EXCHANGE RATES

An exchange rate is simply the price of one currency in terms of another. For example, a
quote of 1.4126 USD/EUR means that each euro costs $1.4126. In this example, the euro is
called the base currency and the USD the price currency. Hence, a quote is the price of one
unit of the base currency in terms of the price currency.
A spot exchange rate is the currency exchange rate for immediate delivery, which for
most currencies means the exchange of currencies takes place two days after the trade. A
forward exchange rate is a currency exchange rate for an exchange to be done in the
future. Forward rates are quoted for various future dates (e.g., 30 days, 60 days, 90 days, or
one year). A forward contract is an agreement to exchange a specific amount of one
currency for a specific amount of another currency on a future date specified in the forward
agreement.
Dealer quotes often include both bid and offer (ask) rates. For example, the euro could be
quoted as $1.4124 − 1.4128. The bid price ($1.4124) is the price at which the dealer will
buy euros, and the offer price ($1.4128) is the price at which the dealer will sell euros. The
“bid–offer” spread is also known as the “bid–ask” spread: the terms “ask” and “offer” mean
the same thing. Accordingly, we will be using them interchangeably.
When a currency increases in value, it experiences appreciation; when it falls in value and
is worth fewer U.S. dollars, it undergoes depreciation. At the beginning of 1999, for
example, the euro was valued at $1.18 and on June 16, 2016, it was valued at $1.11. The
euro depreciated by 6%: (1.11 - 1.18)/1.18 = -0.06 = -6%. Equivalently, we could say that
the U.S. dollar, which went from a value of 0.85 euro per dollar at the beginning of 1999 to
a value of 0.90 euro per dollar on June 16, 2016, appreciated by 6%: (0.90 - 0.85)/0.85 =
0.06 = 6%.
When a country’s currency appreciates (rises in value relative to other currencies), the
country’s goods abroad become more expensive and foreign goods in that country become
cheaper (holding domestic prices constant in the two countries). Conversely, when a
country’s currency depreciates, its goods abroad become cheaper and foreign goods in that
country become more expensive.
Depreciation of a currency makes it easier for domestic manufacturers to sell their goods
abroad and makes foreign goods less competitive in domestic markets. From 2002 to 2016,
the dollar depreciated, which helped U.S. industries sell more goods, but it hurt American
consumers because foreign goods were more expensive. The prices of French wine and
cheese and the cost of vacationing abroad all rose as a result of the weak dollar.

How Is Foreign Exchange Traded?

You cannot go to a centralized location to watch exchange rates being determined;
currencies are not traded on exchanges such as the New York Stock Exchange. Instead, the
foreign exchange market is organized as an over-the-counter market in which several
hundred dealers (mostly banks) stand ready to buy and sell deposits denominated in
foreign currencies. Because these dealers are in constant telephone and computer contact,
the market is very competitive; in effect, it functions no differently from a centralized
market.
An important point to note is that although banks, companies, and governments talk about
buying and selling currencies in foreign exchange markets, they do not take a fistful of
dollar bills and sell them for British pound notes. Rather, most trades involve the buying
and selling of bank deposits denominated in different currencies. So when we say that a
bank is buying dollars in the foreign exchange market, what we actually mean is that the
bank is buying deposits denominated in dollars. The volume in this market is colossal,
exceeding $5 trillion per day.
Trades in the foreign exchange market consist of transactions in excess of $1 million. The
market that determines the exchange rates in the Following the Financial News box is not
where one would buy foreign currency for a trip abroad. Instead, we buy foreign currency
in the retail market from dealers such as American Express or from banks. Because retail
prices are higher than wholesale, when we buy foreign exchange, we obtain fewer units of
foreign currency per dollar—that is, we pay a higher price for foreign currency—than the
exchange rates quoted in the newspaper indicate.
FOREIGN EXCHANGE SPREAD
The difference between the offer and bid price is called the spread. Spreads are often stated
as “pips.” When the spot quote has four decimal places, one pip is 1/10,000. In the above
example, the spread is $0.0004 (4 pips) reflecting the dealer’s profit. Dealers manage their
foreign currency inventories by transacting in the interbank market (think of this as a
wholesale market for currency). Spreads are narrow in the interbank market.
The spread quoted by a dealer depends on:
● The spread in an interbank market for the same currency pair. Dealer spreads
vary directly with spreads quoted in the interbank market.
● The size of the transaction. Larger, liquidity-demanding transactions generally get
quoted a larger spread.
● The relationship between the dealer and client. Sometimes dealers will give
favorable rates to preferred clients based on other ongoing business relationships.
The interbank spread on a currency pair depends on:
● Currencies involved. Similar to stocks, high-volume currency pairs (e.g., USD/EUR,
USD/JPY, and USD/GBP) command lower spreads than do lower-volume currency
pairs (e.g., AUD/CAD).
● Time of day. The time overlap during the trading day when both the New York and
London currency markets are open is considered the most liquid time window;
spreads are narrower during this period than at other times of the day.
● Market volatility. Spreads are directly related to the exchange rate volatility of the
currencies involved. Higher volatility leads to higher spreads to compensate market
makers for the increased risk of holding those currencies. Spreads change over time
in response to volatility changes.
In addition to these factors, spreads in forward exchange rate quotes increase with
maturity. The reasons for this are: longer maturity contracts tend to be less liquid,
counterparty credit risk in forward contracts increases with maturity, and interest rate
risk in forward contracts increases with maturity.

WORKING WITH FOREIGN EXCHANGE QUOTES

Earlier, we stated that a dealer will sell a currency at the ask price and purchase it at the
bid price. We need to be a bit more specific. For example, imagine that you are given a
USD/AUD bid and ask quote of 1.0508-1.0510. Investors can buy AUD (i.e., the base
currency) from the dealer at the ask price of USD 1.0510. Similarly, investors can sell AUD
to the dealer at the bid price of USD 1.0508. Remember, investors always take a loss due to
the spread. So the rule is buy the base currency at ask, and sell the base currency at bid.

For transactions in the price currency, we do the opposite. If we need to buy USD (i.e., the
price currency) using AUD (i.e., selling the base currency), we now use the dealer bid quote.
Similarly, to sell the price currency, we use the dealer ask quote. So the rule is buy the price
currency at bid, and sell the price currency at ask.
Alternatively, it is useful to follow the up-the-bid-and-multiply, down-the-ask-and-divide
rule.
Again, given a USD/AUD quote, if you want to convert USD into AUD (you are going down
the quote—from USD on top to AUD on bottom), use the ask price for that quote.
Conversely, if you want to convert AUD into USD, you are going up the quote (from bottom
to top) and, hence, use the bid price.

EXAMPLE: Converting currencies using spot rates

A dealer is quoting the AUD/GBP spot rate as 1.5060 − 1.5067. How would we:
1. Compute the proceeds of converting 1 million GBP.
2. Compute the proceeds of converting 1 million AUD.
Answer:
1. To convert 1 million GBP into AUD, we go “up the quote” (i.e., from GBP in the
denominator to AUD in the numerator). Hence, we would use the bid price of 1.5060 and
multiply.
1 million GBP × 1.5060 = 1,506,000 AUD
2. To convert 1 million AUD into GBP, we go “down the quote” (i.e., from AUD in the
numerator to GBP in the denominator). Hence, we would use the ask price of 1.5067 and
divide.
1 million AUD / 1.5067 = 663,702.13 GBP

CROSS RATE
The cross rate is the exchange rate between two currencies implied by their exchange
rates with a common third currency. It is necessary to use cross rates when there is no
active foreign exchange (FX) market in the currency pair being considered. The cross rate
must be computed from the exchange rates between each of these two currencies and a
major third currency, usually the USD or EUR.

Suppose we have the following quotes:

USD/AUD = 0.60 and MXN/USD = 10.70. What is the cross rate between Australian
dollars and pesos (MXN/AUD)?

So our MXN/AUD cross rate is 6.42 pesos per Australian dollar. The key to calculating
cross rates is to make sure the common currency cancels out.

CROSS RATES WITH BID-ASK SPREADS

Bid-ask spreads complicate the calculation of cross rates considerably. Suppose we are
given three currencies A, B, and C; we can have three pairs of currencies (i.e., A/B, A/C,
and B/C).
Rules:
To compute the cross rate for A/C, given A/B and B/C, we can follow the above rules to
obtain the bid and offer prices. If we are instead given A/B and C/B rates, we will have to
make adjustments to obtain the B/C bid and offer rates from the C/B bid and offer rates,
because A/B × C/B ≠ A/C. The process is as follows:

TRIANGULAR ARBITRAGE
Real-world currency dealers will maintain bid/ask quotes that ensure a profit to the dealer,
regardless of which currencies customers choose to trade. If this was not the case,
customers could earn profits through the process of triangular arbitrage. In triangular
arbitrage, we begin with three pairs of currencies, each with bid and ask quotes, and
construct a triangle where each node in the triangle represents one currency. To check for
arbitrage opportunities, we go around the triangle clockwise (and later, counterclockwise)
until we reach our starting point. As before, we follow the up-the-bid and-multiply, down-
the-ask-and-divide rule.

The following example will illustrate triangular arbitrage.

EXAMPLE: Triangular arbitrage
The following quotes are available from the interbank market:
Quotes:
USD/AUD 0.6000 − 0.6015
USD/MXN 0.0933 − 0.0935
1. Compute the implied MXN/AUD cross rate.
2. If your dealer quotes MXN/AUD = 6.3000 − 6.3025, is an arbitrage profit possible? If so,
compute the arbitrage profit in USD if you start with USD 1 million.
Answer:
1. To compute implied cross rates, we need:
Since we are given USD/MXN quotes instead of MXN/USD quotes, we first invert these
quotes:

and

Now, the implied cross rates:

2. Since the dealer quote of MXN/AUD = 6.3000 − 6.3025 falls outside of these cross
rates, arbitrage profit may be possible (we have to check this). Remember to use the
dealer quotes in the triangle and not the cross rates we computed.
To label the arrows in this triangle, we follow the “up the bid, down the offer” rule. To
convert from USD to MXN, (“down” with respect to the USD/MXN quote), we use the offer
rate of 0.0935.
Going clockwise and starting with USD 1 million:
1. Convert USD 1 million into MXN @ 0.0935 USD/MXN. Note that the quote is USD/MXN
and hence we are going down, and thus need to use the ask. Also remember: down, divide.
We get 1 million/0.0935 = 10,695,187 MXN.
2. Next, we convert 10,695,187 MXN into AUD @ 6.3025 MXN/AUD to get 1,696,975 AUD.
3. Finally, we convert AUD 1,696,975 into USD @ 0.6000 USD/AUD. Here the quote is
USD/AUD and we are converting from AUD to USD, so we are going “up the quote” and
need to multiply by the bid. (Remember: up, multiply.) We get 1,696,975 × 0.60 =
1,018,185 USD − a profit of 18,185 USD.
We can also check for arbitrage in the counter-clockwise direction (even though we can
never earn an arbitrage profit in both directions):
1. Convert USD 1 million into AUD using 0.6015. Again, the quote is USD/AUD and we are
going down, so use the ask price and divide. We get 1 million/0.6015 = 1,662,510 AUD.
2. Next, we convert 1,662,510 AUD into MXN using 6.3000 to get 10,473,814 MXN.
3. Finally, we convert MXN 10,473,814 into USD at 0.0933 to get 977,207 USD − a loss of
22,793 USD.

SPOT AND FORWARD RATES

A currency is quoted at a forward premium relative to a second currency if the forward
price (in units of the second currency) is greater than the spot price. A currency is
quoted at a forward discount relative to a second currency if the forward price (in units
of the second currency) is less than the spot price. The premium or discount is for the base
currency (i.e., the currency at the bottom of the quote). For example, if the spot price is
1.20$/€ and the forward price is 1.25$/€, we say that the euro is trading at a forward
premium.
forward premium (discount) = F − S0
Given a quote of A/B, if the above equation results in a positive value, we say that currency
B (i.e., the base currency) is trading at a premium in the forward market. In the FX markets,
forward quotes are often presented as a premium or discount over spot rates. The
following example illustrates this convention.
EXAMPLE: Spot and forward quotes
Given the following quotes for AUD/CAD, compute the bid and offer rates for a 30-day
forward contract.

Answer:
Since the forward quotes presented are all positive, the CAD (i.e., the base currency) is
trading at a forward premium.
30-day bid = 1.0511 + 3.9/10,000 = 1.05149
30-day offer = 1.0519 + 4.1/10,000 = 1.05231
The 30-day all-in forward quote for AUD/CAD is 1.05149/1.05231
180-day bid = 1.0511 + 46.9/10,000 = 1.05579
180-day offer = 1.0519 + 52.3/10,000 = 1.05713
The 180-day all-in forward quote for AUD/CAD is 1.05579/1.05713

Factors That Affect Exchange Rates in the Long Run

In the long run, four major factors affect the exchange rate: relative price levels, tariffs and
quotas, preferences for domestic versus foreign goods, and productivity. We examine how
each of these factors affects the exchange rate while holding the others constant.
The basic reasoning proceeds along the following lines: Anything that increases the demand
for domestically produced goods that are traded relative to foreign traded goods tends to
appreciate the domestic currency because domestic goods will continue to sell well even
when the value of the domestic currency is higher. Similarly, anything that increases the
demand for foreign goods relative to domestic goods tends to depreciate the domestic
currency because domestic goods will continue to sell well only if the value of the domestic
currency is lower. In other words, if a factor increases the demand for domestic goods
relative to foreign goods, the domestic currency will appreciate; if a factor decreases the
relative demand for domestic goods, the domestic currency will depreciate.
Relative Price Levels In the long run, a rise in a country’s price level (relative to the
foreign price level) causes its currency to depreciate, and a fall in the country’s relative
price level causes its currency to appreciate.
Trade Barriers Increasing trade barriers causes a country’s currency to appreciate in the
long run.
Preferences for Domestic Versus Foreign Goods Increased demand for a country’s
exports causes its currency to appreciate in the long run; conversely, increased demand for
imports causes the domestic currency to depreciate.
Productivity Higher productivity, therefore, is associated with a decline in the price of
domestically produced traded goods relative to foreign traded goods. As a result, the
demand for traded domestic goods rises, and the domestic currency tends to appreciate.
Our long-run theory of exchange rate behavior is summarized in the following Table. We
use the convention that the exchange rate E is quoted so that an appreciation of the
currency corresponds to a rise in the exchange rate. In the case of the United States, this
means that we are quoting the exchange rate as units of foreign currency per dollar (say,
yen per dollar).

Ref: Factors That Change the Exchange Rate (p383-392 from Mishkin and Eakins)
Covered Interest Rate Parity
The word covered in the context of covered interest parity means bound by
arbitrage. Covered interest rate parity holds when any forward premium or
discount exactly offsets differences in interest rates, so that an investor would earn
the same return investing in either currency. If euro interest rates are higher than
dollar interest rates, the forward discount on the euro relative to the dollar will just
offset the higher euro interest rate.
Formally, covered interest rate parity requires that (given A/B quote structure):

EXAMPLE: Covered interest arbitrage: The U.S. dollar MRR is 8%, and the euro MRR is
6%. The spot exchange rate is $1.30 per euro (USD/EUR), and the 1-year forward rate is $1.35
per euro. Determine whether a profitable arbitrage opportunity exists.

Uncovered Interest Rate Parity

With covered interest rate parity, arbitrage will force the forward contract exchange
rate to a level consistent with the difference between the two country’s nominal
interest rates. If forward currency contracts are not available, or if capital flows are
restricted so as to prevent arbitrage, the relationship need not hold. Uncovered
interest rate parity refers to such a situation; uncovered in this context means not
bound by arbitrage.

Consider Country A (let USA) where the interest rate is 4%, & Country B (let BD)
where the interest rate is 9%. Under uncovered interest rate parity, currency B
(Taka) is expected to depreciate by 5% annually relative to A (USD), so that an
investor should be indifferent between investing in Country A or B.
Given a quote structure of A/B, the base currency (i.e., currency B) is expected to
appreciate by approximately RA − RB. (When RA − RB is negative, currency B is
expected to depreciate). Mathematically:

The following example illustrates the use of uncovered interest rate parity to
forecast future spot exchange rates using market interest rates.
EXAMPLE: Forecasting spot rates with uncovered interest rate parity
Suppose the spot exchange rate quote is ZAR/EUR = 8.385. The 1-year
nominal rate in the eurozone is 10% and the 1-year nominal rate in South
Africa is 8%. Calculate the expected percentage change in the exchange rate
over the coming year using uncovered interest rate parity.
Answer:
The rand interest rate is less than the euro interest rate, so uncovered
interest rate parity predicts that the value of the rand will rise (it will take
fewer rand to buy one euro) because of higher interest rates in the eurozone.
The euro (the base currency) is expected to “appreciate” by approximately
RZAR − REUR = 8% − 10% = –2%. (Note the negative 2% value.) Thus, the euro
is expected to depreciate by 2% relative to the rand, leading to a change in
exchange rate from 8.385 ZAR/EUR to 8.217 ZAR/EUR over the coming year.

Purchasing Power Parity

The law of one price states that identical goods should have the same price in all
locations. For instance, a pair of designer jeans should cost the same in Paris as they
do in New York, after adjusting for the exchange rate. The potential for arbitrage is
the basis for the law of one price: if designer jeans cost less in New York than they
do in Paris, an enterprising individual will buy designer jeans in New York and sell
them in Paris, until this action causes the price differential to disappear. Note,
however, that the law of one price does not hold in practice, due to the effects of
frictions such as tariffs and transportation costs.

Instead of focusing on individual products, absolute purchasing power parity

(absolute PPP) compares the average price of a representative basket of
consumption goods between countries using an index such as The United States
Consumer Price Index (CPI). Absolute PPP requires only that the law of one price
be correct on average, that is, for like baskets of goods in each country.
S(A/B) = CPI(A) / CPI(B)

In practice, even if the law of one price held for every good in two economies,
absolute PPP might not hold because the weights (consumption patterns) of the
various goods in the two economies may not be the same (e.g., people eat more
potatoes in Russia and more rice in Japan).

Relative Purchasing Power Parity

Relative purchasing power parity (relative PPP) states that changes in exchange
rates should exactly offset the price effects of any inflation differential between two
countries. Simply put, if (over a 1-year period) Country A has a 6% inflation rate and
Country B has a 4% inflation rate, then Country A’s currency should depreciate by
approximately 2% relative to Country B’s currency over the period.
The equation for relative PPP is as follows:

Relative PPP is based on the idea that even if absolute PPP does not hold, there may
still be a relationship between changes in the exchange rate and differences
between the inflation rates of the two countries.

EXAMPLE: Calculating the exchange rate predicted by the PPP

The current spot rate is USD/AUD = 1.00. You expect the annualized
Australian inflation rate to be 5%, and the annualized U.S. inflation rate to be
2%. According to the ex-ante version of PPP, what is the expected change in
the spot rate over the coming year?
Answer:
Since the AUD has the higher expected inflation rate, we expect that the AUD
will depreciate relative to the USD. To keep the cost of goods and services the
same across borders, countries with higher rates of inflation should see their
currencies depreciate. The expected change in the spot rate over the coming
year is inflation (USD) − inflation (AUD) = 2% − 5% = –3%. This predicts a
new USD/AUD exchange rate of approximately 0.97 USD/AUD.