CHAPTER 9 CURRENCY EXCHANGE RATES Presenter’s name Presenter’s title dd Month yyyy

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. Copyright © 2014 CFA Institute 2

2. THE FOREIGN EXCHANGE MARKET Currencies are referred to by their ISO code (e.g., USD, CHF, EUR). Exchange rate: The number of units of one currency (the price currency) that one unit of another (the base currency) will buy. Convention for exchange rate: A/B = Number of units of A that one unit of B will buy. A = Price currency B = Base currency Example: USD/INR = This means that one Indian rupee will buy US dollars. 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. Copyright © 2014 CFA Institute 3

REAL EXCHANGE RATES Copyright © 2014 CFA Institute 4

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. Copyright © 2014 CFA Institute 5

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. 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. Copyright © 2014 CFA Institute 6

FX PARTICIPANTS BUY SIDE Corporations Real money accounts Leverage accounts Retail accounts Governments Central banks Sovereign wealth funds SELL SIDE Large dealing banks Other financial institutions Copyright © 2014 CFA Institute 7

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. Copyright © 2014 CFA Institute 8

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]. Dealers will quote a bid (at which the dealer will buy) and an offer price (at which the dealer will sell). [Note: bid < offer] Copyright © 2014 CFA Institute 9 FX Rate Quote Convention Name Convention Actual Ratio (Price currency/Base currency) EUReuroUSD/EUR JPYdollar–yenJPY/USD GBPsterlingUSD/GBP

APPRECIATING OR DEPRECIATING Copyright © 2014 CFA Institute 10

CURRENCY CROSS-RATES Copyright © 2014 CFA Institute 11 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.

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. Copyright © 2014 CFA Institute 12

FORWARD DISCOUNTS AND PREMIUMS Copyright © 2014 CFA Institute 13

CALCULATING FORWARD RATES Copyright © 2014 CFA Institute 14

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. Copyright © 2014 CFA Institute 15 Independently Floating Rate Regime Pegged System Fixed Exchange Rate Regime

EXCHANGE RATE REGIMES RegimeTypeDescription No separate legal tender FixedDollarization: Use another nation’s currency as the medium of exchange (USD). Shared currencyFixedMonetary union: Use a currency of a group of countries as the medium of exchange. Currency board system FixedUse another currency in reserve as the monetary base, maintaining a fixed parity. Fixed parity or fixed rate system FixedUse another currency or basket of currencies in reserve, but with some discretion (parity bands). Target zoneFixedFixed parity (peg) with fixed horizontal intervention bands. Copyright © 2014 CFA Institute 16

EXCHANGE RATE REGIMES Copyright © 2014 CFA Institute 17 RegimeTypeDescription Active and passive crawling pegs PegAdjust the exchange rate against a single currency, with adjustments for inflation (passive) or announced in advance (active). Fixed parity with crawling bands PegSimilar to target zone, but bands can be widened. Managed floatFloatAllow exchange rate to float, but intervene to manage it toward targets. Independently floating rates FloatExchange rate is market determined (supply and demand).

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: The potential flow of financial capital in or out of a country is mitigated by changes in asset prices and exchange rates. Copyright © 2014 CFA Institute 18 X – M=(S – I)+(T – G) ↑ Exports less imports ↑ Savings less investment ↑ Taxes less government spending ↑ Trade surplus or deficit ↑ Fiscal surplus or deficit

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. Copyright © 2014 CFA Institute 19

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. Copyright © 2014 CFA Institute 20

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. Copyright © 2014 CFA Institute 21

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. Copyright © 2014 CFA Institute 22

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. Copyright © 2014 CFA Institute 23

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. Copyright © 2014 CFA Institute 24

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. Copyright © 2014 CFA Institute 25