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 worlds largest market.
- The FX market facilitates world trade.
- The FX participants buy and sell currencies needed for trade, but also
transact to reduce risk (hedge) and speculate on currency exchange rates.
An exchange rate is the price of a countrys currency in terms of another
countrys currency.

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 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:
INR/USD = 66.9100
This means that one US dollar will
buy 66.91 Indian rupees.
If this exchange rate falls to 65, the
dollar will buy fewer Indian rupees.
In other words,
- The US dollar is depreciating
relative to the rupee or
- The rupee is appreciating relative
to the US dollar

Important note : There are many different conventions that are used around
the world, but this presentation is using the conventions displayed by the
authors in the chapters examples.

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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:
/
Real exchange rate/ = = /

where
/ is the nominal or spot exchange rate and

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
FX and
Governments Exchange- currency
traded swaps, 44%
Central banks derivatives, 4%

Sovereign wealth funds

OTC forwards,
12%

FX options and
other, 4%

Spot, 36%

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 3. CURRENCY EXCHANGE
RATE QUOTES
A direct currency quote uses Example
the domestic currency as the Consider the quote BRL/USD = 3.1912.
price currency and the foreign
- The base currency is the US dollar
currency as the base currency. (USD).
An indirect currency quote - The price currency is the Brazilian real
uses the domestic currency as (BRL).
the base currency and the - BRL/USD is a direct currency quote
foreign currency as the price from the Brazilian perspective.
currency.
- BRL/USD is an indirect currency quote
from the US perspective.
From the Brazilian perspective, we can
convert the BRL/USD into indirect quote of
USD/BRL by inverting:
1
USD/BRL = 3.1912 = 0.3134

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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].

Actual Ratio
FX Rate Quote Name
(Price currency/Base
Convention Convention
currency)
EUR euro USD/EUR
JPY dollaryen JPY/USD
GBP sterling 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 Example:
with respect to the base Suppose CZK/USD is 24.20 and increases to
currency relative to the price 24.40.
currency. The percentage change is
24.4000
Appreciation is a gain in 1 = 0.8264%
24.2000
value of one currency relative
to another currency. This means that the US dollar (USD), the
base currency in the quote, has appreciated
Depreciation is the loss in 0.8264% against the Czech koruna.
value of one currency relative - It takes fewer US dollars to buy each
to another currency. koruna.
The percentage change is the This also means that the Czech koruna (invert
ratio of the exchange rates the rate and treat CZK as the base currency)
minus one: depreciated by
1


24.40 1 = 0.04098 1 = 0.8228%
% change = 1 1 0.04132

24.20
relative to the US dollar.

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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:
DKK/USD = 6.6630 USD/AUD = 0.7685
What is the DKK/AUD exchange rate?
DKK USD DKK
= = 6.6630 0.7685 = 5.1205
USD AUD AUD
Example 2: Suppose you have the following quotes:
ILS/USD = 3.8105 NOK/USD = 8.2210
What is the ILS/NOK exchange rate?
ILS USD ILS 1
= = 3.8105 8.2210 = 0.4635
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
1.1200 and that the one-month forward
premium is 47 pips. Therefore, the forward
rate is
Forward rate = 1.1200 + 4710,000
= 1.1200 + 0.0047
= 1.1247
Example: Using a percentage
Suppose that the spot rate of MXN/USD is
18.1000 and that the one-month forward
premium as a percentage of the spot rate is
0.4%. The one-month forward rate is
Forward rate = 18.1000 x 1.0040
= 18.1724
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 FORWARD DISCOUNTS AND PREMIUMS
Consider the relationship between Example
forward and spot rates:
Suppose that the AUD/USD spot rate
= is 1.3012 and that the one-month
1 + forward rate 1.2985.
where
Therefore,
= Forward rate
= 1.2985,
= Spot rate
= 1.3012, and
= Domestic interest rate
= 30/360.
= Foreign interest rate
There is a forward discount of
= Time (in years)
This means that any premium or 1.2985 1.3012 = 0.0027
discount is a function of the interest or 27 pips, so < .
rates (domestic, , and foreign, )
and time, .

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 CALCULATING FORWARD RATES

Using = 1+
,

we can calculate a forward rate based on , , ,and .

Example:
Suppose we have the spot exchange rate of the CAD/USD of 1.2923. If the
one-year T-bill interest rate in the United States is 0.55% and the Canadian
one-year Treasury rate is 0.95%, what is the one-year forward rate?

= +
1 +
0.0095 0.0055
= 1.2923 + 1.2923 1 = 1.2923 + 0.0051 = 1.2974
1 + 0.0055 x 1
The estimated forward rate is 1.2974, representing a forward rate premium of
1.2974 1.2923 = 51 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 able to undertake independent monetary policy for domestic
objectives.

Exchange rate regime choices:

Independently
Fixed Exchange
Pegged System Floating Rate
Rate Regime
Regime

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 EXCHANGE RATE REGIMES
Regime Type Description
No separate legal Fixed Dollarization: Use another nations currency as the
tender medium of exchange (USD).
Shared currency Fixed Monetary union: Use a currency of a group of
countries as the medium of exchange.
Currency board Fixed Use another currency in reserve as the monetary
system base, maintaining a fixed parity.
Fixed parity or fixed Fixed Use another currency or basket of currencies in
rate system reserve, but with some discretion (parity bands).
Target zone Fixed Fixed parity (peg) with fixed horizontal intervention
bands.

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 EXCHANGE RATE REGIMES
Regime Type Description
Active and passive Peg Adjust the exchange rate against a single
crawling pegs currency, with adjustments for inflation (passive)
or announced in advance (active).
Fixed parity with Peg Similar to target zone, but bands can be widened.
crawling bands
Managed float Float Allow exchange rate to float, but intervene to
manage it toward targets.
Independently Float Exchange rate is market determined (supply and
floating rates demand).

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 5. EXCHANGE RATES, INTERNATIONAL TRADE,
AND CAPITAL FLOWS
The net effect of imports and exports affects a countrys 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:
XM = (S I) + (T G)

Exports less imports Savings less Taxes less government
investment spending

Trade surplus or deficit 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. MarshallLerner 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 trade balance
- If the demand for exports and imports is price inelastic, trade is less
responsive to devaluation or depreciation.
2. The Absorption Approach
- Devaluation or depreciation of the exchange rate must decrease expenditure
relative to income to improve the trade balance.
- This affects national income through the wealth effect: reduced purchasing
power of domestic-currency-denominated assets leads to lower expenditure
and increased saving.

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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 pairsA/B and A/Cwe 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 (or subtracted from) 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 MarshallLerner 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 MarshallLerner 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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