Currency Exchange

Rates
Reading 21

IFT Notes for the 2015 Level I CFA® exam

 Currency Exchange Rates [Link]

Contents

1. Introduction ................................................................................................................................. 3
2. The Foreign Exchange Market.................................................................................................... 3
3. Currency Exchange Rate Calculations...................................................................................... 12
4. Exchange Rate Regimes ........................................................................................................... 20
5. Exchange Rates, International Trade, and Capital Flows ......................................................... 25
Summary ....................................................................................................................................... 32
Next Steps ..................................................................................................................................... 35

This document should be read in conjunction with the corresponding reading in the 2015 Level I
CFA® Program curriculum.

Some of the graphs, charts, tables, examples, and figures are copyright 2013, CFA Institute.
Reproduced and republished with permission from CFA Institute. All rights reserved.

Required disclaimer: CFA Institute does not endorse, promote, or warrant the accuracy or
quality of the products or services offered by Irfanullah Financial Training. CFA Institute,
CFA®, and Chartered Financial Analyst® are trademarks owned by CFA Institute.

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1. Introduction

The foreign exchange (forex) market is a global market for trading currencies, and it is by far the
most actively traded market as it operates 24 hours a day, each business day. It is the largest
financial market in the world. The daily turnover jumped to $5.3 trillion per day in 2013 from $4
trillion in 2010, a 35% increase in three years. This is about 10 to 15 times larger than the daily
trading volume of the global bond markets and 50 times larger than global turnover in equities.

Unlike equities, the forex market is not a single exchange. Market participants across the world,
ranging from large investment funds to small retail individual investors, trade in real time
connected to each other through electronic communications networks.

This reading covers:

 How the foreign exchange market is structured; who the major players are, and how they
conduct their business
 The nitty-gritty of how exchange rates are quoted and calculated
 How to calculate cross-exchange rates and forward exchange rates
 The different exchange rate regimes throughout the world
 The effect of exchange rates on international trade and capital flows

2. The Foreign Exchange Market

Before we begin, let’s look at some of the standard conventions and three-letter codes used for
individual currencies. Every currency has a three-letter code as per the International
Organization for Standardization (ISO). Exhibit 1 in the curriculum presents a list of codes for
commonly used currencies.

Note: You need not know the symbols for all the currencies. Just be familiar with a few widely
used ones like U.S. dollar, Euro, Japanese yen, British pound, Swiss Francs, and the fact that
every currency is represented this way in the forex market.

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Some basic terms related to the forex market:

Individual currency: A standalone way of telling how many units of a currency you have. It is
not in reference to any other currency. Ex: $ 100,000 in a time deposit.
Exchange rate: The price of one currency in terms of another. It specifies how many units of a
currency, one unit of another currency will buy. With an exchange rate, there are always two
currencies. Ex: 1 USD = 0.73 EUR. This means that 1 U.S. dollar can buy 0.73 euros.
EUR
Exchange rate notation: The same can be written as = 0.73. What goes in the denominator
USD

and numerator? The 1 unit of currency goes in the denominator while the other is in the
numerator (how many Euros per U.S. dollar?). The exchange rate is quoted as per unit of the
base currency.
Note: There are many ways of expressing an exchange rate, but this is the one the curriculum
uses, and we will use this throughout the reading.
 Base currency: In the above example, the currency in the denominator is the base
currency (USD). This is the currency of which we have one unit.

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 Price currency: In the above example, the currency in the numerator is the price
currency (EUR). It is the currency in which the price of the base currency is quoted.
 Exchange rate: The number of units of the price currency needed to buy/sell one unit of
the base currency. In the above example 1 U.S. dollar is worth 0.73 Euros

EUR
Currency appreciation: Let us assume the exchange rate at the start of the year was =
USD
EUR
0.73. At the end of the year, the exchange rate is = 0.75. This means that at the start of the
USD

year, 1 U.S. dollar could buy 0.73 Euros and at the end of the year, 1 U.S. dollar will buy 0.75
Euros. That is, you are now able to buy more Euros with the same 1 U.S. dollar than you could at
the start of the year. This is called currency appreciation. The U.S dollar has strengthened or
appreciated. If one currency strengthens, it automatically implies that the other currency has
weakened. In this case, USD strengthened while EUR weakened.

Currency depreciation: Now, let us assume that at the end of the year, the exchange rate is
EUR
= 0.71. This means that at the start of the year 1 U.S dollar could buy 0.73 Euros and at the
USD

end of the year I U.S. dollar could buy 0.71 Euros. That is, you are now able to buy fewer Euros
with the same 1 U.S dollar than you could at the start of the year. This is called currency
depreciation. The U.S. dollar has weakened or depreciated. If one currency weakens, it
automatically means that the other currency has strengthened. In this case, USD weakened while
EUR strengthened.

Tips:
If the exchange rate goes up, the base currency has appreciated or strengthened.
Appreciation of the base currency automatically implies that the price currency has
depreciated.
If the exchange rate goes down this means that the base currency has depreciated or
weakened. Depreciation of the base currency automatically implies that the price
currency has appreciated.

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Nominal exchange rate: The EUR/USD exchange rate, we saw in the example above and the
quotes you see in the news/newspaper are nominal exchange rates.
Real exchange rate: Measures the relative purchasing power of one currency compared with
another. It is:
 An increasing function of nominal exchange rate
 An increasing function of the foreign price level (in base currency)
 A decreasing function of the domestic price level (in price currency)
Let us use an example to see what the above relationships mean:
A person in Sri Lanka wants to buy the Lamborghini Aventador in a year. The price of the car is
quoted in euros. What are the factors that may affect his buying (purchasing power) decision?
Domestic currency Price currency Sri Lankan rupee
The exchange rate is written as = =
Foreign currency Base currency Euro

 If there is an increase in the nominal exchange rate i.e. the Euro strengthens and the Sri
Lankan rupee weakens. This means that the person would have to pay more Sri Lankan
rupee to buy the car a year later and his purchasing power is reduced.
 If there is an increase in the price levels of the foreign currency assume that the car
manufacturer announced an increase in prices so it is more expensive now in domestic
currency. This also means more money to be paid in Sri Lankan rupees. (2nd relationship
in real exchange rate). This reduces his purchasing power.
 The domestic prices have increased. Assuming price levels are linked to income levels;
we can say that the purchasing power has increased. This is an inverse relationship unlike
the above two factors.

Equation 1:
Foreign price level in domestic currency P
Spot exchange rate SP = = PP
B
Foreign price level in foreign currency B

Combining the three relationships we saw above, the real exchange rate can be expressed as:

Equation 2:
P
Real exchange rate R P = SP ∗ PB
B B P

where

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SP = spot exchange rate

B

Now, assume you want to calculate the real exchange rate between the U.S. dollar and the Indian
rupee using the price levels in both the countries. U.S. dollar is the base currency and the Indian
rupee is the price currency.
Spot exchange rate S INR = 60; PUSD =2; PINR =20
USD

2
Real exchange rate R INR = 60 ∗ 20 = 6
USD

Let’s analyze the impact of each of these factors on the real exchange rate:
 Spot rate goes up but price levels stay the same: If the spot rate goes up from 60 to 70,
then the real exchange rate goes up. The purchasing power of the base currency (dollar)
goes up. Conversely, the purchasing power of the price currency goes down.
 Price level of the foreign currency (base currency) goes up: If PUSD increases from 2 to 4,
then the real exchange rate goes up. Purchasing power of the price currency decreases;
and that of the base currency goes up.
 Price level of the domestic currency (price currency) goes down: If PINR goes down from
20 to 10, then the real exchange rate goes up as they are inversely related. The purchasing
power of the base currency increases and that of the base currency decreases.
Equation 3:
Increase in real exchange rate  Decrease in purchasing power of the price currency
(domestic currency)
Increase in real exchange rate  Increase in purchasing power of the base currency
(foreign currency)

Solve example 1 from the curriculum.

2.1 Market Functions

 There are several motivations for foreign exchange transactions such as:
- International trade: Companies buying and selling products/services across
geographies

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- Capital market transactions such as investors buying fixed assets in other

countries, investing in stocks/bonds denominated in foreign currencies.
- The growth of international tourism. Tourists buy the currency of the country they
are visiting.
 Hedging versus speculating
- Hedging is engaging in a transaction to mitigate foreign exchange risk.
For example: A Chinese food products company imports canned peaches, Maple
syrup, and various types of vinegar from the United States. It makes the payment
in dollars. The company can engage in a forex transaction to buy a certain amount
of dollars at a specified rate. This removes the risk (uncertainty) of the U.S. dollar
becoming too expensive in the future. This is an example of hedging.
For example: Take another example of a software services exporter in Pakistan
who gets paid in dollars. But the revenues are reported in Pakistani rupee (PKR).
To remove the uncertainty of how much the U.S. dollar translates into PKR, the
company may engage in forex transaction to receive certain amount of PKR for
every dollar at a certain date.
- Speculating: This means that unlike in the examples above, the person engaging
in the transaction has no intention of taking delivery of the currency. They seek to
profit from exchange rate changes. They were merely anticipating a movement in
a certain direction (currency appreciating / depreciating) and trading on that view.
- At times the difference between hedging and speculation is blurred.
 Spot transactions
Spot transactions involve the exchange of currencies for immediate delivery. For
most currencies, this corresponds to “T+2” delivery, meaning that the exchange of
currencies is settled two business days after the trade is agreed to by the two sides
of the deal (One exception to the T + 2 rule is the Canadian dollar, for which the
spot delivery/settlement against U.S dollars is on a T + 1 basis).
- The exchange rate used for such transactions is called the spot exchange rate.
 Forward contracts

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- Forward contracts are agreements to deliver foreign exchange at a future date at

an exchange rate agreed upon today. As such, they are any exchange rate
transactions that occur with currency settlement longer than T+2 days.
- In the hedging examples we saw earlier a forward contract may be used. For
example, the Chinese company may enter into a contract on Jan 13, 2014 to pay
CNY
$500,000 on Apr 13, 2014 at the rate of 6.21 CNY ( USD = 6.2100)

- Two factors are defined in each forward contract:

 The date at which the currencies are to be exchanged.
 The exchange rate applicable on the settlement date. This exchange rate is
defined now and is called the forward exchange rate; it is different from
the spot rate.
- Forward contracts can be of any size the counterparties agree upon, however the
liquidity in forward market decreases as the trade size and term to maturity
increases.
 FX Swap
- A FX swap is an agreement between two parties to simultaneously engage in an
offsetting spot and a forward transaction. It involves the purchase and sale of a
specified amount of currency at two different dates. In a spot/forward FX swap,
one party buys the currency in the spot market and simultaneously sells the same
amount back in the forward market.
- It is best to understand swaps using an example. Assume two parties A and B
enter into a forward contract. Party A agrees to sell €100 million at a forward
exchange rate of USD/EUR = 1.3600. The settlement date is 100 days from now.
To roll the forward contract, party A will engage in a FX swap. The spot rate on
day 98 is 1.3400

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Day 98: Forward Day 100

contract two days
from settlement

Party A: Deliver €100 million

Party A: buy €100 as per the forward contract.
million spot. Pay USD Receive USD per forward rate
per spot rate

$134 million $136 million

€100 million €100 million

Party B
Party B

- Net cash flow to party A will be: € 100 million (1.36 - 1.34) = $2,000,000. On
day 98, a new forward contract may be initiated to sell €100 million at the
USD/EUR forward exchange rate quoted on day 98. This is effectively rolling
forward the currency forward position.
- Why are swaps needed?
 To roll existing forward positions to a new future date
 Used by market participants as a funding source

Note: From an exam perspective, focus on spot and forward rates. FX swap is not mentioned in
the learning objectives

2.2 Market Participants

The forex market has a diverse range of participants. One way of classifying them is to group
them based on buy side and sell side players.

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Sell side:
 Large FX trading banks such as Deutsche bank, Citigroup, UBS, and HSBC.
 Other banks fall into the second and third tier of the FX market.
Buy side:
 Clients who use banks to undertake FX transactions.
 Corporate accounts: Corporations using forex transactions for cross-border trade of goods
and services.
 Real money accounts: restricted use of leverage. Investment funds managed by mutual
funds, ETFs, pension funds, endowments etc.
 Leveraged accounts: Hedge funds, high-frequency algorithmic traders.
 Retail accounts: Individuals trading for their own accounts, tourists exchanging currency
during international travel.
 Governments
 Central banks: Intervene in the forex market to control their domestic exchange rate. For
instance, during 2012-13, the Reserve Bank of India bought billions of U.S. dollars to
strengthen the depreciating Indian rupee.
 Sovereign wealth funds: Countries with current account surpluses like Norway, UAE,
Kuwait, and China direct international capital inflows into SWFs instead of holding them
as foreign exchange reserves. SWF then invests these funds internationally in natural
resources, infrastructure projects and real estate to earn higher returns and exert more
influence.

2.3 Market Size and Composition

Exhibit 3 in the curriculum (reproduced below) lists FX turnover by instrument.

FX Turnover by Instrument

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The largest turnover is in the swaps market, followed by the spot market.

Note: You need not memorize the numbers.

Exhibit 4 in the curriculum (reproduced below) lists FX flows by counterparty. Average daily
FX flow between financial clients is higher than that between the sell-side banks (interbank
market).
FX Flows by Counterparty.

3. Currency Exchange Rate Calculations

3.1 Exchange Rate Quotations

Exchange rate is the price of one currency relative to another. Exchange rates are typically
quoted at four decimal places. The ratio or exchange rate is quoted as price currency per unit of
base currency.

USD
Consider this quote: EUR = 1.4000

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What does it mean? It means you can buy 1.4 U.S. dollars for one euro. The currency in the
denominator (one unit of the currency) is the base currency. The currency in the numerator is the
price currency.

EUR
The same quote may also be written as USD = 0.7142. If you notice, it is the reciprocal of 1.4.

Direct quote: A direct quote takes domestic currency as the price currency and the foreign
currency as the base currency
Indirect quote: An indirect quote takes domestic currency as the base currency and the foreign
currency as the price currency

Direct and indirect quotes are the reciprocal of each other.

USD
For example: From a German investor’s perspective, is EUR = 1.4000 a direct quote?

The domestic currency for a German investor is the Euro. In this case, the Euro is shown as the
base currency. Therefore from the German investor’s perspective this quote is an indirect quote.

Bid-ask: Currencies are always quoted as bid-ask. (This is from the perspective of a dealer, not
from the client’s perspective). Bid rate is the rate at which the dealer will buy the base
currency. Ask rate is the rate at which the dealer will sell the base currency.

USD
For example: A bid-ask quote of EUR = 1.3990 - 1.4010 means that the dealer is willing to buy 1

euro for $1.399 and sell 1 euro for $1.4010.

The bid price is always lower than the sell price as the dealer makes money on the bid-ask
spread.

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USD
Price currency
= 1.3990 - 1.4010
EUR

The dealer will sell 1

Base currency The dealer will buy 1 euro for 1.401 US
euro for 1.399 US dollars
dollars

Bid rate -- Buy rate

Ask rate -- Sell rate
The dealer buys the base currency at the low price and sells the base currency at the high price.

Worked Example 1:
Appreciation of one currency is the depreciation of the other. Say the USD/EUR rate changed
from 1.4 to 1.5. What is the appreciation/depreciation of each currency?

Solution:
The base currency is EUR; the price currency is USD.
The exchange rate goes up from 1.4 to 1.5. It means the base currency (EUR) has
appreciated/strengthened. The USD has depreciated or weakened.
1.5−1.4
% appreciation of EUR = ∗ 100 = 7.142%
1.4

To calculate the depreciation in USD, we must first convert the quote in EUR/USD terms.
Take a reciprocal of the quote to get the EUR/USD values.
1 1
Initial value: 1.4 = 0.7143 Later value EUR/USD = 1.5 = 0.6667
0.6667−0.7143
% Depreciation of dollar = ∗ 100 = - 6.67%
0.7143

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Note: The percentage amount by which one currency goes up (appreciates) is not necessarily the
same as the percentage amount by which the other currency goes down. In our example, while
the Euro appreciated by 7.142%, the U.S. dollar did not depreciate by 7.142%, instead it only
depreciated by 6.67%.

3.2 Cross-rate Calculations

Given two exchange rates and three currencies, it is possible to determine the third exchange
rate. This way of determining the third exchange rate by converting one foreign exchange quote
into another is called the cross rate.
PKR
Given the two exchange rates below, what is the rate?
INR

Ratio Spot rate

PKR
100.0000
USD
INR
60.0000
USD

Solution:
PKR PKR USD PKR
= USD ∗ INR In this equation, the USD cancels out giving us INR .
INR
PKR USD INR
We are given the value of . To get the value of , we take the reciprocal of which is
USD INR USD

given.
PKR 1
= 100 ∗ 60 = 1.667
INR

Triangular arbitrage: If the implied cross rate is not equal to the quoted cross rate, then an
arbitrage opportunity exists and it is called triangular arbitrage. In such cases, one would profit
by buying low and selling high. For example, in the case above, if the bank quoted a rate of 1.8
PKR
for , then you may buy INR (sell PKR) for 1.667 and sell INR (buy PKR) for 1.8 to profit
INR

from the mispricing.

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3.3 Forward Calculations

Forward exchange rates are generally quoted in terms of points or pips. A spot rate is the rate
that is in effect today. A forward rate is a fixed exchange rate that we lock in today based on
which currencies will be exchanged at some future date. This rate is such that it does not allow
for arbitrage.

Points on a forward rate quote = Forward exchange rate quote – Spot exchange rate quote

Forward premium: If forward rate > Spot rate

Forward discount : If forward rate < Spot rate

USD
The table below lists the spot rate and several forward rates for currency pair. As you can
EUR

see, the spot rate today is 1.2875. The forward points (with reference to the spot rate) applicable
if the transaction happens a year (12 months) later is - 26.5. But the forward rate calculated using
this forward point is locked in today. As you can see, the absolute number of points increases
with maturity. The longer the time to maturity, the higher the number of forward points. The
number of points represents the interest rate differential between the two countries.

Maturity Spot rate or forward points

Spot 1.2875

One week - 0.3

One month - 1.1

Three months - 5.5

Six months - 13.3

Twelve months - 26.5

What does the negative sign indicate?

It means that the forward rate is less than the spot rate. The Euro, the base currency, is
weakening relative to the U.S. dollar, the price currency.

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Equation 4:
How to convert forward points into a forward rate:
Forward points
Forward rate = Spot rate + 10000

Note: divide by 10000 if the exchange rate uses a four decimal place convention and by 100 if the
exchange rate uses a two decimal place convention

What is the 12-month forward rate?

26.5
Forward rate = 1.2875 + − 10000 = 1.28485

At times, forward points are expressed as a percentage of the spot rate.

0.00265
− * 100 = -0.21%
1.2875

Worked Example 2:
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 what? Solution:
For some exchange rates, the convention is to use two decimal places like the Japanese yen/U.S.
dollar.
Forward rate – Spot rate = 100.40 - 100.55 = - 0.15
Forward points or pips = - 0.15*100 = - 15 (Note: It is multiplied by 100 and not 10000, because
the exchange rate uses a two decimal places convention)

3.4 Relationship between Spot Rates, Forward Rates, and Interest Rates

The forward exchange rate depends on relative interest rates. To derive the relationship between
spot rates, forward rates, and interest rates, assume you have one unit of domestic currency to be
invested for let us say, one year. There are two (options) alternative investments you consider:
Foreign currency Price currency
The exchange rate convention used = Domestic currency = Base currency

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 Option 1: Invest one unit of domestic currency (base currency) at the domestic risk-free
rate iB for one period.
Amount at the end of the period = 1+ iB
 Option 2: Convert one unit of domestic currency into foreign currency (base currency)
SP
today using the spot rate . Invest this amount at the foreign risk-free rate iP for one
B

period. Determine the forward rate F_P/B today at which the price currency will be
converted back to base currency.
SP
Amount of units of price currency at the end of the period = (1 + iP )
B
SP 1
Amount in terms of base (domestic currency) at the end of the period = (1 + iP ) ∗
B FP
B

Note: By using forward rate, any foreign exchange risk was eliminated in this transaction.

Since the risk of these two investments is the same, they should generate equivalent returns. And
as an investor, you should be indifferent between the two as it is a no-arbitrage relationship.

SP 1
1+ iB = (1 + iP ) ∗
B FP
B

The above equation can be rewritten as:

Equation 4:
𝟏 + 𝐢𝐏
𝐅𝐏 = 𝐒𝐏 ∗
𝐁 𝐁 𝟏 + 𝐢𝐁
where FP = forward rate
B

iP = risk − free rate of the price currency

iB = risk − free rate of the base currency

Forward rate as a percentage of the spot rate

𝐅𝐏 𝟏 + 𝐢𝐏
𝐁
=
𝐒𝐏 𝟏 + 𝐢𝐁
𝐁

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Let us use some values now to compute the forward rate. The spot rate for INR/USD S INR = 100.
USD

The risk-free rate for INR is 10% and the risk-free rate for dollar (base currency) is 1%.
1+𝑖 1+0.1
Forward rate F INR = S INR ∗ 1+𝑖 𝐼𝑁𝑅 = 100 ∗ 1+0.01 = 108.9108
USD USD 𝑈𝑆𝐷

Some important points to be noted:

 The currency with the higher (lower) interest rate will always trade at a discount
(premium) in the forward market. (I don’t get what they’re trying to say here, is it
higher/lower?)
In our example above, USD was the base currency with a risk-free rate of 1%, while INR
was the price currency with a risk-free rate of 10%. The forward rate calculated was
108.91 which means that the currency with the lower interest rate (USD) appreciated,
while the currency with the higher interest rate (INR) depreciated. (Trading at a discount
means the currency depreciates. Trading at a premium means the currency appreciates.)
 This relationship ensures that there is no arbitrage. The only forward rate that prevents
arbitrage is 108.91. Otherwise, for any rate greater/lesser than 108.91 traders can exploit
mispricing by buying low and selling high.
 If the forward contract is for x days, make an adjustment based on the x/360 convention
unless told otherwise. Equation 4 can be rewritten as:
Equation 4:
𝟏 + (𝐢𝐏 ∗ 𝐱/𝟑𝟔𝟎)
𝐅𝐏 = 𝐒𝐏 ∗ 𝐱
𝐁 𝐁 𝟏 + (𝐢𝐁 ∗ 𝟑𝟔𝟎)

Worked Example 3:
Given the following data, calculate the 37-day forward rate for JPY/CAD:
Canadian dollar risk-free interest rate = 3.97%
Japanese yen risk-free interest rate = 0.23%
Spot rate S JPY =100.87
CAD

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37
1+0.0397∗
Forward rate = 100.87 ( 360
37 ) = 100.87*(1.00408/1.000236) = 101.26 JPY/CAD
1+0.0023∗
360

 The currency with the higher (lower) interest rate will always trade at a discount
(premium) in the forward market.
 Interest rate differential = iP − iB
 Percentage change in spot rates is proportional to the interest rate differential

4. Exchange Rate Regimes

 Every exchange rate is managed to some degree by central banks. The policy framework
adopted by a central bank or the monetary authority to manage its currency relative to
other currencies is called the exchange rate regime.
 You may ask, why must the central bank intervene in the exchange rate? This is because
high exchange rate volatility can affect investment decisions or affect how foreign
investors perceive the investment climate (risky or stable) of a country.

Before we look at the different exchange rate regimes, let us understand what an ideal regime
must have.
Properties of an ideal exchange rate regime:
1. The exchange rate between any two currencies would be credibly fixed.
2. All currencies would be fully convertible. (i.e. currencies could be freely exchanged for
any purpose and in any amount)
3. Each country would be able to undertake fully independent monetary policy in pursuit of
domestic objectives, such as growth and inflation targets.

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Free capital flows

Ideal
exchange rate
policy
Independent
Fixed exchange rate
monetary policy

But, in reality, these three properties are not consistent. If properties 1 and 2 hold good, then
there would really be only one currency in the world and independent monetary policy will not
be possible.

Historical perspective on currency regimes:

Note: This is not part of the learning objectives and there are no practice problems. However, a
brief history of the currency regime is summarized below:
 Most of the 19th century until the start of World War 1 in 1914: the U.S. dollar and the
U.K. pound sterling operated on the gold standard, meaning the price of each currency
was fixed in terms of gold. Any other currency that fixed its price in terms of these two
currencies was also indirectly operating on the gold standard. Trade imbalances,
deflation, hyperinflation, economies facing depression paved way for a new standard
instead of gold.
 Towards the end of World War II 1944 – early 1970s: A Fixed parity system called “The
Bretton Woods” system was introduced by John Keynes and Harry White: adopted by 44
countries replacing the gold standard. There were now fixed parities for exchange rate
between currencies. There would be periodic realignments of currencies to bring them
back to the fixed parity or equilibrium state. Inflation issues, countries not able to

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exercise monetary policy, and excessive capital mobility made countries move to the
floating exchange rate system.

4.1 A Taxonomy of Current Regimes

These regimes span a spectrum. At one end of the spectrum, there are rates which are fixed
against a major currency such as the U.S. dollar/euro and at the other end are free floating
currencies. Flexible exchange rate regimes enjoy the independence of monetary policy while
fixed exchange rate regimes have little or no leeway on monetary policy.

 Arrangements with no separate legal tender

- Dollarization: The country does not have a currency of its own. Instead, it uses
the currency of another country as its medium of exchange and unit of account.
For example: El Salvador, Panama use the U.S. dollar. These countries do not
need to have a monetary policy of their own.
However, it does not mean the dollarized country gets the creditworthiness of the
nation whose currency it adopts. The interest rate on the U.S. dollars in Panama
may be different than it is in the United States.
- Monetary union: The country does not have a currency of its own. Instead, it
participates in a monetary union whose members share the same currency.
For example: European Economic and Monetary Union (EMU) is represented by
the European Central Bank (ECB). 18 members of the European Union use the
euro as their currency. Similar to dollarized countries, the creditworthiness of
each country in the Eurozone may be different as, Greece has a higher credit risk
than Germany, and does not have a monetary policy of its own.
 Currency board system: An explicit legislative commitment to exchange domestic
currency for a specified foreign currency at a fixed exchange rate; it does allow for a
small band.
For example: Hong Kong, where 100% U.S. dollar reserves are held to cover the entire
monetary base, at the fixed parity.
There is an advantage of this method compared to dollarization. The monetary authority
can earn a market rate on its asset, the U.S. dollar reserves in the case of Hong Kong,

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while it pays little or no interest on its liability: the monetary base denominated in HKD.
This profit is called seigniorage.
 Fixed parity: A country pegs its currency within a band of 1% versus another currency.
This regime offers credibility. For example: Saudi Arabia & UAE
It differs from the currency board system in two aspects:
- No legislative commitment to maintain the specified parity
- Level of foreign exchange reserves is discretionary. There is no relationship
between the amount of foreign reserves and the monetary base. The monetary
authority may spend or buy foreign currency to maintain the exchange rate parity
within the band, usually +/- 1%. Within this band, the private flows may
determine the exchange rate.
 Target zone: Like fixed parity, but with wider bands (+/- 2%)
- The slightly wider band gives the monetary authority more flexibility
 Active and passive crawling peg: Currency is pegged against another currency. It is a
fixed rate regime but with the flexibility of the floating rate regime.
- Exchange rate adjusted frequently to keep pace with inflation (passive crawl).
Consider Brazil in the 1980s.
- Exchange rate pre-announced for coming weeks (active crawl). The objective was
to set expectations for inflation in the future.
 Fixed parity with crawling bands
- For example Canada from 1970 to 2001.
- The country may initially fix its rates to a foreign currency with the objective to
tame inflation or set expectation for future inflation.
- Then it may gradually introduce crawling bands around the fixed rate to introduce
more flexibility and scope for monetary policy.
- Allows for a gradual exit strategy from fixed parity
 Managed float or dirty 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

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- The market determines the exchange rate. The monetary authority has the
freedom to independently exercise monetary policy aimed at achieving such
objectives as price stability and full employment.
- Ex: the most commonly traded currencies are free floating such as the U.S. dollar,
yen, euro, Swiss franc, U.K pound. Occasionally, the central bank intervenes.

Exhibit 8 that lists the different types of regimes and currencies is reproduced from the
curriculum:

Exchnage Rate Regimes As of 30 April 2008

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5. Exchange Rates, International Trade, and Capital Flows

Impact of exchange rates and other factors on the trade balance must be mirrored by their impact
on capital flows. This is an important statement. Let us break it down into parts to understand
what it means.

Trade deficit: Consider a country that imports more than it exports. This situation will lead to a
trade deficit as it must borrow from foreigners to pay for the excess it imported. X-M is negative.

Trade surplus: Now consider a country that exports more than it imports. This situation leads to
trade surplus. The country lends the surplus to foreigners or invests it in foreign assets. A trade
surplus reflects an excess of domestic savings over investment spending.

Trade balance is roughly represented by current account. A trade deficit (surplus) must be offset
by a surplus (deficit) capital account.
Equation 5:
𝐗 − 𝐌 = (𝐒 − 𝐈) + (𝐓 − 𝐆)
where
X= exports; M =imports
S = private savings; I = investment in plant and equipment
T = taxes net of transfers: G = government expenditure
Excess saving over investment = S-I ;
Fiscal surplus = T-G
If (S − I) + (T − G) is +ve, it leads to trade surplus
If (S − I) + (T − G) is –ve, it leads to trade deficit

 Capital flows – potential and actual – are the primary determinant of exchange rate
movements in the short-to-intermediate term. If the demand for a particular currency is
high (e.g.: portfolio investments in financial instruments, FDI), then the currency will
strengthen. If the demand for a particular currency is low because of low demand for its
products and services, then the currency will weaken.

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 The impact of exchange rate (when a currency appreciates/depreciates) on trade balance

can be examined using two approaches: the elasticities approach and the absorption
approach.

5.1 Exchange Rates and Trade Balance: The Elasticities Approach

What happens if a country is facing a trade deficit (more imports than exports)? Can the deficit
be reduced and the balance restored through policy changes like currency devaluation?

The elasticity approach helps in answering these questions. It states that the impact of currency
devaluation on trade balance depends on the price elasticity of demand for imports and exports.
The approach assumes that under equilibrium conditions of demand and supply for goods and
services:
 Devaluation (in a fixed exchange system) /depreciation (in a floating exchange system) of
a currency will improve the trade balance, i.e. reduce the trade deficit, under one
condition. This condition is called the Marshall-Lerner condition.
 The Marshall-Lerner condition describes what effect depreciation of the currency will
have on the trade balance for various combinations of export and import demand
elasticities.
- It states that the trade balance will improve with devaluation if the sum of
domestic demand elasticity for imports and foreign demand elasticities for exports
is greater than 1.
- Devaluation will worsen the trade balance if the sum of export and import
demand elasticities is less than 1.
- Devaluation will have no effect if the sum of export and import demand
elasticities is equal to 1.
Equation 6:
Marshall-Lerner condition to reduce trade deficit if currency depreciates:
ωx ∗ εx + ωM ∗ (εM − 1) > 0
where
ωx = amount of exports
ωM = amount of imports

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εx = price elastictity of foreign demand for domestic country exports

εM = price elastictity of domestic country demand for imports
Note: if ε > 1, then demand is elastic; if ε < 1, then demand is inelastic

What happens when the domestic currency depreciates?

 Exports:
- Price of exports decreases. It becomes cheaper for foreign countries to import the
domestic country’s products and services.
- This results in an increase in demand by foreigners for domestic products. This is
represented by εx .
- The assumption is that domestic currency price remains unchanged so there is no
change in domestic revenue.
 Imports:
- The price of imports in domestic currency increases. Import expenditures
increase.
- If the import demand is elastic, i.e. εM > 1, then the quantity of imports
decreases, which in turn, decreases import expenditures.

Let us understand the Marshall-Lerner condition with the help of an example (taken from the
curriculum). Assume Italy is the domestic country (€) and its trading partner is the United States
($). Initially, Italy’s exports are €400 million and imports are €600 million. So, there is a trade
deficit of €200 million. The total trade value is €1 billion.

Assumptions Exports Imports

Demand elasticity 0.75 0.65

Percent price change

In domestic currency (€) 0 10%

In foreign currency -10% 0

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The demand elasticity for exports is 0.75. If you recall from an earlier reading, the price
% change in quantity
elasticity of demand ε = - = 0.75 means quantity demanded by U.S. increases
%change in price

by 7.5% when the price declines by 10% (due to depreciation of currency). Italian products are
cheaper from a U.S. perspective, so the demand by Americans increases.

Italy imports €600 million worth of goods and services from the U.S. The demand elasticity for
imports is 0.65. The quantity demanded by Italians decreases by 6.5% when the price of imports
in euro terms increases by 10%. Importing products become expensive for Italians.

Results Initial value (€) Change (€)

Exports 400,000,000 30,000,000

Imports 600,000,000 21,000,000

Trade balance -200,000,000 9,000,000

Total trade 1,000,000,000 51,000,000

Effect of euro depreciation on exports and imports in euro terms:

Exports:
 No change in euro price for exports.
 Foreign currency prices of exports declines by 10 percent. Quantity of exports increases
by 7.5%. In euro terms, the change is: 0.075 *400,000,000 = €30,000,000
Imports:
 Euro price of foreign imports increases by 10%
 Domestic quantity demand declines by 6.5%. But, it is not sufficient to offset the increase
in the euro price of imports. Import expenditure must rise by (10%-6.5%) = 3.5%. In euro
terms, the change or increase in import expenditure is = (1- ε) ∗ %ΔP = (1-
0.65)*600,000,000= €21,000,000

Trade balance = Exports – Imports = 30,000,000-21,000,000 = €9,000,000. The trade deficit has
reduced by €9,000,000. This indicates that the trade balance is improving. Both exports and
imports went up, but the share of exports increased by much more than that of imports.

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Going back to the Marshall-Lerner condition and plugging in values in equation 6, we get:
ωx ∗ εx + ωM ∗ (εM − 1) = 0.4*0.75+0.6(0.65-1) = 0.09
Since the value is greater than 0, the Marshall-Lerner condition holds true that the trade balance
will reduce when currency depreciates.

Interpretation of 0.09:
 A 1% decrease in euro will improve the trade balance by 0.09%
 A 10% decrease in euro will improve the trade balance by 0.9%
 The impact on trade balance (deficit/surplus) depends on the elasticities of demand for
imports and exports.

5.1.1 Elasticities approach: impact on trade surplus (X-M) under four scenarios

The table below illustrates the four possibilities for the Marshall-Lerner condition (> 0, <0) and
appreciation/depreciation of currency. The effect on the trade balance is shown in each box of
the quadrant. The Italy/U.S. example we saw above is a case of the currency depreciating when
the MLC holds true (>0). The effect is that the trade balance improves.

Marshall-Lerner condition is Marshall-Lerner condition is

positive (>0) negative (<0)

Currency appreciates Trade balance worsens Trade balance improves

Currency depreciates Trade balance improves Trade balance worsens

MLC condition: Currency devaluation will improve trade balance only if εx + εM >1.
The higher the elasticities, the higher the value of 𝛚𝐱 ∗ 𝛆𝐱 + 𝛚𝐌 ∗ (𝛆𝐌 − 𝟏)

In simple terms, the improvement of trade balance depends on the elasticities of demand.

Elasticity of demand depends on four factors:

 Presence or absence of close substitutes

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 Structure of the market for that product. Is that market for the product competitive?
 What percentage of consumer’s expenditure does that good represent
 The nature of the product and its role in the economy – luxury goods, or necessities like
food
Price changes have two effects on demand:
 Substitution effect: When the price of a product decreases (increases), customers demand
more (less) of the same.
 Income effect: When the price of a product decreases (increases), the purchasing power
of people increases (decreases). But, it depends on the nature of the product and what
percentage of their income they are willing to spend on the product. Luxuries are
sensitive to income effect. Necessities are insensitive to income effect.

5.1.2 The J-curve

The J-curve theory suggests that in the short-term, even if the Marshall-Lerner condition holds
good, devaluation (depreciation) of the currency will initially worsen the trade balance before
making it better in the long term. The graph below (reproduced from the curriculum with
markings for A, B, and C) is known as the J-curve.

Trade Balance Dynamics: The J-Curve

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Assume (hypothetically) that this is the J-curve for Greece. Initially, Greece has a trade deficit as
indicated by point A in the diagram. The exchange rate is devalued to improve the trade balance.
As you can see, in the short run represented by point B, trade deficit deteriorates further. It could
be due to two reasons:
 There is a lag before lower export prices lead to increased demand. Assume the
depreciation means Greece’s resorts are available cheaper in foreign currency terms for
tourists. But, it is a while before people are aware and there is an increase in demand. In
the medium to long term, demand picks up and exports increase. However, the price
increase for imports is almost immediate without a lag.
 The J-curve pattern also occurs if price elasticities (MLC condition) is not met in the
short term, but long-term elasticities (B-C in the curve) satisfy it.

5.2 Exchange Rates and Trade Balance: The Absorption Approach

 This is another approach to analyze the impact of devaluation on trade balance.

Elasticities approach can be viewed as a microeconomic view as it focuses on demand
elasticities, while the absorption approach can be viewed as a macroeconomic view.
 Trade surplus (deficit) X - M = (S - I) + (G - T)
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. That is, (S - I) must increase to increase the surplus. Or, G - T represents
government savings which must also increase to move towards surplus.
 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. The excess capacity is shifted to produce goods and
services meant for exports. Spending increases on import substitutes.
 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-

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denominated assets (including the present value of current and future earned income),
and households respond by reducing expenditure and increasing saving.

Summary

Note: This summary has been adapted from the CFA Program curriculum.

Foreign exchange markets are crucial for understanding both the functioning of the global
economy as well as the performance of investment portfolios. In this reading, we have described
the diverse array of FX market participants and have introduced some of the basic concepts
necessary to understand the structure and functions of these markets. The reader should be able
to understand how exchange rates—both spot and forward—are quoted and be able to calculate
cross exchange rates and forward rates. We also have described the array of exchange rate
regimes that characterize foreign exchange markets globally and how these regimes determine
the flexibility of exchange rates, and hence, the degree of foreign exchange rate risk that
international investments are exposed to. Finally, we have discussed how movements in
exchange rates affect international trade flows (imports and exports) and capital flows.

The following points, among others, are made in this reading:

 Measured by average daily turnover, 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 commonly used.
 A direct currency quote takes the domestic currency as the price currency and the foreign
currency as the base currency (i.e.𝑆𝑑 ). An indirect quote uses the domestic currency as the
𝑓

base currency (i.e.𝑆𝑓 ). To convert between direct indirect quotes, the inverse (reciprocal) is
𝑑

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used. Professional FX markets use standardized conventions for how the exchange rate for
specific currency pairs will be quoted.
 Currencies trade in foreign exchange markets based on nominal exchange rates. An increase
(decrease) in the exchange rate, quoted in indirect terms, means that the domestic currency is
appreciating (depreciating) versus the foreign currency.
 The real exchange rate, defined as the nominal exchange rate multiplied by the ratio of price
levels, measures the relative purchasing power of the currencies. An increase in the real
exchange rate (𝑅𝑑 ) implies a reduction in the relative purchasing power of the domestic
𝑓

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. Depending on how the rates are quoted, this may require
inversion of one of the quoted rates.
 Spot exchange rates are for immediate settlement (typically, T + 2), while forward exchange
rates are for settlement at agreed-upon future dates. Forward rates can be used to manage
foreign exchange risk exposures or can be combined with spot transactions to create FX
swaps.
 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. Given the spot exchange rate and the foreign and
domestic interest rates, the forward exchange rate must take the value that prevents riskless
arbitrage.
 Forward rates are typically quoted in terms of forward (or swap) points. The swap points are
added to the spot exchange rate in order to calculate the forward rate. Occasionally, forward
rates are presented in terms of percentages relative to the spot rate.
 The base currency is said to be trading at a forward premium if the forward rate is above the
spot rate (forward points are positive). Conversely, the base currency is said to be trading at a
forward discount if the forward rate is below the spot rate (forward points are negative).
 The currency with the higher (lower) interest rate will trade at a forward discount (premium).
 Swap points are proportional to the spot exchange rate and to the interest rate differential and
approximately proportional to the term of the forward contract.

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 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 as a guide to managing exchange rate exposures. FX markets are too complex and
too intertwined with other global financial markets to be adequately characterized by a single
variable, such as the interest rate differential.
 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. These regimes
range from using another country’s currency (dollarization), to letting the market determine
the exchange rate (independent float). In practice, most regimes fall in between these
extremes. The type of exchange rate regime used varies widely among countries and over
time.
 An ideal currency regime would have three properties: (1) the exchange rate between any
two currencies would be credibly fixed; (2) all currencies would be fully convertible; and (3)
each country would be able to undertake fully independent monetary policy in pursuit of
domestic objectives, such as growth and inflation targets. However, these conditions are
inconsistent. In particular, a fixed exchange rate and unfettered capital flows severely limit a
country’s ability to undertake independent monetary policy. Hence, there cannot be an ideal
currency regime.
 The IMF identifies the following types of regimes: arrangements with no separate legal
tender (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.
 A trade surplus (deficit) must be matched by a corresponding deficit (surplus) in the capital
account. Any factor that affects the trade balance must have an equal and opposite impact on
the capital account, and vice versa.
 A trade surplus reflects an excess of domestic saving (including the government fiscal
balance) over investment spending. A trade deficit indicates that the country invests more
than it saves and must finance the excess by borrowing from foreigners or selling assets to
foreigners.
 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

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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.
 The elasticities approach leads to the Marshall–Lerner condition, which describes
combinations of export and import demand elasticities such that depreciation (appreciation)
of the domestic currency will move the trade balance toward surplus (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.
 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.

Next Steps

 Work through the examples in the curriculum.

 Solve the practice problems in the curriculum.
 Solve the IFT Practice Questions associated with this reading.
 Review the learning outcomes presented in the curriculum. Make sure that you can perform
the implied actions

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