Reading 21: Currency Exchange Rates

Calculate and interpret the forward rate consistent with the spot rate and the interest rate in each currency

The condition that must be met so that there is no arbitrage opportunity available is: Forward/Spot = (1 + I_price_currency)/(1 + I_base_currency) so that the forward = spot x (1 + I_price_currency)/(1+I_base_currency) If the spot exchange rate for the euro is 1.25 USD/EUR, the eur interest rate is 4% per year, and the dollar interest rate is 3% per year, the no-arbitrage one-year forward rate can be calculated as: 1.25 x (1.03/1.04) = 1.238 USD/EUR

Explain the arbitrage relationship between spot rates, forward rates and interest rates

If a forward exchange rate does not correctly reflect the difference between the interest rates for two currencies, an arbitrage opportunity for a riskless profit exists. In this case, borrowing one currency, converting it to the other currency at the spot rate, investing the proceeds for the period, and converting the end-of-period amount back to the borrowed currency at the forward loan rate will produce more than enough to pay off the initial loan, with the remainder being a riskless profit on the arbitrage transaction.

Describe functions of and participants in the foreign exchange market

A market for foreign exchange is the largest financial market in terms of the value of daily transactions and has a variety of participants, including large multinational banks (the sell side) and corporations, investment fund managers, hedge fund managers, and investors, governments, and central banks (the buy side) Participants in the foreign exchange markets are referred to as hedgers if they enter into transactions that decrease an existing foreign exchange risk and as speculators if they enter into transactions that increase their foreign exchange risk.

Define an exchange rate and distinguish between nominal and real exchange rates and spot and forward exchange rates

Currency exchange rates are given as the price of one unit of currency in terms of another. A nominal exchange rate of 1.44 USD/EUR is interpreted as $1.44 per euro. We refer to the USD as the price currency and the EUR as the base currency. A decrease (increase) in a direct exchange rate represents an appreciation (depreciation) of the domestic currency relative to the foreign currency. A spot exchange rate is the rate for immediate delivery. A forward exchange rate is a rate for exchange of currencies at some future date. A real exchange rate measures changes in relative purchasing power over time. real exchange rate (domestic/foreign) = spot exchange (domestic/foreign) x CPI_foreign/CPI_domestic

Explain the effects of exchange rates on countries' international trade and capital flows

Elasticities of export and import demand must meet the Marshall-Lerner condition for a depreciation of the domestic currency to reduce an existing trade deficit: WxeX + Wi(eI - 1) > 0 Under the absorption approach, national income must increase relative to national expenditure in order to decrease a trade deficit. This can also be viewed as a requirement that national saving must increase relative to domestic investment in order to decrease a trade deficit.

Describe exchange rate regimes

Exchange rate regimes for countries that do not have their own currency: 1) With formal dollarization, a country uses the currency of another country 2)In a monetary union, several countries use a common currency Exchange rate regimes for countries that have their own currency: 1) A currency board arrangement is an explicit commitment to exchange domestic currency for a specified foreign currency at a fixed exchange rate 2) In a conventional fixed peg arrangement, a country pegs its currency within margins of +-1% versus another currency 3) In a system of pegged exchange rates within horizontal bands or a target zone, the permitted fluctuations in currency value relative to another currency or basket of currencies are wider (e.g. 2%) 3) With a crawling peg, the exchange rate is adjusted periodically, typically to adjust for higher inflation versus the currency used in the peg 4) With management of exchange rates within crawling bands, the width of the bands that identify permissle exchange rates is increased over time 5) With a system of managed floating exchange rates, the monetary authority attempts to influence the exchange rate in response to specific indicators such as the balance of payments, inflation rates, or employment 6) When a currency is independently floating, the exchange rate is market-determined

Calculate and interpret the percentage change in currency relative to another currency

For a change in an exchange rate, we can calculate the percentage appreciation (price goes up) or depreciation (price goes down) of the base currency. For example, a decrease in the USD/EUR exchange rate from 1.44 to 1.42 represents a depreciation of the EUR relative to the USD of 1.39% (1.42/1.44 -1= -.0139) because the price of a euro has fallen 1.39%. To calculate the appreciation or depreciation of the price currency, we first invert the quote so it is now the base currency and then proceed as above. For example, a decrease in the USD/EUR exchange rate from 1.44 to 1.42 represents an appreciation of the USD relative to the EUR of 1.41%: (1/1.42)/(1/1.42)-1=1.44/1.42 - 1 = .0141 The appreciation is the inverse of the depreciation, 1/(1-.0139) - 1= .0141

Calculate and interpret currency cross-rates

Given two exchange rate quotes for three different currencies, we can calculate a currency cross rate. If the MXN/USD quote is 12.1 and the USD/EUR quote is 1.42, we can calculate the cross rate of MXN/EUR as 12.1 x 1.42 = 17.18

Convert forward quotations expressed on a points basis or in percentage terms into an outright forward quotation

Points in a foreign currency quotation are in units of the last digit of the quotation. For example, a forward quote of +25.3 when the USD/EUR spot exchange is 1.41158 means that forward exchange rate is 1.4158 + .00253 = 1.41833 USD/EUR For a forward exchange rate quote given as a percentage, the percentage (change in the spot rate) is calculated as forward / spot -1. A forward exchange rate quote of +1.787%, when the spot USD/EUR exchange rate is 1.4158, means that the forward exchange rate is 1.4158 (1 + .01787) = 1.4411 USD/EUR.

Calculate and interpret a forward discount or premium

To calculate a forward premium or forward discount for Currency B using exchange rates quoted as units of Currency A per unit of Currency B, use the following formula: (forward/spot) - 1