2017 Level I Exam

Currency Exchange Rates

THE FOREIGN EXCHANGE MARKET

The foreign exchange market is by far the world's largest market when measured by daily
turnover. It is a global market that operates 24 hours a day. Transaction and investment markets
are now international. Even domestic companies are affected by world markets.

Most currencies in the FX market are referenced by three letter codes (e.g. USD for U.S. dollar
and EUR for Euro). The exchange rate is the number of units of the price currency that one unit
of the base currency will buy. It is the cost of one unit of the base currency in terms of the price
currency.

Unfortunately, the same three letter codes are used to reference currencies and exchange rates. It
is more precise to use the "A/B" terminology which means the number of units of A that can be
purchased by one unit of B. In this case B is the base currency.

Nominal exchange rates are usually quoted. Real exchange rates focus on the relative purchasing
power changes. The real exchange rate is an increasing function of the nominal exchange rate
and a decreasing function of the domestic price level.

Purchasing power parity (PPP) asserts nominal exchange rates will adjust, so identical baskets of
goods have the same real price in different countries. This does not hold true because baskets are
not identical across countries and trade barriers exist.

The foreign price level in the domestic currency can be represented with Sd/f Pf

Where Sd/f is the spot exchange rate (number of units of domestic currency per one unit of
foreign currency)

The real exchange rate is / ( ). This represents the real price you pay to purchase
foreign goods. Thus, a higher value means less purchasing power.

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Example: Real Exchange Rate

You reside in Sweden and frequently make investments and purchases in Mexico.
Assume the SEK/MXN exchange rate increases 5%, the price of goods in Sweden
increase 4%, and the price of goods in Mexico increase 3%.
Calculate the impact on your Mexican investments and the change in your relative
purchasing power of Mexican goods.

Solution
When the nominal exchange rate increases by 5%, the Mexican currency becomes more
valuable relative to the Swedish currency. This helps your investments in Mexico
because now they can be converted back to more SEK. Therefore, the Mexican
investments are now worth 5% more on a nominal basis due to the favorable movement
in exchange rates.
Regarding the purchasing power of Mexican goods
The real exchange rate would increase by(1.05)(1.031.04) 1 = 4.0%. This
means the purchasing power has been reduced by 4.0%.

Market Functions
While FX markets facilitate international trade in goods and services, the dominant transactions
in FX markets are from capital transactions. Market participants can either use FX trading for
speculation or hedging. Often the hedging must be done for uncertain future payments or
receipts, so estimates are required.

Spot transactions are used to exchange currencies immediately. Usually the settlement takes two
days (T + 2). Most FX transactions are done through forward contracts, FX swaps, and FX
options.

Forward contracts are agreements today to transact in the future. The amount, date, and exchange
rate must be specified. Forwards are used for the majority of foreign exchange trades with future
settlement dates.

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Exchange-traded futures contracts are also used for currencies. Futures contracts are similar to
forward contracts, but differ in the following:

Trade on exchanges rather than in the over-the-counter (OTC) market

Available for fixed amounts and settlement dates

Collateral must be posted and marked-to-market

An FX swap is a simultaneous spot and forward transaction. The swap transactions can extend
existing forward positions to later dates. Rolling the position forward leads to cash flow on the
settlement date. FX swaps are also used to convert funding from one currency into another.

FX options give the right (not obligation) to make an FX transaction in the future. A fee must be
paid up front to purchase this option.

Example: Spot and Forward Exchange Rates

You are an investor from South Korea with a one-year investment horizon. The one-year
risk free bond denominated in KRW has a yield of 3.00%. The one-year risk free bond
denominated in USD has a yield of 1.50%. The spot exchange rate (KRW/USD) is 1084.
The one-year forward exchange rate is 1105.
Determine the best risk-free yield you can get over a one-year investment horizon.

Solution
One option is to invest domestically in South Korea and get a 3.00% yield.
Another option is to convert KRW to USD at the spot rate, invest at 1.50% in USD, and
use a forward contract to convert back to KRW. The yield on that risk-free investment
strategy is:
1 1105
(1) ( ) (1.015) ( ) 1 = 3.47%
1084 1
The second option is the best approach since it has greater yield.

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Market Participants
There are many types of participants in the FX markets. The sell side consists of large FX trading
banks. The buy side can be broken down into several categories:

Corporate accounts purchases and sales of goods and services; investment flows

Real money accounts investment funds managed by entities like insurance companies
and mutual funds; restricted in use of leverage

Leveraged accounts entities like hedge funds and commodity trading advisers that
engage in active trading for profit

Retail accounts includes exchanging currency at airport kiosk and small electronic
trading accounts

Governments could be transactional or following policy goals

Central banks these entities sometimes intervene to protect the domestic exchange rate

Sovereign wealth funds (SWFs) countries with large current account surpluses use
these to hold capital flows rather than reserves managed by central banks

The sell side is composed of very large dealing banks (e.g. Deutsche Bank, Citigroup). All other
banks fall into the second and third tier.

Market Size and Composition

Participating banks take a survey every three years that can be used to measure the size and
distribution of the FX market. The daily turnover is about USD 4 trillion. About 80% is done
through swaps and spot transactions. Most is done by financial clients. All the top five active
currency pairs include the USD. London and New York are the largest hubs.

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CURRENCY EXCHANGE RATE CALCULATIONS

Exchange Rate Quotations
The "A/B" quoting convention for exchange rates represents how many units of currency A can
be purchased by one unit of currency B. Currency A is the price currency and currency B is the
base currency. A direct quote uses the domestic country for the price currency and the foreign
country for the base currency. An indirect quote is just the reverse, which turns out to be the
reciprocal.

A three-letter code is used to represent common exchange rates. For example, EUR is used for
the USD/EUR exchange rate. Six-letter codes are used for major cross-rates. The first three
letters represent the base currency. Markets will usually quote both direct and indirect quotes.

Two-sided prices are quoted in professional FX markets. The bid represents the price at which
the bank will buy the currency and the offer represents the price at which bank will sell the
currency. The price is shown in terms of the price currency. The bid/offer spreads allow dealers
to make a profit. The bid/offer spreads are much lower now with electronic trading.

An increase in the exchange rate will represent appreciation for the base currency and
depreciation for the price currency. The appreciation and depreciation will not be equal.

Cross-Rate Calculations
Two exchange rates involving three currencies can be used to determine the third exchange rate.
Usually the dealer or the electronic platform will perform the calculation. The cross-rate
calculations must be consistent to avoid triangular arbitrage.

Example: Cross Exchange Rates

You are given the following three spot exchange rates:
JPY/USD 92.13 JPY/CAD 89.81 BRL/CAD 1.93
Calculate the BRL/USD exchange rate.

Solution
1
= = (92.13) ( ) (1.93) = 1.98
89.81

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Forward Calculations
Forward exchange rates are typically quoted in points (or "pips"). The points represent the
difference between the forward rate quote and the spot rate quote. The points will be positive
when the forward rate is greater than the spot rate, which is the case of a forward premium. It is a
forward discount if the points are negative. The points are scaled to represent the last decimal
place (e.g. one point equals 0.0001).

For example, if the spot rate was 1.28630 and the forward points were 24.7, the forward rate
would be:

24.7
1.28630 + = 1.28877
10000

The absolute number of points usually increases with maturity because the points are related to
the yield differential between the countries. An investor can either invest risk-free in the
domestic currency or risk-free in a foreign currency using spot and forward exchanges. The two
investment strategies must be equal to avoid arbitrage. This can be represented with the
following formula:

1
1 + = (1 + )( )

If the two sides of the equation were not equal, the investor could make arbitrage profits by
borrowing at the lower rate and investing at the higher rate. The currency with the higher interest
rate will trade at a discount in the forward market.

It is appealing to think of forward rates as expected future spot rates. However, historical data
shows forward rates are inaccurate, though unbiased, predictors of spot rates. FX markets are
affected by many factors other than interest rates.

Example: Forward Rates

The 180-day LIBOR rates (annualized) for GBP and JPY are 1.7% and 1.3%,
respectively. The spot JPY/GBP exchange rate is 139.69.
Calculate the number of forward points for a 180-day forward rate.

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Solution
1
1 + = (1 + )( )

180 180 1
1 + (0.017) ( ) = (139.69)(1 + (0.013) ( ))( )
360 360
= 139.413

= (139.413 139.69)(100) = 27.7

EXCHANGE RATE REGIMES

The Ideal Currency Regime
An exchange rate regime is the policy adopted by each central bank. The ideal currency regime
would have the following properties.

1. The exchange rate between any two currencies would be credibly fixed.

2. All currencies would be fully convertible.

3. Each country could undertake independent monetary policy for domestic objectives.

The above properties are not consistent. If the first two were true, then there would really only be
one world currency.

With floating exchange rates a decrease in the domestic interest rate makes the domestic
currency less attractive. This would increase the demand for domestic goods, which reinforces
the expansionary monetary policy that was seeking to lower the interest rates.

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Historical Perspective on Currency Regimes

There tends to be a dominant exchange rate system in the world at any point in time. Prior to
World War I, the U.S. dollar and the U.K. pound were on the gold standard. Countries with a
trade surplus accumulated gold. Countries could find more gold to increase their supply. This
kept inflation in check.

The world trade dropped significantly in the 1930s and the gold standard was dropped. Fixed
exchange rates (the Bretton Woods system) were common from World War II until the 1970s.
Periodic realignments were made.

Flexible exchange rates known as the Smithsonian Agreements were adopted in 1973 in the face
of worldwide inflation. Milton Friedman had argued for this since the 1950s, saying it was better
for the market to determine the exchange rates than the banks.

People soon realized the exchange rates were investment-driven rather than determined by
transactions of goods and services. This explained the high volatility.

The European Union tried to limit flexibility in 1979. This did not last long since pressure was
exerted to force exchange rates outside the bands.

The Euro was created in 1999. This common currency increased transparency and enhanced
competition in Europe. It limited each country's ability to engage in monetary policy.

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A Taxonomy of Currency Regimes

Many countries adopt regimes somewhere between fixed and flexible exchange rates. Fixed
approaches are better for countries that lack credibility. The financial markets are very complex
and diverse. The International Monetary Fund (IMF) has classified actual exchange rate regimes
into eight categories.

1. Arrangements with No Separate Legal Tender

There are two types of this regime dollarization and monetary union. In both cases the
country cannot have its own monetary policy.

In dollarization, the country uses the currency of another nation (usually the U.S. dollar).
The country inherits the currency credibility. Dollarization imposes fiscal discipline.

The European Economic and Monetary Union is the largest example of a monetary
union. The member countries jointly determine the monetary policy.

2. Currency Board System

A currency board system (CBS) is a legislative commitment to fix the exchange rate with
a specified foreign currency. The foreign currency is held as a reserve to back the entire
monetary base. Hong Kong is an example.

This system is similar to the gold system. It works best if domestic prices and wages are
flexible and the reserve asset grows at a slow, steady rate. The monetary authority can
earn a profit called seigniorage by earning interest on the foreign currency reserve and
paying little on its liability.

3. Fixed Parity

Fixed parity differs from CBS because there is no legislative commitment to maintain the
parity and the target level of foreign exchange reserves is discretionary. The exchange
rate can be pegged to a single currency or index of multiple currencies. The country must
be willing to offset private demand for currency.

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4. Target Zone

Target zone regimes are fixed rate parity regimes with wider bands. This gives the
monetary authority more latitude.

5. Active and Passive Crawling Pegs

Under this regime exchange rates are adjusted frequently to keep pace with inflation. The
approach is active if the adjustment is announced in advance. This helps the monetary
authority influence inflation rates.

6. Fixed Parity with Crawling Bands

This regime allows a country to gradually wean off a fixed parity system.

7. Managed Float

In this approach a country bases exchange rate policy on internal or external policy
targets.

8. Independently Floating Rates

This regime allows the market to determine the exchange rate and the monetary authority
to carry out independent monetary policy. Most major currencies use this approach,
although some government intervention is still present.

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EXCHANGE RATES, INTERNATIONAL TRADE, AND CAPITAL FLOWS

A country that imports more than it exports must borrow from foreigners. This results in a trade
deficit which must be offset by a capital account surplus. The relationship between the trade
balance and expenditure/saving decisions can be expressed as follows:

= ( ) + ( )

A trade surplus (X > M) must be reflected in excess private savings over investment (S > I) or
fiscal surplus (T > G). The excess savings are invested in the rest of the world.

Investors continuously look for ways to profit from future exchange rate movements. This forces
asset prices and exchange rates to adjust to minimize potential and actual capital flows for
financial reasons.

Exchange Rates and the Trade Balance: The Elasticities Approach

The price elasticity of demand is:

%
=
%

The above equation can be used to approximate the percentage change in expenditure (R).

% = % + % = % + ()(%) = (1 )(%P)

This means that if the price elasticity of demand is elastic ( > 1), an increase in price will reduce
expenditure. If the price elasticity of demand is inelastic ( < 1), then an increase in price will
increase expenditure.

The Marshall-Lerner inequality states the conditions under which depreciation of the local
currency improves the balance of trade. Increasing the relative price of imports will change the
trade balance.

( 1) > 0 + = 1

where and are the proportions of exports and imports

There is a trade deficit if > . A depreciation of the domestic currency is needed to move
back towards a surplus.

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Demand elasticity depends on at least four factors:

1. Existence or absence of close substitutes

2. Structure of the market for that product (e.g. monopoly, perfect competition)

3. Portion of household budget

4. Nature of product and role in economy

Price changes will trigger both the substitution effect and the income effect. Both of these
interact with the four factors above to determine the elasticity of a good or service.

Exchange rate changes will be more effective in adjusting the trade balance when the elasticity is
high. This is true for goods that have close substitutes, are traded in competitive markets, are
luxuries, or represent a large portion of household expenditures.

Depreciation could make the trade balance worse before it gets better. This is called the J-curve
effect. It happens because there is a lag on ordered goods that already have a specified price.

Exchange Rates and the Trade Balance: The Absorption Approach

The absorption approach takes a macroeconomic approach to the trade balance. A depreciation
of the domestic currency must increase income relative to expenditure or national saving relative
to investment to move the trade balance towards a surplus. Currency depreciation will only work
in the long-term if there is excess capacity in the economy.

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