2015, Study Session # 6, Reading # 21

CURRENCY EXCHANGE RATES

LOS 21.a
Exchange rate: The price or cost of one currency (DC or FC) in terms of another (FC or DC)
e.g.
DC/FC = Domestic currency per unit of foreign currency
$ 2.510/ = 2.510 Dollars per one unit of pound.
Nominal Exchange Rate: $2.510/ means one pound unit can purchase 2.510 units of U.S. dollars.
Real Exchange: It shows the dollar cost of purchasing same unit of goods/services based on
relative price levels among two countries & the current dollar/pound exchange rate.
Real exchange rate (d/f) = nominal exchange rate (d/f)
All else constant:
() CPIFC () real exchange rate (DC/FC)
() CPIDC () real exchange rate
() nominal exchange rate () real exchange rate
Spot exchange rate: The exchange rate for immediate delivery
Forward exchange rate: The exchange rate for delivery sometime in future.

LOS 21.b

Foreign Exchange Market

Functions
Facilitate companies & individuals
that purchase or sell goods/services
denominated in foreign currencies
Currency risk can be reduced or
eliminated through forward currency
contracts.

Participants in foreign exchange market

Large multinational banks are primary
dealers & originators of forward contracts
Buyers include:
i) Corporations
ii) Investment accounts
a) Real money accounts: refer to accounts
managed mutual funds, insurance
companies and other institutional
investors that dont use derivatives
b) Leverage accounts: they refer to the
professional trading community that do
use derivatives.
iii) Governments & Government entities
iv) Retail accounts
Central banks

LOS 21.c
i) Direct Quote:

Base Currency: The currency which is represented by

one unit
Price currency: The currency represented by more or
less than one unit is called price currency.

ii) Indirect Quote:

Indirect Quote =

"# $% #

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2015, Study Session # 6, Reading # 21

LOS 21.d
For Direct Quote:
% Exchange rate =

34
54

3
5

If, % >0; FC appreciated

% <0; FC depreciated.

LOS 21.e
Cross rate:
Its the exchange rate between two
currencies derived from a third
common currency.

9:!

LOS 21.f.g

;<=
9:!

;<=

Forward exchange rate is quoted in two ways

i) Unit of points:
Its the last decimal place in the spot
exchange rate quote.
For example:
+10.2

?.A

?,???

= 0.00102

Note:
If Forward rate > Spot rate, is
trading at a forward premium
If Forward rate < Spot rate, is
trading at a forward discount

ii) Percentage terms:

Continuing with our example;
Forward premium =

?.?? ?A
E.FG

100

= 0.0286%
or 0.029%

Suppose,
S0 =3.561 USD/
Forward rate = 3.561 + 0.00102
= 3.56202 USD/

LOS 21.h
Interest rate parity (for DC/FC):
H

IJ K

LM #

N OPQRSTU

N VPWRXYSZ

forward = spot [

N OPQRSTU

N VPWRXYSZ

If,
Market forward rate spot rate [

N OPQRSTU

N VPWRXYSZ

Arbitrage is possible

LOS 21.i

Exchange Rate Regimes

Countries That Dont Have Their Own Currency:

i. Use currency of another country as its own (formal
dollarization).
ii. Use of a common currency (Participating in a
monetary union)

Countries That Have Their Own Currency:

i. Currency board arrangement
ii. Conventional fixed peg arrangement
iii. Crawling peg (active and passive)
iv. Management of fixed exchange rate with crawling
bands
v. Managed floating exchange rates.
vi. Independently floating rates

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2015, Study Session # 6, Reading # 21

LOS 21.j
Exports Imports = (Private Savings Investment in physical capital) + (Tax
revenue govt. spending)
X M = (S I) + (T G)
Trade surplus (X > M) must be reflected in a fiscal surplus (T > G), an excess
savings (S > I) or both.

LOS 21.j
Elasticities Approach:
^_`abcd
] =
^_`abcd + fg`abcd
fg`abcd
]< =
^_`abcd + fg`abcd
Marshall Lerner condition where depreciation of DC Trade deficit (X
M)
WX EX + WI (EI 1) >0

The J-Curve:
Short-term in deficit followed by when Marshall-Lerner condition is met is
referred to as the J-Curve

Absorption Approach:
Focuses on capital account & can be represented by:
BT = Y E
Where,
BT: Balance of Trade
Y: National Income
E: Domestic expenditure

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