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CHAPTER 9
CURRENCY EXCHANGE RATES
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1. INTRODUCTION
The foreign exchange (FX) market is the market for trading currencies against
each other.
- The FX market is the world’s largest market.
- The FX market facilitates world trade.
- The FX participants buy and sell currencies needed for trade, but also
transact to hedge and speculate on currency exchange rates.
• An exchange rate is the price of a country’s currency in terms of another
country’s currency.
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2. THE FOREIGN EXCHANGE MARKET
• Currencies are referred to by their
ISO code (e.g., USD, CHF, EUR).
Example:
• Exchange rate: The number of
units of one currency (the price
currency) that one unit of another
(the base currency) will buy.
• This means that one Indian rupee
will buy 61.965 US dollars.
• Convention for exchange rate:
A/B = Number of units of A that one
unit of B will buy.
A = Price currency
B = Base currency
USD/INR = 61.965
• If this exchange rate falls to 60.5,
the rupee will buy fewer US dollars.
That means that it will take fewer US
dollars to buy a rupee. In other
words,
- The rupee is depreciating relative
to the US dollar or
- The US dollar is appreciating
relative to the rupee.
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REAL EXCHANGE RATES
• A real exchange rate is an exchange rate that has been adjusted for the
relative purchasing power of the two currencies’ home countries.
- Quoted exchange rates are nominal exchange rates.
- We calculate a real exchange rate by adjusting the exchange rates for the
relative price levels of the countries in the pair.
• The real exchange rate, using AUD and USD, is the spot rate adjusted for the
relative price levels:
𝑆𝐴𝑈𝐷/𝑈𝑆𝐷 × 𝑃𝑈𝑆𝐷
𝑃𝑈𝑆𝐷
Real exchange rate𝐴𝑈𝐷/𝑈𝑆𝐷 =
= 𝑆𝐴𝑈𝐷/𝑈𝑆𝐷 ×
𝑃𝐴𝑈𝐷
𝑃𝐴𝑈𝐷
where
𝑆𝐴𝑈𝐷/𝑈𝑆𝐷 is the nominal or spot exchange rate and
𝑃𝑈𝑆𝐷
𝑃𝐴𝑈𝐷
is the relative price level.
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SPOT AND FORWARD RATES
• A spot exchange rate is an exchange rate for an immediate delivery (that is,
exchange) of currencies.
• A forward exchange rate is an exchange rate for the exchange of currencies
at some specified, future point in time.
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THE FX MARKET
PARTICIPANTS AND PURPOSES
• Companies and individuals
transact for the purpose of the
international trade of goods and
services.
• Capital market participants transact
for the purpose of moving funds into
or out of foreign assets.
• Hedgers, who have an exposure to
exchange rate risk, enter into
positions to reduce this risk.
• Speculators participate to profit
from future movements in foreign
exchange.
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TYPES OF FX PRODUCTS
• Currencies for immediate delivery
(spot market).
• Forward contracts, which are
agreements for a future exchange
at a specified exchange rate.
• FX swaps, which are a
combination of a spot contract and
a forward contract, used to roll
forward a position in a forward
contract.
• FX options, which are options to
enter into an FX contract some
time in the future at a specified
exchange rate.
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FX PARTICIPANTS
BUY SIDE
SELL SIDE
• Corporations
• Large dealing banks
• Real money accounts
• Other financial institutions
• Leverage accounts
Exhibit 9-3
FX Turnover by Instrument
• Retail accounts
• Governments
• Central banks
• Sovereign wealth funds
Exchangetraded
derivatives, 4%
FX and
currency
swaps, 44%
OTC forwards,
12%
FX options and
other, 4%
Spot, 36%
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3. CURRENCY EXCHANGE
RATE CALCULATIONS
• A direct currency quote uses
the domestic currency as the
price currency and the foreign
currency as the base currency.
• An indirect currency quote
uses the domestic currency as
the base currency and the
foreign currency as the price
currency.
Example
Consider the quote USD/BRL = 2.3638.
- The base currency is the Brazilian real
(BRL).
- The price currency is the US dollar
(USD).
- USD/BRL is a direct currency quote
from the US perspective.
- USD/BRL is an indirect currency quote
from the Brazilian perspective.
From the Brazilian perspective, we can
convert the USD/BRL into the direct quote
of BRL/USD by inverting:
1
BRL/USD =
= 0.4230
2.3638
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IN PRACTICE
• There are a number of conventions, which simply refer to a particular
exchange rate [see Exhibit 9-6 for a more comprehensive list].
FX Rate Quote
Convention
Name
Convention
EUR
JPY
GBP
euro
dollar–yen
sterling
Actual Ratio
(Price currency/Base
currency)
USD/EUR
JPY/USD
USD/GBP
• Dealers will quote a bid (at which the dealer will buy) and an offer price (at
which the dealer will sell). [Note: bid < offer]
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APPRECIATING OR DEPRECIATING
Appreciation or depreciation is
with respect to the base
currency relative to the price
currency.
• Appreciation is a gain in
value of one currency relative
to another currency.
• Depreciation is the loss in
value of one currency relative
to another currency.
The percentage change is the
ratio of the exchange rates
minus one:
𝐴
% change =
𝐴
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𝐵 𝑁𝑒𝑤
𝐵 𝑂𝑙𝑑
−1
Example:
Suppose USD/CZK is 20.2000 and increases
to 20.3258.
• The percentage change is
20.3258
− 1 = 0.6228%
20.2000
• This means that the Czech koruna (CZK)
appreciated 0.6228% against the US dollar.
- It takes more US dollars to buy each
koruna.
• This also means that the US dollar
depreciated by
1
20.3258 − 1 = 0.0492 − 1 = −0.0061%
1
0.0495
20.2000
relative to the Czech koruna.
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CURRENCY CROSS-RATES
Given three currencies, a currency cross-rate is the implied exchange rate
of a third country pair given the exchange rates of two pairs of three
currencies that have a common currency.
• If arbitrage is possible, cross-rates will be consistent.
Example 1: Suppose you have the following quotes:
AUD/USD = 0.8812
USD/DKK = 5.5027
What is the AUD/DKK exchange rate?
AUD USD AUD
×
=
= 0.8812 × 5.5027 = 4.8490
USD
DKK DKK
Example 2: Suppose you have the following quotes:
ILS/USD = 3.4885
NOK/USD = 6.1706
What is the ILS/NOK exchange rate?
ILS
USD
ILS
1
×
=
= 3.4885 ×
= 0.5589
6.1706
USD NOK NOK
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FORWARD RATE QUOTATIONS
• Forward exchange rates are
quoted in terms of points (pips:
points in percentage).
If forward rate > spot rate,
the base currency is trading at a
forward premium.
If forward rate < spot rate,
the base currency is trading at a
forward discount.
• Points are 1:10,000 (move the
decimal place four places).
• Forward quotes can be specified
as the number of pips from the
spot rate or as a percentage of
the spot rate.
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Example: Using pips
Suppose that the USD/EUR spot rate is
1.3559 and that the one-month forward is
1.47 pips. Therefore, the forward rate is
Forward rate = 1.3559 + 1.47 10,000
= 1.3559 + 0.000147
= 1.356047
Example: Using a percentage
Suppose that the spot rate of USD/CHF is
0.9105 and that the one-month forward
points as a percentage of the spot rate is
0.02%. The one-month forward rate is
Forward rate = 0.9105 x 1.0002
= 0.9106821
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FORWARD DISCOUNTS AND PREMIUMS
Consider the relationship between
forward and spot rates:
𝑖𝑓 − 𝑖𝑑
𝐹𝑓 𝑑 − 𝑆𝑓 𝑑 = 𝑆𝑓 𝑑
τ
1 + 𝑖𝑑 τ
where
𝐹𝑓
𝑑
= Forward rate
𝑆𝑓
𝑑
= Spot rate
𝑖𝑑 = Domestic interest rate
𝑖𝑓 = Foreign interest rate
τ = Time (in years)
This means that any premium or
discount is a function of the interest
rates (domestic, 𝑖𝑑 , and foreign, 𝑖𝑓 )
and time, τ.
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Example
Suppose that the AUD/USD spot rate
is 0.8808 and that the one-month
forward rate is 0.8789.
Therefore,
• 𝐹𝑓
𝑑
= 0.8789,
• 𝑆𝑓
𝑑
= 0.8808, and
• τ = 30/360.
There is a forward discount of
0.8808 – 0.8789 = – 0.0019
or 19 pips, so 𝑖𝑓 < 𝑖𝑑 .
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CALCULATING FORWARD RATES
Using 𝐹𝑓
𝑑
− 𝑆𝑓
𝑑
= 𝑆𝑓
𝑖𝑓 − 𝑖𝑑
𝑑
1+𝑖𝑑 τ
τ,
we can calculate a forward rate based on 𝑆𝑓 𝑑 , 𝑖𝑓 , 𝑖𝑑 ,and τ.
Example:
Suppose we have the spot exchange rate of the CAD/USD of 1.0969. If the
one-year T-bill interest rate in the United States is 0.109% and the Canadian
one-year Treasury rate is 0.95%, what is the one-year forward rate?
𝑖𝑓 − 𝑖𝑑
𝐹𝑓 𝑑 = 𝑆𝑓 𝑑 + 𝑆𝑓 𝑑
τ
1 + 𝑖𝑑 τ
𝐹𝑓
𝑑
= 1.0969 + 1.0969
0.0095 − 0.00109
1 = 1.0969 + 0.0092 = 1.1061
1 + 0.00109
The estimated forward rate is 1.1061, which means that the forward rate
should be trading at a premium of 1.1061 – 1.0969 = 92 pips.
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4. EXCHANGE RATE REGIMES
• An exchange rate regime is the policy framework for foreign exchange.
• The ideal currency regime (which does not exist) would consist of the following
circumstances:
1. Exchange rate is credible and fixed.
2. All currencies are fully convertible.
3. All countries undertake independent monetary policy for domestic
objectives.
Fixed
Exchange
Rate Regime
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Pegged
System
Independently
Floating Rate
Regime
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EXCHANGE RATE REGIMES
Regime
Type
No separate legal
tender
Fixed Dollarization: Use another nation’s currency as the
medium of exchange (USD).
Shared currency
Fixed Monetary union: Use a currency of a group of
countries as the medium of exchange.
Currency board
system
Fixed Use another currency in reserve as the monetary
base, maintaining a fixed parity.
Fixed parity or fixed
rate system
Fixed Use another currency or basket of currencies in
reserve, but with some discretion (parity bands).
Target zone
Fixed Fixed parity (peg) with fixed horizontal intervention
bands.
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Description
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EXCHANGE RATE REGIMES
Regime
Type
Description
Active and passive
crawling pegs
Peg
Adjust the exchange rate against a single
currency, with adjustments for inflation (passive)
or announced in advance (active).
Fixed parity with
crawling bands
Peg
Similar to target zone, but bands can be widened.
Managed float
Float
Allow exchange rate to float, but intervene to
manage it toward targets.
Independently
floating rates
Float
Exchange rate is market determined (supply and
demand).
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5. EXCHANGE RATES, INTERNATIONAL TRADE,
AND CAPITAL FLOWS
• The net effect of imports and exports affects a country’s capital flows:
Trade deficit
→
Capital account surplus
Trade surplus
→
Capital account deficit
• Using the national accounts relationship, we see the relationship between
trade and expenditures/savings and taxes/government spending:
X–M
↑
Exports less imports
↑
Trade surplus or deficit
=
(S – I)
↑
Savings less
investment
+
(T – G)
↑
Taxes less government
spending
↑
Fiscal surplus or deficit
• The potential flow of financial capital in or out of a country is mitigated by
changes in asset prices and exchange rates.
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EXCHANGE RATES AND TRADE
There are two theories on the exchange rate/trade relationship:
1. Marshall–Lerner theory
- The effectiveness of currency devaluations or depreciation on trade depends
on the price sensitivities (that is, price elasticities) of the goods and services.
- If the goods and services are highly elastic, trade responds to devaluation or
depreciation, improving the domestic economy.
- If the goods and services are inelastic, trade is less responsive to
devaluation or depreciation.
2. The Absorption Approach
- If there is devaluation or depreciation, this change in the exchange rate must
increase income relative to expenditures to improve the economy.
- This affects national income through the wealth effect: more savings and
buying financial assets from foreigners.
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CONCLUSIONS AND SUMMARY
• The foreign exchange market is by far the largest financial market in the world.
It has important effects, either directly or indirectly, on the pricing and flows in
all other financial markets.
- There is a wide diversity of global FX market participants that have a wide
variety of motives for entering into foreign exchange transactions.
• Individual currencies are usually referred to by standardized three-character
codes. These currency codes can also be used to define exchange rates (the
price of one currency in terms of another). There are a variety of exchange rate
quoting conventions.
- A direct currency quote takes the domestic currency as the price currency
and the foreign currency as the base currency.
- An indirect quote uses the domestic currency as the base currency.
- To convert between direct and indirect quotes, invert the quote.
- FX markets use standardized conventions for quoting exchange rate for
specific currency pairs.
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CONCLUSIONS AND SUMMARY
• Currencies trade in foreign exchange markets based on nominal exchange
rates. An increase in the exchange rate, quoted in indirect terms, means that
the domestic currency is appreciating versus the foreign currency.
• The real exchange rate measures the relative purchasing power of the
currencies. An increase in the real exchange rate implies a reduction in the
relative purchasing power of the domestic currency.
• Given exchange rates for two currency pairs—A/B and A/C—we can compute
the cross-rate (B/C) between currencies B and C.
• Spot exchange rates are for immediate settlement (typically, T + 2), whereas
forward exchange rates are for settlement at agreed-on future dates.
• Forward rates can be used to manage foreign exchange risk exposures or can
be combined with spot transactions to create FX swaps.
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CONCLUSIONS AND SUMMARY
• The spot exchange rate, the forward exchange rate, and the domestic and
foreign interest rates must jointly satisfy an arbitrage relationship that equates
the investment return on two alternative but equivalent investments.
• Forward rates are typically quoted in terms of forward points. The points are
added to the spot exchange rate to calculate the forward rate.
• The base currency is said to be trading at a forward premium if the forward rate
is higher than the spot rate (that is, forward points are positive). Conversely,
the base currency is said to be trading at a forward discount if the forward rate
is less than the spot rate (that is, forward points are negative).
• The currency with the higher interest rate will trade at a forward discount.
• Points are proportional to the spot exchange rate and to the interest rate
differential and approximately proportional to the term of the forward contract.
• Empirical studies suggest that forward exchange rates may be unbiased
predictors of future spot rates, but the margin of error on such forecasts is too
large for them to be used in practice.
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CONCLUSIONS AND SUMMARY
• Virtually every exchange rate is managed to some degree by central banks.
The policy framework that each central bank adopts is called an “exchange
rate regime.”
• An ideal currency regime would have three properties:
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.
• The IMF identifies the following types of regimes: dollarization, monetary union,
currency board, fixed parity, target zone, crawling peg, crawling band,
managed float, and independent float.
- Most major currencies traded in FX markets are freely floating, albeit subject
to occasional central bank intervention.
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CONCLUSIONS AND SUMMARY
• Any factor that affects the trade balance must have an equal and opposite
impact on the capital account, and vice versa.
• The impact of the exchange rate on trade and capital flows can be analyzed
from two perspectives.
1. The elasticities approach focuses on the effect of changing the relative
price of domestic and foreign goods. This approach highlights changes in
the composition of spending.
2. The absorption approach focuses on the impact of exchange rates on
aggregate expenditure/saving decisions.
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CONCLUSIONS AND SUMMARY
• The elasticities approach leads to the Marshall–Lerner condition, which
describes combinations of export and import demand elasticities such that
depreciation of the domestic currency will move the trade balance toward
surplus and appreciation will lead toward a trade deficit.
• The idea underlying the Marshall–Lerner condition is that demand for imports
and exports must be sufficiently price sensitive so that an increase in the
relative price of imports increases the difference between export receipts and
import expenditures.
- If there is excess capacity in the economy, then currency depreciation can
increase output/income by switching demand toward domestically produced
goods and services.
- If the economy is at full employment, then currency depreciation must reduce
domestic expenditure to improve the trade balance.
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