example: Using a percentage Suppose that the spot rate of MXN/USD is and that the one-month forward premium as a percentage of the spot rate is 0.4%. The one-month forward rate is Forward rate = x =
LOS: Convert a forward quotation expressed on a points basis or in percentage terms into an outright forward quotation.
Pages 492–494
Forward quotes can be specified as the number of pips from the spot rate or as a percentage of the spot rate. If the quote is in terms of points, then the points are first divided by 10,000 and then added or subtracted from the spot quote. If the quote is in terms of a percentage, that percentage is added to one and then multiplied by the spot quote.
Notes to the presenter:
The math is straightforward, but the participant may get confused using pips.
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13. Forward discounts and premiums
Consider the relationship between forward and spot rates: 𝐹 𝑓 𝑑 − 𝑆 𝑓 𝑑 = 𝑆 𝑓 𝑑 𝑖 𝑓 − 𝑖 𝑑 1+ 𝑖 𝑑 τ τ where 𝐹 𝑓 𝑑 = Forward rate 𝑆 𝑓 𝑑 = Spot rate 𝑖 𝑑 = Domestic interest rate 𝑖 𝑓 = Foreign interest rate τ = Time (in years) This means that any premium or discount is a function of the interest rates (domestic, 𝑖 𝑑 , and foreign, 𝑖 𝑓 ) and time, τ.
Example
Suppose that the AUD/USD spot rate is and that the one-month forward rate
Therefore,
𝐹 𝑓 𝑑 = ,
𝑆 𝑓 𝑑 = , and
τ = 30/360.
There is a forward discount of
– = –
or 27 pips, so 𝑖 𝑓 < 𝑖 𝑑 .
LOS: Calculate and interpret a forward discount or premium.
Pages 492–498
A forward discount or premium is attributed to time scaled differences in interest rates between the two countries. We calculate this discount or premium by adjusting the spot rate for time and the differences in interest rates between the two countries.
Notes for the presenter:
This formula appears on p. 497.
There is a temptation to interpret a forward discount or premium as a predictor of future spot rates. The most we can really conclude is that the discount or premium is attributed to time-scaled differences in interest rates between the two countries.
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14. Calculating forward rates
Using 𝐹 𝑓 𝑑 − 𝑆 𝑓 𝑑 = 𝑆 𝑓 𝑑 𝑖 𝑓 − 𝑖 𝑑 1+ 𝑖 𝑑 τ τ, we can calculate a forward rate based on 𝑆 𝑓 𝑑 , 𝑖 𝑓 , 𝑖 𝑑 ,and τ.
Example:
Suppose we have the spot exchange rate of the CAD/USD of If the one-year T-bill interest rate in the United States is 0.55% and the Canadian one-year Treasury rate is 0.95%, what is the one-year forward rate?
𝐹 𝑓 𝑑 = 𝑆 𝑓 𝑑 + 𝑆 𝑓 𝑑 𝑖 𝑓 − 𝑖 𝑑 1+ 𝑖 𝑑 τ τ
𝐹 𝑓 𝑑 = − x = =
The estimated forward rate is , representing a forward rate premium of – = 51 pips.
LOS: Calculate and interpret a forward rate consistent with the spot rate and the interest rate in each currency.
Pages 497–498
We can calculate the forward rate by starting with the spot rate and then adjusting for time and the relative interest rates of the two countries. The forward rate is the expected future spot rate, given time, the current spot rate, and interest rates.
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15. 4. 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 able to undertake independent monetary policy for domestic objectives.
Exchange rate regime choices:
Independently Floating Rate Regime
Pegged System
Fixed Exchange Rate Regime
LOS: Describe exchange rate regimes.
Pages 500–508
Notes to the presenter:
A fixed exchange rate regime is also referred to as a hard peg system.
The ideal exchange rate regime does not exist, but it would be floating, with each country managing its own domestic monetary policy.
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16. Exchange rate regimes Regime Type Description No separate legal tender
Fixed
Dollarization: Use another nation’s currency as the medium of exchange (USD).
Shared currency
Monetary union: Use a currency of a group of countries as the medium of exchange.
Currency board system
Use another currency in reserve as the monetary base, maintaining a fixed parity.
Fixed parity or fixed rate system
Use another currency or basket of currencies in reserve, but with some discretion (parity bands).
Target zone
Fixed parity (peg) with fixed horizontal intervention bands.
LOS: Describe exchange rate regimes.
Pages 500–511
If there is no separate legal tender (also known as dollarization when the USD is used), the country uses another nation’s currency as its medium of exchange.
In a shared currency system (a form of a separate legal tender system), there is a monetary union and a group of countries uses this shared currency as a medium of exchange.
If there is a currency board system, another currency is held in reserve as the monetary base, maintaining a fixed parity.
In a fixed parity or fixed rate system, the country uses another currency or basket of currencies in reserve, but with some discretion (parity bands for fluctuation).
With a target zone regime, there is fixed parity (peg) with fixed horizontal intervention bands.
Notes to the presenter:
A monetary union is also referred to as a currency union.
Dollarization is used most often in small, open economies (e.g., Ecuador).
Currency union example: European Union
Currency board example: Hong Kong
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17. Exchange rate regimes Regime Type Description
Active and passive crawling pegs
Peg
Adjust the exchange rate against a single currency, with adjustments for inflation (passive) or announced in advance (active).
Fixed parity with crawling bands
Similar to target zone, but bands can be widened.
Managed float
Float
Allow exchange rate to float, but intervene to manage it toward targets.
Independently floating rates
Exchange rate is market determined (supply and demand).
LOS: Describe exchange rate regimes.
Pages 503–511
A regime with active and passive crawling pegs adjusts the exchange rate against a single currency, with adjustments for inflation (passive) or announced in advance (active).
A fixed parity with crawling bands is similar to a target zone policy, but the bands can be widened.
In a managed float system, the country allows the exchange rate to float, but intervenes to manage it toward targets.
An independently floating rates regime allows the exchange rate to be determined by supply and demand.
Notes to the presenter:
A floating exchange system in which the government’s interventions directly affect the country’s currency is referred to as a dirty float or a managed float.
A crawling peg system means that the exchange rate can follow a trend, with some variation (in a band).
Example of managed float: Brazil
Example of independently floating: United States, Japan
It is sometimes the case that a country may state that it has one policy but, in reality, is practicing another.
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18. 5. Exchange rates, 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:
The potential flow of financial capital in or out of a country is mitigated by changes in asset prices and exchange rates.
X – M =
(S – I) +
(T – G) ↑
Exports less imports
Savings less investment
Taxes less government spending
Trade surplus or deficit
Fiscal surplus or deficit
LOS: Explain the impact of exchange rates on countries’ international trade and capital flows.
Pages 511–519
There is an inverse relationship between the trade balance and the capital account. When there is a trade surplus or deficit, exchange rates and prices change, which offsets the effect of the financial flows out of or into a country. For example, if there is a trade deficit, foreign capital flows into the country.
Notes to the presenter:
The national accounts relationship was first introduced in Chapter 5 (p. 208): GDP = C + I + G + (X - M) and (p. 219): G – T = (S – I) – (X – M).
A trade deficit is balanced by a capital account surplus (foreign funds flowing into the country).
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19. Exchange rates and trade
There are two theories on the exchange rate/trade relationship:
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 trade balance
If the demand for exports and imports is price inelastic, trade is less responsive to devaluation or depreciation.
The Absorption Approach
Devaluation or depreciation of the exchange rate must decrease expenditure relative to income to improve the trade balance.
This affects national income through the wealth effect: reduced purchasing power of domestic-currency-denominated assets leads to lower expenditure and increased saving.
LOS: Explain the impact of exchange rates on countries’ international trade and capital flows.
Pages 511–519
Exchange rates affect trade and capital flows either through the relative prices of domestic goods and services (Marshall–Lerner approach) or through the savings/expenditure effect (the absorption approach).
Notes to the presenter:
The Marshall-Lerner approach is focused on elasticities of demand for and the relative prices of exports and imports
The absorption approach is focused on the wealth effect, leading to a reduction in expenditures relative to savings, impacting the trade balance.
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20. Conclusions and Summary
The foreign exchange market is by far the largest financial market in the world. It has important effects, either directly or indirectly, on the pricing and flows in all other financial markets.
There is a wide diversity of global FX market participants that have a wide variety of motives for entering into foreign exchange transactions.
Individual currencies are usually referred to by standardized three-character codes. These currency codes can also be used to define exchange rates (the price of one currency in terms of another). There are a variety of exchange rate quoting conventions.
A direct currency quote takes the domestic currency as the price currency and the foreign currency as the base currency.
An indirect quote uses the domestic currency as the base currency.
To convert between direct and indirect quotes, invert the quote.
FX markets use standardized conventions for quoting exchange rate for specific currency pairs.
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21. Conclusions and Summary
Currencies trade in foreign exchange markets based on nominal exchange rates. An increase in the exchange rate, quoted in indirect terms, means that the domestic currency is appreciating versus the foreign currency.
The real exchange rate measures the relative purchasing power of the currencies. An increase in the real exchange rate implies a reduction in the relative purchasing power of the domestic currency.
Given exchange rates for two currency pairs—A/B and A/C—we can compute the cross-rate (B/C) between currencies B and C.
Spot exchange rates are for immediate settlement (typically, T + 2), whereas forward exchange rates are for settlement at agreed-on future dates.
Forward rates can be used to manage foreign exchange risk exposures or can be combined with spot transactions to create FX swaps.
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22. Conclusions and Summary
The spot exchange rate, the forward exchange rate, and the domestic and foreign interest rates must jointly satisfy an arbitrage relationship that equates the investment return on two alternative but equivalent investments.
Forward rates are typically quoted in terms of forward points. The points are added to (or subtracted from) the spot exchange rate to calculate the forward rate.
The base currency is said to be trading at a forward premium if the forward rate is higher than the spot rate (that is, forward points are positive). Conversely, the base currency is said to be trading at a forward discount if the forward rate is less than the spot rate (that is, forward points are negative).
The currency with the higher interest rate will trade at a forward discount.
Points are proportional to the spot exchange rate and to the interest rate differential and approximately proportional to the term of the forward contract.
Empirical studies suggest that forward exchange rates may be unbiased predictors of future spot rates, but the margin of error on such forecasts is too large for them to be used in practice.
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23. Conclusions and Summary
Virtually every exchange rate is managed to some degree by central banks. The policy framework that each central bank adopts is called an “exchange rate regime.”
An ideal currency regime would have three properties:
The exchange rate between any two currencies would be credibly fixed;
All currencies would be fully convertible; and
Each country would be able to undertake fully independent monetary policy in pursuit of domestic objectives, such as growth and inflation targets.
The IMF identifies the following types of regimes: dollarization, monetary union, currency board, fixed parity, target zone, crawling peg, crawling band, managed float, and independent float.
Most major currencies traded in FX markets are freely floating, albeit subject to occasional central bank intervention.
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24. Conclusions and SUmmary
Any factor that affects the trade balance must have an equal and opposite impact on the capital account, and vice versa.
The impact of the exchange rate on trade and capital flows can be analyzed from two perspectives.
The elasticities approach focuses on the effect of changing the relative price of domestic and foreign goods. This approach highlights changes in the composition of spending.
The absorption approach focuses on the impact of exchange rates on aggregate expenditure/saving decisions.
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25. Conclusions and Summary
The elasticities approach leads to the Marshall–Lerner condition, which describes combinations of export and import demand elasticities such that depreciation of the domestic currency will move the trade balance toward surplus and appreciation will lead toward a trade deficit.
The idea underlying the Marshall–Lerner condition is that demand for imports and exports must be sufficiently price sensitive so that an increase in the relative price of imports increases the difference between export receipts and import expenditures.
If there is excess capacity in the economy, then currency depreciation can increase output/income by switching demand toward domestically produced goods and services.
If the economy is at full employment, then currency depreciation must reduce domestic expenditure to improve the trade balance.
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